Background: In response to the financial crisis of 2008, the central banks improved stress testing, as a methodology to assess the resilience of banks. The main objectives of stress testing are: (i) preventing the undercapitalization of the banking sector; (ii) valuating the bank’s loss absorbing capacity; (iii) identifying vulnerabilities in bank’s risk management strategies; (iv) providing valuable information to regulators and, at the same time, (v) increasing confidence, predictability and security in financial markets.
Data/Methods: We use an augmented capital asset pricing model (CAPM) model to test the impact of the information releases on each stress test (Announcement, Methodology and Results events) on the stock markets, by measuring their impact on risk and for the presence of cumulative abnormal returns (CAR).
Results/Expected Results: We find that the Announcement and Methodology events have stronger impacts on the stock markets, than the Results event. This is evidenced by abnormal returns, but not in terms of temporary or permanent changes of the banks’ risk. The Results event did not have any relevant impact on returns or risk, in any of the three European Union (EU) Stress Tests. The group of banks that passed the 2014 Stress Test experienced a positive abnormal return after the Announcement event and a decrease of their permanent risk after the Methodology and Results event. The group of banks that failed the 2014 EU Stress Test was the most affected in the stock markets.
Policy Implications: We conclude that the EU Stress Tests became more relevant from exercise to exercise, as they became more realistic and provided useful information to the markets about the banking system, and that a significant part of that information is conveyed by the Announcement and Methodology events. The 2014 EU Stress Test was an important and credible tool to inform the market about the level of resilience of the banks.