An analytical assessment of the impact of the 2016 EU-wide stress test on equity returns of participating financial institutions

Abstract

The European banking sector is currently being faced with several challenges that are continuously testing the resilience of each financial institution. For this reason, stricter regulations are imposed on these institutions to raise enough capital as a provision against the losses that could eventually materialize. Stress testing is a forward-looking risk management tool that is commonly used by regulatory authorities, supervisors, and financial institutions alike to determine the amount of capital that would be eroded under hypothetical adverse scenarios. Furthermore, stress testing provides market participants with sufficient information about the stability of financial institutions, as well as the macro-financial sector as a whole, thereby inducing market confidence. The aim of this paper is to assess the impact of the 2016 EU-wide stress test on equity returns of public listed financial institutions that were subjected to the stress test. For the purpose of this study, an econometric model was constructed to measure the impact on equity returns during a 5-day event window evolving around the days when the official results were published. The results reveal that there was no impact on equity returns for all public listed financial institutions during the period when the official results were published. However, the results were anticipated and priced in the equity returns for each financial institution prior to the publication of the official results.