Limits of stress-test based bank regulation

How should supervisory risk assessments, such as stress tests, inform bank regulation when such assessments provide imprecise signals? What trade-offs do regulators face when redesigning assessments to improve accuracy? Does the disclosure of assessment results improve the effectiveness of capital requirements? The BIS develop a theoretical framework to investigate these questions. A key element of its framework is the impact of assessment accuracy on the future behaviour of banks. This, in turn, is crucial for the design of risk assessments and for subsequent decision-making about capital requirements.

Please find the Working Paper here.