Bank Recapitalization and the Information Value of a Stress Test in a Crisis

During the recent financial crisis, uncertainties about banks' solvency paralyzed financial markets and persuaded regulators to reveal an unprecedented amount of information about banks. We examine the trade-off faced by a welfare-maximizing regulator who can choose whether to disclose banks' capital shortfall in crisis times. Disclosure forces banks to reduce their risk of default, but leads them to downsize unless the regulator is able to recapitalize the banks that do not replenish their shortfall. We show that a regulator who cannot recapitalize banks will prefer less information to be disclosed if the costs of downsizing are greater than expected default costs. In the opposite case, or in case the regulator is able to recapitalize banks, we demonstrate that banks' capital shortfall will be fully revealed. Our model explains why the market's reaction to stress tests was favorable in the U.S. and negligible in Europe. Our results also have implications for bank regulation. Among them, we highlight that recapitalizing banks through the European Stability Mechanism would make bank stress tests more effective in Europe.