The recent financial crisis demonstrated that existing capital regulations—in design, implementation, or some combination of the two—were completely inadequate to prevent a panic in the financial sector. Needless to say, policymakers and pundits have been making widespread calls to reform bank regulation and supervision. But how best to redesign capital standards? Before joining the calls for reform, it’s important to look at how financial institutions performed through the crisis to see if we’re learning the right lessons from the crisis. Is capital regulation justified? What type of capital should banks hold to ensure that they can better withstand periods of stress? Should a simple leverage ratio be introduced to reduce regulatory arbitrage and improve transparency? These are some of the questions addressed in a recent paper I wrote with Enrica Detragiache and Ouarda Merrouche.
Since the first Basel capital accord in 1988, the prevailing approach to bank regulation has put capital front and center: banks that hold more capital should be better able to absorb losses with their own resources, without becoming insolvent or necessitating a bailout with public funds. In addition, by forcing bank owners to have some “skin in the game,” minimum capital requirements help counterbalance incentives for excessive risk-taking created by limited liability and amplified by deposit insurance and bailout expectations. However, many of the banks that were rescued in the latest turmoil appeared to be in compliance with minimum capital requirements shortly before and even during the crisis. In the ensuing debate over how to strengthen regulation, capital continues to play an important role. A consensus is being forged around a new set of capital standards (Basel III), with the goal of making capital requirements more stringent.