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 DoddFrank 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 DoddFrank’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 DODDFRANK ACT STRESS TESTING RULES ..................... 1713
D. STRESS TESTS RESULTS FROM 2012–2018 ............................. 1715
E.RECENT PROPOSALS TO ROLL BACK THE DODDFRANK
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).

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