The CCAR is a significant supervisory innovation intended to ensure that large, complex bank holding companies have robust internal capital planning processes and sufficient capital to withstand stressed economic conditions and to continue to be viable financial intermediaries. Importantly, the CCAR takes a forward-looking perspective in assessing a bank’s capital adequacy, including ensuring that its internal stress testing processes address its unique vulnerabilities and exposures. The CCAR should push banks to proactively manage their capital so as to be well prepared for the type of market stresses that could cause significant declines in income and capital. Other steps could be taken to complement the CCAR. One approach would be to implement a long-term debt requirement in a way that further enhances market discipline and provides incentives for regulators to promptly intervene if necessary. Another might be to structure compensation practices to strengthen senior bank managers’ incentives to proactively manage risk. For example, imagine how incentives would change if a significant portion of senior bank management’s compensation each year were deferred to be available to cover future capital losses. I suspect that over time this would meaningfully alter management’s risk tolerance. Also, in addition to the quantity of the deferred compensation, the form it takes could also affect incentives. If most of the deferred compensation were in the form of debt rather than equity, I suspect this would also affect management’s risk tolerance and the appetite to cut dividend payments, reduce share repurchases or raise more capital more promptly when the firm began to become stressed.
After all, collectively these enhancements to our current regime may not solve another important problem evident within some large financial institutions – the apparent lack of respect for law,  6  BIS central bankers’ speeches  regulation and the public trust. There is evidence of deep-seated cultural and ethical failures at many large financial institutions. Whether this is due to size and complexity, bad incentives or some other issues is difficult to judge, but it is another critical problem that needs to be addressed. Tough enforcement and high penalties will certainly help focus management’s attention on this issue. But I am also hopeful that ending too big to fail and shifting the emphasis to longer-term sustainability will encourage the needed cultural shift necessary to restore public trust in the industry. One alternative strategy for dealing with too big to fail is to reduce the size of large banks by imposing size limits. While I understand the motivation, it is important to recognize that imposing size limitations might not be a very efficient means of making the financial system more stable. First, it could sacrifice some socially beneficial economies of scale and scope, especially to the global clients of large financial institutions, depending on how the size limits were implemented. Second, the resulting benefits in terms of reducing systemic risk might be quite small.