U.S. banking regulation resembles a cat-and-mouse game of industry change and regulatory response. Often, a crisis or industry innovation will lead to a new regulatory regime. Past regulatory regimes have included geographic restrictions, activity restrictions, disclosure mandates, risk management rules, and capital requirements. But the recently enacted Dodd-Frank Act introduced a new strain of banking-industry supervision: regulation by hypothetical. Regulation by hypothetical refers to rules that require banks to predict future crises and weaknesses. Those predictions—which by definition are speculative—become the basis for regulatory intervention. Two illustrative instances of this regulation were codified in Dodd-Frank: stress tests and living wills. They are two pillars on which Dodd-Frank builds to manage risk in systemically important financial institutions (SIFIs).  As I argue in my forthcoming article, regulation by hypothetical in Dodd-Frank should be abandoned for three reasons: it relies on a faulty premise, tasks an agency with a conflicted mission, and likely exacerbates the moral hazards involved with governmental sponsorship of private institutions. Because of these weaknesses, the regulation-by-hypothetical regime must be either abandoned (my first choice) or strengthened. One way to strengthen these hypothetical scenarios would be to conduct financial war games.
First, regulation by hypothetical is an extension of the risk-management regime, which most scholars believe was either a failure or of limited efficacy. If the risk-management framework failed, as some say, because firms did not consider risks that were severe enough, then hypothetical regulation could provide an antidote by compelling banks to consider more severe scenarios of economic failure. However, if the risk-management regime failed because it was based on a faulty premise—that it is possible to imagine and prepare for every scenario that might affect a firm in the future—then any regulations designed on hypotheticals are of limited use, too. The FRB uses historical modeling in designing its hypotheticals, and therefore these models are inherently unable to account for unprecedented events (or “black swans”), which are often the triggers for financial crises.
Second, the FRB, the creator and administrator of mandated hypothetical testing, comes to the project with a conflict of interest. The FRB has always been a systemic risk regulator, and Dodd-Frank emphasizes and strengthens that function of the FRB. But the FRB is also tasked with ensuring calm markets. Therefore, if the FRB creates a stress test that is too difficult and firms are not able to withstand the pressure, markets may panic. On the other hand, if the FRB creates a “soft” stress test to reassure markets about bank safety, systemic risks may well go unaddressed. This is not only a theoretical problem. It was apparent during the first round of stress testing that the FRB was more interested in calming markets. The FRB publicized the results, predictably causing a boost in the stock prices of the tested banks and a general surge of market confidence.
Third and relatedly, when the government conducts what it claims to be rigorous stress-test of a bank and then gives it a clean bill of health, the market receives a signal not only that the bank’s risks are well managed, but that the government itself will stand behind the bank in case that assessment proves incorrect. In other words, whereas faulty risk management modeling before Dodd-Frank was used by individual firms to inform their investment strategies, regulation by hypothetical has a game-changing quality. Regulators are now using models to reassure markets of firm strength, thereby providing a stamp of approval that could well lead to unjustifiable reliance by markets. The federal government has already been accused of over-subsidizing large banks by providing below-market funding, FDIC insurance, and TBTF implicit bailout protection. This new regime creates another federal subsidy to the largest banks—a market signal that certifies the health of these firms. If the hypotheticals were accurate and the stress testing rigorous, this might not be that troublesome, but these hypothetical tests are not accurate barometers of bank health because of the two failings mentioned above. In fact, the regulatory stamp of approval more likely has the effect of lulling markets into complacency and suppressing more rigorous analysis of the largest firms. It may also make it more likely that these firms would be bailed out again (another subsidy) in the event of a disaster because counterparties can claim reliance on FRB pronouncements that led them to invest in unsafe banks.
There are two ways to deal with these shortcomings: (1) recognize them and abandon the hypothetical regime based on the conclusion that unreliable data and indicators are worse than none at all, or (2) attempt to remedy them by taking account of human behavior in the hypothetical scenarios. Although I think that the first option is better, I recognize that regulation by hypothetical may be here to stay. If regulators continue to mandate hypothetical regulation, they must both understand the limits and problems with these models and also strengthen the regime by increasing its diagnostic value. One tool for improving regulation by hypothetical would involve borrowing from military war game modeling to better predict crisis responses. The current hypotheticals only look at balance sheets at a static point in time and do not attempt to predict how firm management might react to specific market events. For example, it would be relevant to know in predicting systemic risk, whether a fund manager faced with a stock market loss would try to prevent further loss, double down on risk to try to recuperate, or attempt to hedge to account for the loss. All of these responses would implicate different parts of the financial market as well as different counterparties. An accurate war game scenario could provide regulators better information about firm response and systemic vulnerabilities. Even so, these financial war games would still rely on hypotheticals created by regulators and would suffer from the same limitations and problematic market signals.
The full article is available for download here.
 See 12 U.S.C. § 5365(a), (d) & (i).