Gaming the test? : window-dressing and portfolio similarity around the EU-wide stress tests

This study investigates the impact of supervisory stress testing on banks' behaviors and their systemic risk implications. Utilizing confidential supervisory data from the European Banking Authority's EU-wide stress tests in 2021 and 2023, we employ a difference-in-differences framework to analyze how these exercises influence portfolio management decisions among European banks. This methodology allows us to compare stress-tested banks with similar non-tested institutions before and after the stress test events, isolating the effects specifically associated with the EU-wide assessments. Our findings reveal significant patterns of anticipatory behavior, with banks strategically window-dressing their capital ratios before stress tests begin. This behavior is particularly pronounced among institutions that subsequently receive the lowest scores in terms of capital depletion. We document that these anticipatory adjustments lead to decreased portfolio similarity across banks, an effect that persists after the stress tests and remains consistent across different similarity measures. Importantly, such a decrease in similarity does not spin off into more granular business model or country clusters, thus limiting potential systemic risk through portfolio synchronization. Our results, while considering how financial institutions incorporate stress test considerations into their strategic decision-making, highlight the dual role of stress tests in enhancing individual bank resilience and reducing systemic vulnerabilities. These findings contribute to the ongoing debate on effective banking supervision and the design of regulatory stress testing frameworks.