On Market-Based Approaches to the Valuation of Capital

Market measures suggest banks are as risky as they were in the pre-crisis period. This appears attributable to a decrease in bank franchise value, rather than a byproduct of the current low interest rate environment, and cautions about the stability of the financial sector. However, stress test results reveal little cause for concern; in 2017, all 34 stressed institutions in the United States passed the tests, suggesting they will remain well-capitalized in the event of a downturn more severe than the Great Recession. Their passage paved the way for capital disbursements and ignited calls for deregulation. In this paper, we demonstrate that a market-based stress test approach produces results that are significantly less encouraging than the regulatory tests. While a pure market-based stress test is undesirable, we believe it is important to incorporate market information into the stress test methodology to facilitate more credible inferences about bank safety.