Optimal severity of stress test scenarios

Regularly conducted stress tests constitute a constraint on bank balance sheets: future equity must suffice to maintain current lending even after absorbing severe losses. Studying such a forward-looking constraint in a representative bank model, we show that a stricter stress test scenario leads to lower dividends, higher equity buffers, and lower, albeit less volatile, lending. Given this trade-off, the optimal scenario implies capital buffers of up to 6% when facing loan returns similar to those of large U.S. banks. Finally, we show that complementing stress tests with dividend restrictions improves lending stability, while relaxing counter-cyclical capital buffers does not.