99 BANKING PERSPECTIVES QUARTER 4 2018 investor runs on multiple asset-backed commercial paper programs. At this point, there was no longer any real doubt about the nature of the shock confronting the financial system, even if its exact magnitude was yet to be determined. And yet during the interval from the start of 2007 through the third quarter of 2008, the largest U.S. financial firms – which, collectively would go on to charge off $375 billion of loans over the next 12 quarters – paid out almost $125 billion in cash to their shareholders via common dividends and share repurchases, while raising only $41 billion in new common equity. This all happened while there was a clear and growing market awareness of the solvency challenges they were facing. Indeed, the aggregate market capitalization of these firms fell by approximately 50% in the pre-Lehman period from the start of 2007 through the end of June 2008. It seems indisputable that the severity of the crisis would have been mitigated if policymakers had clamped down on these payouts earlier and had compelled banks to raise substantial amounts of new equity. With this observation in mind, a central question to ask about CCAR is this: Suppose we were granted a do-over, and it was late 2007. If we had the current CCAR process in place, would things have turned out differently? Would we have seen significantly more equity issuance at this earlier date by the big banks, and hence a better outcome for the real economy? The answers to these questions are not entirely clear. On the one hand, the rule underpinning the current CCAR framework gives the Federal Reserve the authority to curtail a bank’s payouts to shareholders in the event that its post-stress capital ratios fall below the specified minimum. There is somewhat more ambiguity as to whether the same rule also gives the Fed the authority to compel new equity issues, as opposed to letting a bank come into compliance with its required post-stress capital ratio by shrinking its assets – e.g., by slowing its loan growth or by selling assets. So, one useful direction for reform is to strengthen the CCAR rule so as to make it clear that the Fed does indeed have the authority to compel new equity issues when doing so is necessary to prevent an undesirable contraction in bank balance sheets at a time of macroeconomic stress. At the same time, having the authority to do something is necessary, but it is not sufficient – there also needs to be the institutional resolve to follow through. And such resolve can be hard to come by at a time of systemwide stress, when banks can be expected to object strenuously to having to do what they perceive to be highly dilutive equity issues, and when regulators are likely to be skittish about further unsettling the market for bank stocks. Thus, in addition to rewriting the formal CCAR rule, another important aspect of the annual CCAR process should be an explicit form of war-gaming, whereby regulators rehearse the details – both among themselves and in cooperation with bank executives – of exactly how they would go about implementing a rapid recapitalization of the system in the face of large looming losses. The hope would be that repeated rounds of such war- gaming would help to build the institutional culture and muscle memory needed to go forward with an aggressive systemwide recapitalization plan when the time comes. Finally, and also in the spirit of buttressing institutional resolve, whenever the Fed designs a CCAR stress scenario, it should be publicly accountable after the fact to explain how its assumptions for loan losses and other outcomes can be reconciled with the information in bank stock prices and credit default swap (CDS) spreads – particularly at times when these market prices are sending pessimistic signals. Think again of the period from early 2007 to mid- 2008, when bank stocks fell by about 50%. If a CCAR adverse scenario is being drawn up in a mid-2008-like environment, it seems hard to argue that it shouldn’t take on board the growing market skepticism about the state of bank balance sheets. Moreover, doing so should serve to heighten the pressure on regulators to push for a rapid recapitalization of the banking system. Of course, any market indicator can be driven by noise as well as news, and so it probably doesn’t make sense to have a mechanical rule tying market prices either to CCAR assumptions or to recapitalization requirements. But the current system, which has no real role for market-based information, is also far from optimal in this regard. Suppose we were granted a do-over, and it was late 2007. If we had the current CCAR process in place, would things have turned out differently?