Strengthening and Streamlining Bank Capital Regulation 96 BANKING PERSPECTIVES QUARTER 4 2018 I IN THE WAKE of the global financial crisis of 2008–2009, financial regulation has undergone a dramatic overhaul, in the U.S. and elsewhere. There are many elements to the new regulatory regime, including enhanced capital requirements and stress testing, liquidity rules, resolution planning, margin and clearing requirements for derivatives transactions, and much more. With the bulk of the rule-making and implementation now nearly complete, it is a natural time to take stock of the changes: to ask whether the new regulations are working as hoped, how they are meshing with one another, and what the unintended consequences and other inefficiencies might be. This article discusses three principles that can be used to assess the efficiency of those parts of the regulatory regime that are most directly tied to bank equity capital, including the standard risk-based Basel III capital requirements, the leverage ratio, and the Federal Reserve’s stress-testing process. Although these are far from being the whole regulatory toolkit, they are among the most important pieces of it, and these elements alone have become very complex. PRINCIPLE 1: CONSOLIDATE CONSTRAINTS With respect to capital regulation in particular, basic economic theory suggests that, in a “normal times” steady state, one can achieve a relatively efficient regulatory outcome that leads banks to properly internalize the social costs of their activities with a single capital requirement that forces each bank to maintain a sufficient ratio of equity to risk-weighted assets, provided the risk weights are chosen appropriately. Moreover, requiring different banks to maintain different ratios of equity to risk-weighted assets, as Basel III does with its capital-ratio surcharges for global significantly important banks (G-SIBs), also makes sense within the context of the same framework. However, crucially, the same economic logic does not support having multiple independent constraints on bank equity ratios – as is the case when banks have to separately satisfy minimum values for their risk-based capital ratios, their leverage ratios, and their post-stress capital ratios. This is because when banks have heterogeneous business models, different constraints can bind in equilibrium for different banks. As a result, two different banks can face different relative risk weights when performing the same two activities, which distorts their behavior, just as would happen if different non-financial firms faced different relative marginal tax rates for the same two activities. Thus, a first core design principle is that wherever possible, multiple constraints on the minimum level of equity capital should be consolidated into a single risk-based constraint. PRINCIPLE 2: DYNAMIC RESILIENCE Next, it is important to think about what optimal regulation looks like away from the steady state, when the banking system has been hit with a negative shock that reduces its capital base below the natural long- run level. In this case, as long as there are flow costs to raising new external equity, ratio-based capital requirements are not sufficient to implement an efficient outcome. Rather, in addition to specifying capital ratios, the regulator must also compel banks to recapitalize – i.e., to raise new dollars of outside equity, above and beyond what they would voluntarily do on their own. Thus, a second design principle is an emphasis on what might be called dynamic resilience : After an adverse shock, the ability of regulators to implement a prompt recapitalization of the banking system is at least as important as setting the exact value of the capital ratio in normal times. In many ways, this is an obvious point, but it’s one that has been underappreciated in much of the work in this area, which has been more concerned with calibrating static optimal capital ratios. PRINCIPLE 3: COMBAT REGULATORY ARBITRAGE BY FILLING IN CONTINGENCIES EX POST Finally, one needs to ask how regulators can best respond to the inevitable gaming of any rules that they write down.