The Corporate Finance Case for Deliberation-Oriented Stress Testing Regulation

Abstract

Stress testing regulation has become a pillar of the financial regulatory apparatus in recent years. In previous work I have argued in favor of a regulatory regime that seeks to embed a more deliberative, mindful decisional infrastructure in financial institutions. Such a “deliberation-oriented” stress testing regulatory program could serve as an antidote to certain decisional pathologies that inhibit institutional learning about risk. But the normative case for deliberation-oriented stress testing regulation depends also on resolving an organizational question: even if regulators are successful in encouraging greater deliberation on stress and failure within the firm, how will the heightened awareness of risk and the possibility of loss translate into different decision outcomes? This article addresses that question by using basic corporate finance principles such as discounted cash flow valuation methods and the net present value rule to explain how decisions are likely to change – for the better, from the perspective of regulators and the public. I also will show how more specialized capital budgeting tools such as value-at-risk, expected shortfall, risk-adjusted return on capital, economic capital, scenario analysis, decision tree analysis, and Monte Carlo simulation will similarly yield better decision outcomes.

Keywords: stress testing, risk management, corporate finance, monte carlo, decision trees, value-at-risk, expected shortfall, corporate governance, financial regulation, banking law, economic capital