United They Fall: Bank Risk After the Financial Crisis
Explicit model-based regulation is a standard tool to control risk-taking in the banking sector. Using the enactment of annual stress-test under the Dodd-Frank Act as an empirical setting, we show that such regulations can lead to a significant increase in commonality in risk exposure across banks. Specifically, stress-tested banks have become increasingly similar in their risk exposure after the formalization of stress tests, a pattern that is absent in non-tested banks, non-financial firms, or non-bank financial firms. Consistent with a causal interpretation, after a bank fails the stress test its risk exposure becomes similar to other stress-tested banks. The results of the stress test itself have also become similar across banks over time. Our findings raise concerns about the buildup of correlated risk in the system in response to model-based regulation.