Bank Capital Requirement Reform: Long-Term Size and Structure, the Transition, and Cycles

There is general agreement that the minimum bank capital ratio requirements (hereafter MCRR) set by regulators in the US and elsewhere were inadequate leading up to the financial crisis, and that this substantially contributed to the financial crisis. Inadequate MCRR contributed to the crisis ex ante by encouraging excessive risk taking (the so-called moral-hazard problem of limited liability, which is exacerbated by the possibility of taxpayer-financed bailouts); ex post, inadequate capital meant that intermediaries’ net worth was too low to absorb losses without jeopardizing banks’ solvency, substantially raising counterparty risk among banks, and thereby producing a funding liquidity crisis for banks that led to massive credit contraction, selloffs of risky assets, and widespread financial distress.

Throughout the world, policy makers are calling for more capital, or in Treasury Secretary Timothy Geithner’s phrasing, “capital, capital, capital.” In this paper, I will address three questions about the reform of MCRR: (1) What size and structure of MCRR should we be moving toward? (2) How should we manage the transitional issues of raising capital requirements, in light of the potentially huge adverse consequences for credit supply that can result from higher MCRR? (3) How should so-called “macro-prudential” capital regulation be managed, together with monetary policy, so that capital requirements can add productively to the policy makers’ toolkit of mitigating business cycles?

Read the full report here.