The Impact of Regulatory Stress Testing on Systemic Risk in Northern and Western European Banks

Abstract

This paper is the first to investigate the impact of regulatory stress testing on systemic risk in Northern and Western European banks. To measure systemic risk, we use average pairwise correlation (APC) of equity returns and cosine similarity of income and loan portfolios. We find that the stress tests implemented by the European Banking Authority (EBA) significantly increases systemic risk among stress tested banks. However, this effect is less pronounced than in comparable US studies. This difference could be explained by a more transparent stress test design in the US, marked by more datapoints, pass/fail criteria, and more stringent consequences for failing banks.