Both the banks and the supervisors conduct independent assessments of the impact of the stress scenarios on the various business lines of the bank. This approach provides a cross-validation of each bank’s analysis, while at the same time generating results that can be compared across the participating banks. Another important feature of CCAR is that the scenarios and the key aspects of the banks results are made public rather than treated as confidential supervisory information. This transparency is important for supporting market confidence in the banking system. Finally, a critical aspect of the stress testing process is the supervisory review of the capital planning process for each participating bank. This planning process is what reinforces and promotes a proactive stance by management to emerging risks. The structure of bank management compensation also could be designed to provide incentives that reinforce a proactive, forward-looking risk management approach. As I will discuss in a moment, sufficient long-term debt that can be converted to equity is an important element of an effective resolution mechanism for G-SIFIs. While the magnitude of this longterm debt needs to be sufficient to ensure that public funds are not at risk in the event that a resolution of a firm is necessary, making this long-term debt a component of management compensation might also be used to help reduce the likelihood of a default. Long-term debt provided by outside creditors exposed to risk of default can create useful market discipline. However, outside creditors do not have the same information or decision rights as inside management.

In addition, international standards on margin requirements for non-centrally cleared derivatives have been adopted.3 By definition, bespoke derivatives cannot be centrally cleared and so do not benefit from the risk reduction and enhanced transparency associated with central clearing. To offset this, these derivatives will be required by regulation to have higher initial margin requirements, as well as variation margin. Despite these efforts, we still may not get the balance right in terms of the requirements applied to non-standard versus standardized, cleared contracts. One worry is that CCPs that are shareholder-owned and operated for profit may compete for market share by offering lower margin requirements on standardized products. This could strike the wrong balance between the private profit motive versus the public benefit of clearing. For this reason, I believe that all CCPs need to have strong governance and regulatory oversight. This must be harmonized on an international basis in order to prevent a potential race to the bottom. It is important to recognize that increased use of CCPs for central clearing also creates potential financial stability issues that must be addressed. While CCPs reduce aggregate risk, they also concentrate the remaining risk. That is, CCPs create potential single points of failure in global derivatives markets. CCPs need adequate capacity to absorb potential losses from the default of one or more of its members, and they need to have access to liquidity so that they can always fully settle their obligations.