Abstract:-
We document a three-fold increase in average pairwise correlation in bank equity returns after the global financial crisis, a pattern that is absent in non-bank  financials or non-financial firms. We tease out one key economic channel behind the increased similarity: stress-test regulations that incentivize banks to make similar portfolio decisions. The increase in similarity is especially strong for smaller stress-tested banks such as regional banks. The stress-tested banks increase their exposure to a factor that is orthogonal to the factors that enter the stress test scenario. Our findings raise concerns about “too-many-to-fail” risk in response to model-based regulations.

(With Priyank Gandhi)