In stress-test window-dressing, timing is everything

EBA and Fed stress tests would have to be in perfect sync to stamp out transatlantic arbitrage

Every year around this time, equity finance desks notice something unusual.

The cost of exchanging stocks for bonds under repurchase agreements mysteriously bumps up by as much as 20 basis points going into the fourth quarter.

Some traders blame the elevated levels on banks’ unwillingness to take on equity exposures ahead of the Federal Reserve’s annual stress tests. The Bank Policy Institute, an industry group, even suggested the market-shock element of the tests was one of several reasons for last month’s outbreak of severe repo volatility. Others speculate banks – more than a few – may be gaming the tests by temporarily swapping market risk off their balance sheets to minimise trading losses.

In May, received an anonymous email accusing banks of doing exactly that. The whistleblower attached a screenshot of a memo from May 2018 detailing a US bank’s proposal to temporarily swap assets with a European bank. In it, staff at the European bank noted the trade could help the US bank with “liquidity needs during stress-test periods” and that “there could be mutual benefit to provide liquidity” given that US and European stress tests take place at different times of the year.

In interviews, several bankers and regulators, both former and current, acknowledged there has always been some window-dressing around stress tests, though some were surprised to see it discussed so openly in a memo.

Regulators are well aware of the problem. To deter window-dressing, the Fed uses a floating start date for its global market-shock. Banks are only informed of the actual date once the stress test scenarios are announced, usually in early February. Until 2017, the start date fell between January 1 and March 1 of the year in which the stress test was taking place. But last year, the Fed widened the range to begin on October 1 after concluding the original three-month window was still being gamed. The change made window-dressing more complex and costly, but apparently didn’t eliminate it entirely

The “mutual benefit” referred to in the memo is likely why the practice continues. European banks may be willing to price these trades more cheaply if they believe US firms will reciprocate by taking risky assets off their balance sheets ahead of the European Banking Authority’s every-other-year stress tests, which have a fixed start date of December 31.

The EBA has finally wised up to that bit of arbitrage. In June, it proposed moving to a floating start date for its 2020 stress test. Under the plan, the market-risk shock could take place on any day between September 1 and December 31 of the year before the stress test. The EBA will release its final methodology for the 2020 test in November.

But even so, if the change is adopted it would be at best a half-solution. The EBA only conducts its stress tests once every two years: that means European banks could still take on risky assets from US firms in the off years without jeopardising their test results. To completely stamp out window-dressing, regulators may need to fully align their stress-testing cycles and perhaps even go so far as to choose the same start dates for the market risk scenario.   

In the meantime, regulators are hoping the occasionally overlapping start date windows for the market risk scenario will dissuade banks from swapping risky assets over the coming months. They may want to check in with equity finance desks to see if it’s working.

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