Executive Summary of Policy Recommendations

This study by the Committee on Capital Markets Regulation (the “Committee”) examines a balanced approach to capital regulation that enhances private market discipline while strengthening the complementary role of government-imposed capital requirements. A regulatory approach that recognizes the dual roles of government and the private market in setting appropriate capital levels at financial institutions will result in a stronger and safer financial system than can be achieved through public regulation alone. The Committee believes that the approaches outlined below will achieve the desired goal of a more robust financial system:

  • Capital should primarily consist of “going concern” capital. The strongest form of capital is common equity, which can absorb losses without disrupting the ongoing operations of the financial institutions (hence, “going concern” capital). Alternative forms of capital that only absorb losses after converting to common equity through a regulatory trigger, such as contingent capital, are much less stable forms of capital. These forms of “gone concern” capital should be disfavored by regulators.
  • Capital adequacy in regulatory stress test scenarios should be based on market assessments. The appropriate amount of terminal capital under a stressed scenario that is deemed sufficient to “pass” the stress test, should be considered from the perspective of the market. In an economic environment in which a financial institution suffers severe losses, the market’s opinion of capital adequacy may differ substantially from government-imposed minimums. Since the ongoing viability of the financial institution depends crucially on the confidence of the market, a market-driven assessment of adequate capital is necessary for effective stress testing.
  • Regulatory stress tests should have both common designs and bespoke components. Stress tests allow regulators to evaluate the systemic risk implications of an adverse macroeconomic environment by looking at the aggregate effects across all financial institutions. To this end, regulators should subject each financial institution to common stressed scenarios so that results can be compared and the stability of the financial system as a whole can be evaluated. Stress tests also give regulators insight into specific vulnerabilities at individual financial institutions that may present themselves in different scenarios for different banks. To identify the bank-specific risks, regulators should also conduct stress tests under bespoke stressed scenarios designed for each individual institution.
  • Public disclosure of stress test results should depend on the macroeconomic environment. During “normal” times in the business cycle, stress tests results should be presented on an aggregate basis without disclosure of bank-specific results. During times of crisis, when market uncertainty heightens the importance of confidence in specific financial institutions, stress test results should be disclosed at the individual bank level in addition to aggregate results.
  • Banks should hold minimum levels of junior debt. Creditors of financial institutions are incentivized to monitor bank capital levels and therefore impose the best form of market discipline. Regulators can use market signals, such as the yield or the price of a credit default swap (“CDS”) on the junior debt, to gauge the capital adequacy of financial institutions. Banks that breach a maximum yield or CDS price should be subject to immediate stress tests to determine whether the institution should improve its capital position or be wound down.
  • Banks should provide more transparency to the markets. Increased disclosure requirements will allow the market to make a well-informed determination of bank’s capital adequacy and, consequently, enhance market discipline. Specific areas for improved disclosure include (i) asset composition, (ii) funding liquidity, (iii) interest rate risk, (iv) credit risk, and (v) performance of core business lines.

The full study is available here.