The corporate finance case for deliberation-oriented stress testing regulation.

• Author: Weber, Robert F.

1. INTRODUCTION II. A BRIEF SUMMARY OF THE ORGANIZATIONAL SOCIOLOGY AND PSYCHOLOGY CASES FOR DOST III. REGULATORY INTERVENTIONS INTO CORPORATE GOVERNANCE ARE ALREADY COMMONPLACE IV. STARTING WITH THE BASICS: HOW DOST WILL IMPACT CORPORATE DECISION MAKING THROUGH THE NET PRESENT VALUE RULE V. OTHER APPLICATIONS: VALUE-AT-RISK, EXPECTED SHORTFALL, PERFORMANCE EVALUATION METRICS, ECONOMIC CAPITAL, DECISION TREE ANALYSIS A. Value-at-Risk B. Expected Shortfall C. Risk-Based Business Performance Evaluation Tools D. Economic Capital and Internal Capital Adequacy Tools E. Scenario Analysis, Decision Tree Analysis, and Monte Carlo Simulations VI. CONCLUSION I. INTRODUCTION

   In recent years, U.S. and European Union lawmakers and regulators have made stress testing of financial institutions to a central pillar of the financial regulatory regime. (1) Stress tests help financial institutions, as well as their regulators and other stakeholders, understand how an institution or system will respond to severe, yet plausible, stressed market conditions such as low economic output, high unemployment, stock market crashes, liquidity shortages, high default rates, and failures of large counterparties. The results of stress tests shed light on the tension points and weak links in portfolios and institutions that could create extraordinary, but plausible, losses. (2) I have cautioned elsewhere that the potential of stress tests to foster a more stable financial system is higher if stress tests are conceptualized as multi-actor deliberations on how a firm might fail, rather than mere assurance, audit-like exercises that validate existing business practices and mathematical models. (3)

   To date, however, assurance and audit norms have dominated stress testing practices and regulation. (4) The empirical fact of the industry's collective failure in recent decades to understand the causal channels through which its spectacular collapse would arise might be thought to be reason enough to re-orient stress testing regulation away from assurance and towards deliberation. But any normative argument in favor of deliberation-oriented stress testing (DOST) must consist of more than registering the failures of assurance-oriented stress testing (AOST).

   Fortunately, the case for DOST is not limited to a critique of the track record of AOST. It is possible to make a positive case for DOST that is grounded in both basic corporate finance principles and organizational psychology-sociology. The organizational psychology-sociology argument posits that DOST might serve as a partial antidote to decisional pathologies that inhibit institutional learning at large organizations. These pathologies complicate institutions' efforts to understand the vulnerabilities that threaten to undermine their corporate objectives. To the extent that regulatory efforts to foster DOST successfully counteract those tendencies, these efforts might contribute to an incremental de-risking of financial institutions, and they might result in more reliable financial institutions and systems. (5)

   The qualification here is necessary because it leaves unresolved a technical question concerning the mechanisms by which the firm's increased deliberation on stress will result in concrete changes in its business practices. This Article takes up this complementary question--which is in essence a corporate governance question concerning how financial firms make and act on decisions--by looking to basic corporate finance principles. It proceeds on the assumption that a successful DOST regulatory program will in fact result in an increased awareness on the part of executives, risk managers, and boards of directors of downside scenarios and the risks associated with prospective projects and investments. It is concerned, in other words, with what happens next.

   When a financial institution shifts from an AOST orientation to a DOST orientation, its decision makers will have a heightened awareness of the riskiness of proposed projects. They will base their decisions on a different information set than they otherwise would have. This shift should in turn prompt two broad sets of responses by the institution's decision makers: (1) they will project lower future cash flows and investment returns for the project; and (2) they will discount those projected future cash flows with higher discount rates. In each case, these changes would lower the estimated present values of the prospective projects or investments. Thus, holding all else equal, a firm that ramps up its awareness of downside scenarios and potential failures should estimate lower project valuations for those projects or investments that are uncovered to be riskier than they would appear to the firm before it committed to a DOST program.

