Regulatory bank stress test results: Do scenario characteristics and time horizons affect the market valuation of bank default risk?

This paper is the first to analyze the impact of the results of the different regulatory bank stress test exercise scenarios and time horizons on the market's valuation of bank default risk. Using the 2014, 2016 and 2018 EU-wide stress tests and the full-term structure of the tested bank CDS spreads, we empirically investigate whether the outcomes of the different scenarios provide new information to market participants. During the calm period of the study, we find that the results of the scenario based on the most likely economic forecasts (baseline) are those considered by market participants rather than those of the extreme and harmful (adverse) scenario, regardless of the time horizon. The increase in the required risk premium is greater for short-and medium-term CDS than for long-term ones. Moreover, the stressed determinants of bank default risk are the usual ones, with the notable exception of Core Tier 1, which is not significant Our findings have some policy implications for bank supervisors in the design and implementation of prudential regulation.