Stress Testing the Banking Agencies

• Author: Matthew C. Turk
• Position: Assistant Professor of Business Law, Indiana University - Kelley School of Business
• Pages: 1701-1757

1701

Stress Testing the Banking Agencies

Matthew C. Turk*

ABSTRACT: 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. But the role of stress tests as a pillar of

financial regulation has been placed in jeopardy by a recent wave of reforms

within Congress and the Trump Administration. Existing legal scholarship

provides minimal guidance for evaluating this development, because it lacks

a coherent account of what the Dodd–Frank Act’s stress testing programs can

and should do. This Article fills that gap.

First, it provides a comprehensive analysis of the promise and limits of

financial stress tests. That analysis reveals that both Dodd–Frank’s architects

as well as its reformist skeptics have misconceived the vices and virtues of the

post-crisis stress testing rules. As it stands, the current procedures bear

surprisingly little relation to the systemic risks they were designed to address.

At the same time, claims that those rules represent a harmful escalation of

regulatory burdens, discretion or uncertainty are overstated.

Second, the Article moves beyond critique and charts a practical path forward

by identifying a simple yet fundamental twist to the administration of stress

tests which would enable them to effectively perform the functions they were

intended to serve. Specifically, it outlines a set of reforms that transform stress

tests into tools for diagnosing weaknesses in the regulatory requirements

promulgated by federal banking agencies, rather than in the banks themselves.

By stress testing for regulatory failure, the market failures which lead to

financial crises are more likely to be prevented.

The broader contribution of this Article is to highlight the need for a genuinely

interdisciplinary approach to financial regulation, which focuses on how

subtle aspects of legal structure interact with the underlying economic

* Assistant Professor of Business Law, Indiana University - Kelley School of Business. I am

grateful for valuable comments on earlier drafts by Bill Bratton, Vince Buccola, Nakita Cuttino,

George Georgiev, Jill Fisch, Gina-Gail Fletcher, Merritt Fox, Todd Haugh, Claire Hill, J eremy

Kress, Anita Krug, Josh Macey, Jeremy McClane, Michael Ohlrogge, Frank Portnoy, Christina

Skinner, and Robert Thompson. I would also like to thank participants at the Canadian Law &

Economics Association Annual Conference, the Academy of Legal Studies in Business Annual

Conference, the National Business Law Scholars Conference, and the Indiana Maurer School of

Law workshop on Financial Regulation and Innovation. For excellent research assistance, I thank

Peter Gauss.

1702 IOWA LAW REVIEW [Vol. 105:1701

principles governing financial markets. The post-crisis stress tests present a

classic case on why taking both the law and economics of financial regulation

seriously is easier said than done. But they also show that without such an

approach, regulatory costs and benefits are misapprehended, basic policy

questions prove impossible to answer, and unintended consequences abound.

I.INTRODUCTION ........................................................................... 1703

II. LEGAL & HISTORICAL BACKGROUND ON FINANCIAL

STRESS TESTS .............................................................................. 1707

A.STRESS TESTING FROM 1987–2008 ....................................... 1707

1.At Firms ........................................................................ 1707

2.In Regulations ............................................................. 1708

B.THE FINANCIAL CRISIS STRESS TEST ....................................... 1710

C.THE DODD–FRANK ACT STRESS TESTING RULES ..................... 1713

D. STRESS TESTS RESULTS FROM 2012–2018 ............................. 1715

E.RECENT PROPOSALS TO ROLL BACK THE DODD–FRANK

RULES ................................................................................... 1717

1. Executive Branch Reforms ......................................... 1717

2. Statutory Reforms ........................................................ 1718

III.EVALUATING THE PROMISE AND LIMITS OF STRESS TESTS:

AN UNFINISHED TASK ................................................................. 1719

A.THE INCOMPLETE CASE AGAINST ........................................... 1719

1. Quantitative Skepticism .............................................. 1719

2. Regulatory Discretion, Opacity, & Uncertainty ........ 1722

3. Compliance Costs ........................................................ 1725

B.THE INCOMPLETE CASE FOR .................................................. 1729

1. The Information-Producing Function ....................... 1729

i.Information for Markets ........................................... 1729

a. Stress Testing in Wartime ............................. 1730

b. Stress Testing in Peacetime .......................... 1733

ii. Information to Banks ............................................... 1736

iii. Information to Regulators ........................................ 1738

a. Macro-Surveillance ........................................ 1738

b. Regulatory Learning ..................................... 1740

2. Safeguards & Stabilizes Banks .................................... 1742

3. Complements other Regulations ............................... 1745

IV. A PROPOSAL: STRESS TESTING THE FEDERAL BANKING

AGENCIES .................................................................................... 1747

A. SUMMARY OF PROPOSAL ........................................................ 1748

1. Methodological Changes ............................................ 1748

2. A New Role for Banks ................................................. 1750

2020] STRESS TESTING THE BANKING AGENCIES 1703

3. A New Role for Regulators ......................................... 1752

B.ADVANTAGES OF THE PROPOSAL ............................................. 1754

1. Addressing Critiques of Stress Testing ...................... 1754

2. Making Good on the Purported Benefits of

Stress Testing ............................................................... 1756

V.CONCLUSION .............................................................................. 1757

I. INTRODUCTION

Over the decade since the collapse of Lehman Brothers in 2008, financial

regulation has undergone its greatest transformation since the Great

Depression. During that period, one legal development that stands out as

particularly novel and important is the emergence of banks stress tests as

regulatory tools.1 Indeed, the rapid rise of regulatory stress testing is difficult

to overstate. The use of those procedures was essentially non-existent until

first introduced by the Federal Reserve on an emergency basis in early 2009.2

Yet, due to the perceived success of that experiment, regulatory stress tests

were soon after enshrined as a cornerstone of the post-crisis legal architecture

established pursuant to the Dodd–Frank Act.3

Within the past few years, however, the role of stress tests has come under

attack from a wave of reforms which call for those procedures to be rolled

back in substantial part or eliminated in full. One source of that pushback is

an Executive Order issued by the Trump Administration in 2017, which

instructed the federal banking agencies to undertake a comprehensive review

of post-crisis financial regulations.4 In response, the Treasury Department has

released a series of policy memoranda which set forth a detailed roadmap for

1. Generally speaking, stress tests are statistical simulations which estimate the impact of a

potentially adverse economic scenario on a bank’s balance sheet and overall financial stability.

See infra Section II.A (providing background on the origins of financial stress tests); see also

Chester S. Spatt, Regulatory Conflict: Market Integrity vs. Financial Stability, 71 U. PITT. L. REV. 625,

627 (2010) (“One of the most interesting innovations to emerge in the bank supervision model

during the financial market crisis is the use of stress tests.”).

2. See infra Section II.B.

3. Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203,

§ 165, 124 Stat. 1376, 1430–31 (2010); see infra Section II.C; see also Patrick Jenkins & Brooke

Masters, Banks: Again Under Strain, GONZALO RAFFO INFONEWS (July 7, 2011, 8:29 PM),

http://gonzaloraffoinfonews.blogspot.com/2011/07/banks-again-under-strain-financial.html

[https://perma.cc/AX5H-YKZ5] (“[S]ince the financial crisis . . . stress-testing [has] become a

vital part of the regulatory arsenal.”).

4. See Exec. Order No. 13,772, 82 Fed. Reg. 9965 (Feb. 8, 2017).