Regulation by Hypothetical

A new paradigm is afoot in banking regulation-and it involves a turn toward the more speculative. Previous regulatory instruments have included geographic restrictions, activity restrictions, disclosure mandates, capital requirements, and risk management oversight to ensure the safety of the banking system. This Article describes and contextualizes these regulatory tools and shows how and why they were formed to deal with industry change. The financial crisis of 2008 exposed the shortcomings in each of these regimes. In important ways, the Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank") departs from these past regimes and proposes something new: Call it "Regulation by Hypothetical."Regulation by hypothetical refers to rules duly promulgated under appropriate statutory and regulatory mechanisms that require banks and their regulators today to make predictions about sources of crisis and weakness tomorrow. Those predictions-which, by their very definition, are conjectural and speculative, even hypothetical-then become the basis of the use of the state's regulatory power. This Article discusses two prominent instances of regulation by hypothetical: stress tests and living wills. It then discusses the strengths and weaknesses of such a regime and describes how the reliance on regulation by hypothetical can exacerbate the practice of government sponsorship of private financial risk taking. The Article then provides a solution that would strengthen this regime: using financial war games to increase the predictive value of the hypothetical scenarios.I. INTRODUCTIONThe history of banking regulation in the United States resembles a cat-and-mouse game of industry change followed by regulatory response. Often, a crisis or industry innovation leads to a new regulatory regime. Regulatory initiatives have included geographic restrictions, activity restrictions, disclosure mandates, capital requirements, and risk management rules.1 The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank"), which was a response to the recent financial crisis, introduces yet another strain of banking industry supervision: regulation by hypothetical. Regulation by hypothetical refers to rules that require banks today to make predictions about crises and weaknesses tomorrow. Those predictions-which, by definition, are speculative-then become the basis for regulatory intervention.This Article discusses two prominent instances of regulation by hypothetical: stress tests and living wills. Both of these forms of regulation were codified in Dodd-Frank, and they are two of the pillars supporting Dodd-Frank's attempt to manage risk in systemically important financial institutions ("SIFIs").2 This Article will examine both the origins and the evolution of these reforms. It will also discuss the strengths and weaknesses of regulation by hypothetical and describe how reliance on this regulatory tool can exacerbate governmental sponsorship of private financial risk taking. Ultimately, this Article concludes that the regulation by hypothetical regime must be either abandoned or strengthened because its current form has significant flaws.Regulation by hypothetical adopts and extends the risk management framework used by firms for decades. That framework uses mathematical models to capture risk exposure in an increasingly complex financial landscape. What distinguishes regulation by hypothetical from prior risk management practices is that banks now must adhere to a governmentally imposed system of regulation that is both derived from and centered on hypothetical risk modeling.3The motivations of regulation by hypothetical are contagion containment, prophylaxis, and building partnerships between public regulators and private institutions to stay ahead of crises before they develop.4 Part of the reason the risk management regime failed is that individual firm models could not account for scenarios that might cripple the entire financial market and cause systemic risk, such as a nationwide decline in housing prices. …