The Capital Solution to Systemic Risk
Chapter 7 examines bank regulators’ ‘capital approach’ to systemic risk: the risk-weighted countercyclical capital buffer and the surcharge for globally systemically important banks, or G-SIBs, leverage ratios, and liquidity regulation governing advanced approaches banks and G-SIBs. It also describes the two stress testing programs: the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act Stress Tests (DFAST). The chapter treats liquidity risk together with other capital regulation whose primary objective is to reduce systemic risk because high-quality liquid short-term assets are a key safeguard in a bank’s capital structure. The chapter also covers Federal Reserve Board guidance on model risk management, a central regulatory concern in stress testing supervision and in firms’ own management of risk to safeguard franchise value. Defective modeling of financial instruments was an important contributing factor to the financial crisis. For each regulatory area covered, the chapter discusses the associated risk management and compliance requirements.