Regulation by Hypothetical

A new paradigm is afoot in banking regulation-and it involves a turn toward the more speculative. Previous regulatory instruments have included geographic restrictions, activity restrictions, disclosure mandates, capital requirements, and risk management oversight to ensure the safety of the banking system. This Article describes and contextualizes these regulatory tools and shows how and why they were formed to deal with industry change. The financial crisis of 2008 exposed the shortcomings in each of these regimes.

In important ways, the Wall Street Reform and Consumer Protection Act of 2010 ('Dodd-Frank') departs from these past regimes and proposes something new: Call it "Regulation by Hypothetical." Regulation by hypothetical refers to rules duly promulgated under appropriate statutory and regulatory mechanisms that require banks and their regulators today to make predictions about sources of crisis and weakness tomorrow. Those predictions-which, by their very definition, are conjectural and speculative, even hypothetical-then become the basis of the use of the state's regulatory power. This Article discusses two prominent instances of regulation by hypothetical: stress tests and living wills. It then discusses the strengths and weaknesses of such a regime and describes how the reliance on regulation by hypothetical can exacerbate the practice of government sponsorship of private financial risk taking.

The Article then provides a solution that would strengthen this regime: using financial war games to increase the predictive value of the hypothetical scenarios.