Strengthening and Streamlining Bank Capital Regulation

We propose three core principles that should inform the design of bank capital regulation. First, whenever possible, multiple constraints on the minimum level of equity capital should be consolidated into a single constraint. This helps to avoid a distortionary situation where different constraints bind for different banks performing the same activity. Second, the best way to deal with the inevitable gaming of any set of ex ante capital rules is not to propose further rules, but rather to allow the regulator sufficient flexibility to address unforeseen contingencies ex post. Third, though a regulatory framework that relies primarily on minimum capital ratios is appropriate for normal times, such a framework is inadequate in the wake of a large negative shock to the system. Following an adverse shock, it becomes critical to emphasize dynamic resilience, which involves forcing banks to actively recapitalize—that is, regulation needs to focus on getting banks to raise new dollars of equity capital, rather than just maintaining their capital ratios. Applying these principles, we suggest a number of modifications to the current set of risk-based capital requirements, to the leverage ratio, and to the Federal Reserve’s stress-testing framework.