Stress Testing the Banking Agencies

One of the major regulatory innovations that has emerged over the decade following the financial crisis is the development of regulatory stress tests for large financial institutions. Within the past few years, however, the role of stress tests has come under attack from a wave of reforms which call for the current programs to be rolled back in substantial part or eliminated in full. These initiatives have emerged from both Congress (see here and here) and the Trump Administration (here and here).

My recent article, Stress Testing the Banking Agencies, charts a path forward by undertaking a comprehensive analysis of the promise and limits of regulatory bank stress testing. It then presents a proposal that would address concerns on both sides of the reform debate but has yet to receive consideration: reorienting the stress testing process so that it is used to assess the rules promulgated by federal financial regulators, rather than banks’ compliance with those rules.

The bulk of the article revisits the arguments for and against the stress testing framework put in place following the financial crisis. That proves to be an important first step, as it reveals that Dodd-Frank’s architects as well as its reformist skeptics have misconceived the vices and virtues of the post-crisis rules. One on hand, the existing procedures bear surprisingly little relation to the financial stability goals they were designed to address. On the other hand, claims that the stress tests represent a harmful escalation of regulatory burdens, discretion or uncertainty tend to be overstated. For example:

• Regulatory stress tests in their current form do not measure systemic risk. In large part, they presuppose no such thing exists;
• The stress tests also have limited capacity to produce information that markets, banks, or regulators may find relevant. For some of those audiences, the tests produce no new information at all;
• Complaints about the lack of transparency in the Dodd-Frank stress test procedures are often misplaced. Along the most important dimensions, those procedures should aim for maximal opacity;
• So too are assertions that the post-crisis rules allow for an unprecedented, heavy-handed intrusion on the management of financial institutions. In substance, the Dodd-Frank stress tests closely mimic other banking regulations which have been in place for decades (some, since the Civil War); and so on.

The collective result of these issues is to leave the future of stress testing at an impasse. As it stands, the purported benefits of the regulatory status quo are unlikely to be forthcoming. At the same time, efforts to overhaul the Dodd-Frank programs fail to remedy the defects in those procedures. Despite the shortcomings my article identifies in the post-crisis stress tests, it explains how an effective role for the Dodd-Frank programs could be salvaged if the process is redirected 180-degrees to stress test the banking agencies.

While the article spells out the methodological and legal changes necessary to implement such a shift in detail, the basic logic behind it is simple. When the results of a stress test indicate that a bank—which is otherwise in full compliance with the applicable supervisory standards—is so fragile that it would pose systemic risks in the event of a financial downturn, the best solution is not an ad hoc imposition of supplemental requirements on an institution-specific basis. If it is discovered that banks are legally authorized to take risks which benefit their shareholders while destabilizing the system as a whole, the regulatory structure itself has been exposed as inadequate.

A better approach is therefore to rely on stress testing as a tool that calibrates the banking agencies’ regulatory capital and liquidity requirements across the board. Under that scenario, the “failure” of one or more banks should trigger a process where the agencies reassess their prior rulemakings and adjust the prevailing ratios upwards in response to the systemic vulnerabilities that have been uncovered. As a result, the article argues, the administration of financial stress tests will become less susceptible to gamesmanship by the parties involved, and begin to deliver useful information to banks, financial market investors, and the regulatory agencies themselves. They will also move closer to meeting the intended goal of preventing systemic risks from destabilizing the financial sector.

The complete article is available for download here.