Strengthening and Streamlining Bank Capital Regulation 100 BANKING PERSPECTIVES QUARTER 4 2018 CONCLUSION In closing, it is useful to note some caveats and qualifications. Perhaps the most important of these has to do with the limits of discretion in regulatory practice. A central theme of this article has been that it would be beneficial to rely less on multiple overlapping rules (such as risk-based capital ratios and leverage ratios) to deal with the challenging problem of regulatory arbitrage, and to instead give regulators more flexibility to respond to such behavior ex post , most importantly in the design of CCAR stress scenarios. In a similar vein, it has also been argued that CCAR stress scenarios should be responsive to movements in bank stock prices and CDS spreads, without necessarily writing these variables into a rule ex ante . However, such a discretionary approach might not work quite as well as hoped. First, and most simply, the regulatory process might not be as nimble and flexible as it needs to be to create the desired benefits. For example, consider the suggestion that regulators look for areas in a bank where growth and profits are unexpectedly strong, or where compensation is unusually high, as clues to pockets of emerging risk and/or gaming of the rules. But what kinds of activities would actually be singled out in the course of such an exercise, and how useful would the information turn out to be? Absent any concrete evidence, it is hard to be fully confident. While this is not a good reason to dismiss a more discretionary approach out of hand, it may suggest that the most constructive first step would be for Fed officials to conduct some in-house trial-run testing of the approach before implementing it in practice. Another potential concern for a more discretionary approach is that it can invite complaints from regulated banks about the CCAR process being nontransparent, arbitrary, and lacking in due process. Consider how a bank might respond if it is told that it is facing tougher assumptions on loss rates in a given year simply because it has been particularly profitable in some areas or is paying some of its employees in these areas generously. At the extreme, such complaints could manifest in legal challenges under the Administrative Procedure Act. And even if they did not, the associated pushback and political pressure might ultimately weaken regulators’ hands to the point where the discretionary approach becomes ineffective. These are difficult issues and should not be minimized. Yet it may be possible to make some progress on them by taking the transparency bull more firmly by the horns. That is, the Fed should be very explicit about its theory of the case with respect to any aspect of the CCAR process that can be seen as less than completely transparent, and it should be committed to full transparency in those cases not covered by the theory. One distinction that may be helpful here is that between ex ante versus ex post transparency. There are good reasons why complete ex ante transparency – in the sense of telling the banks ahead of time what all the modeling parameters for the CCAR stress scenario for a given round will be – is undesirable. If one takes this form of ex ante transparency to an extreme, the CCAR degenerates into just another hard-coded capital rule, with all the associated vulnerability to regulatory arbitrage. On the other hand, this argument does not imply similar costs to ex post transparency. So, absent a fundamentally different theory of the case, the Fed should be expected to disclose in significant detail after each year’s CCAR the specific analysis and evidence that led it to vary – e.g., the modeled loss rates for individual bank- by-asset-type categories relative to prior rounds. All of this is in the same broad spirit as the Fed chair regularly testifying before Congress to explain monetary policy ex post , without necessarily committing to a monetary policy rule ex ante . And the hope would be that, over time, such ex post disclosure would enhance the Fed’s credibility with respect to how it handles its regulatory discretion and would therefore make a regime that relies on such discretion more politically resilient and ultimately more durable. n ENDNOTES 1 This article is excerpted from a paper of the same title, published in Brookings Papers on Economic Activity in Sept. 2017. 2 An approach of this sort may well have surfaced the “London Whale” risk exposures that lost JPMorgan over $6 billion in 2012, as managers and traders responsible for the risk were among the highest paid in the organization. See “JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses, Majority and Minority Staff Report,” Permanent Subcommittee on Investigations, United States Senate, pp. 57-59. 3 When the unemployment rate is 5%, the severely adverse scenario might contemplate unemployment rising by 5 percentage points, to 10%. But when the unemployment rate has already hit 8%, the further increase modeled in the severely adverse scenario might be only 4 percentage points, to 12%. This would tend to reduce the going-forward stress capital buffer, all else being equal.