Stress Tests and Model Monoculture

We study whether regulators should reveal stress test results which contain imperfect information about banks’ financial health. Although disclosure restores market confidence in banks, it misclassifies some healthy banks as risky. This encourages banks to choose portfolios that are deemed safe by regulators, leading to model monoculture and making the financial system less diversified. Optimal policy involves a commitment to reveal stress test results only when adverse selection problems are very severe or very mild. Where possible, stress tests should be designed to avoid predictable bias against particular portfolios, even at the cost of reducing average accuracy.