By Robert Weber. Full text here.
This Article presents a theory for how policymakers should use stress testing as a tool of financial regulation. In finance, a stress test is an exercise gauging how an institution or system will respond to severe, yet plausible, stressed conditions such as stock market crashes, high unemployment rates, liquidity shortages, and high loan default rates. Recently, policymakers have correctly perceived stress testing as a potential antidote to some of the more trenchant problems of contemporary finance, but their initiatives in this area have lacked coherence and even worked at cross purposes.
The Article makes both descriptive and theoretical contributions to this nascent policy debate. As a descriptive matter, it traces the conceptual roots of stress testing to the analysis of failure in the engineering discipline; presents a typology of stress tests used by financial firm risk managers; and surveys the law and regulation of stress testing up to the present time. It also makes two theoretical contributions. First, it distinguishes between stress testing used as an assurance tool and stress testing used as part of a deliberative corporate governance infrastructure. Second, it advocates in favor of this latter use of stress testing and presents a three-part framework to guide efforts to implement a regulatory regime that encourages such uses of stress tests. This three-part framework consists of: (1) conceiving of regulatory efforts as a system of “management-based regulation” that regulates corporate planning processes rather than corporate actions or outputs; (2) encouraging “quantitative skepticism” within bank risk management departments; and (3) seeking to embed corporate governance principles shared by so-called “high-reliability organizations”—such as nuclear power plants and air traffic control systems—that maintain resilient performance and low failure tolerances in conditions of uncertainty and volatility.