Stress Tests, Regulatory Costs, and Valuation Discount: Evidence From a Fuzzy Regression Discontinuity Approach

ABSTRACT

Using a fuzzy regression discontinuity design, we identify a negative causal relationship between stress tests and bank valuation, proxied by Tobin's Q and market‐to‐book ratio. We examine reputational costs and financing costs as measurable regulatory costs contributing to the valuation discount. We also find that the valuation declines induced by any single stress test become more severe as banks participate in more tests. The regulatory costs at both the firm and macroeconomic levels are economically significant. Strong (weak) profitability and robust (poor) ex‐ante capitalization mitigate (aggravate) the negative effects of stress tests, and we quantify such moderating effects. Our study is informative to bank stakeholders and has policy implications.