   This final piece of this puzzle is to show how these estimated project valuations link up directly to the manner in which investment funds are allocated throughout the firm. According to the widely used "net present value rule" of capital budgeting, a firm should only invest in a project if it has a positive present value. The rule can be restated as requiring a proposed investment to have projected risk-adjusted returns in excess of the cost of the capital that would be required to invest in the project. On the margin, lower valuations should result in re-direction of capital away from those (newly appreciable) risky projects or investments that no longer yield positive net present values.

   But the net present value rule is only one of many decisional tools that financial firms utilize when deciding how to allocate funds across businesses and projects. Large financial institutions that transact in fast-moving markets deploy a suite of decisional tools that provide information to decision makers concerning economic outcomes in an uncertain future. Focusing on DOST will flow through several of the more commonly used decisional tools and result in de-risking. Some of the more common tools are examined, including: value-at-risk techniques, expected shortfall metrics, performance evaluation tools such as risk-adjusted return on capital (RAROC), internal "economic capital" models, scenario analysis, decision tree analysis, and Monte Carlo modeling.

   This Article proceeds as follows. To provide context, Part II summarizes the organizational psychology-sociology case for DOST. Part III explains how a DOST regulatory regime amounts to a public law intervention into corporate governance of financial institutions, and why that fits into a broader history of similar interventions. Part IV introduces discounted cash flow valuation and shows how DOST will effectuate a de-risking of project and investment selection through the net present value rule. Part V demonstrates how DOST will impact decision making through other information tools in ways that will result in de-risking. Part VI concludes.

2. A BRIEF SUMMARY OF THE ORGANIZATIONAL SOCIOLOGY AND PSYCHOLOGY CASES FOR DOST

   This Article's main contribution to the scholarly literature on financial regulation is to explain how a DOST regulatory program, by fostering a heightened awareness of the possibility of failure or other downside scenarios, will in practice improve allocation of investment capital within the firm. The argument's validity depends on two premises: first, that DOST holds promise to promote the statutory objectives of financial regulators; and second, that regulatory initiatives to intervene into firm-level corporate governance so as to foster DOST have a credible chance of success. If either of these premises does not hold, then focus on the decision mechanics by which DOST affects firm investment policies is misplaced. This Part will summarize briefly why these premises are likely to hold.

   First, DOST holds promise to promote the statutory objectives of financial regulators. Psychologists have revealed tendencies for people to use mental shortcuts in ways that inhibit organizational learning about risk. These heuristics, which might not raise public policy concerns or motivate regulatory programs in other contexts, have significant negative social ramifications with respect to financial institutions in light of the utility-like roles that they play in the financial system. (6) Regulatory initiatives to promote DOST norms should be conceptualized as attempts to affect the information set that key corporate governance actors within financial institutions take into account when making decisions that bind the firm. Such initiatives amount to interventions into corporate governance to encourage financial institutions to make better--from the perspective of regulators--decisions about how to take on and balance risk against expected returns.

   As a matter of corporate law, the board of directors has the responsibility to set a financial institution's corporate risk policy, as a necessary incident to its responsibility to manage or direct the institution's business affairs. (7) For firms of even modest operational complexity--a group that includes nearly all financial institutions--the board of directors inevitably delegates the responsibility to put that policy into action to an appointed management cohort. (8) But how do these managers generate the information set to take into account when putting the policy into action?

   As an operational matter, today's banks establish risk management departments that are responsible for producing uncertainty- and risk-related information for managers to utilize when making decisions. (9) It is best to think of these risk management departments as the organizational sub-units that consider how future uncertainties impact firm objectives. They are information production centers that trade in uncertainty and risk in an effort "to find the best possible decision to make when faced with uncertainty." (10) They are, not surprisingly, also the operational setting where stress testing occurs.

   A risk management department...