105 Iowa L. Rev. 1701 (2020)

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Abstract

One of the major regulatory innovations that has emerged over the decade following the financial crisis is the development of regulatory stress tests for large financial institutions. But the role of stress tests as a pillar of financial regulation has been placed in jeopardy by a recent wave of reforms within Congress and the Trump Administration. Existing legal scholarship provides minimal guidance for evaluating this development, because it lacks a coherent account of what the Dodd–Frank Act’s stress testing programs can and should do. This Article fills that gap.

First, it provides a comprehensive analysis of the promise and limits of financial stress tests. That analysis reveals that both Dodd–Frank’s architects as well as its reformist skeptics have misconceived the vices and virtues of the post-crisis stress testing rules. As it stands, the current procedures bear surprisingly little relation to the systemic risks they were designed to address. At the same time, claims that those rules represent a harmful escalation of regulatory burdens, discretion or uncertainty are overstated.

Second, the Article moves beyond critique and charts a practical path forward by identifying a simple yet fundamental twist to the administration of stress tests which would enable them to effectively perform the functions they were intended to serve. Specifically, it outlines a set of reforms that transform stress tests into tools for diagnosing weaknesses in the regulatory requirements promulgated by federal banking agencies, rather than in the banks themselves. By stress testing for regulatory failure, the market failures which lead to financial crises are more likely to be prevented.

The broader contribution of this Article is to highlight the need for a genuinely interdisciplinary approach to financial regulation, which focuses on how subtle aspects of legal structure interact with the underlying economic principles governing financial markets. The post-crisis stress tests present a classic case on why taking both the law and economics of financial regulation seriously is easier said than done. But they also show that without such an approach, regulatory costs and benefits are misapprehended, basic policy questions prove impossible to answer, and unintended consequences abound.