97 BANKING PERSPECTIVES QUARTER 4 2018 A natural instinct when seeing that one particular rule (say, a risk-based capital requirement) has been arbitraged is to propose another rule that the historical data suggests would have worked better. This, in part, is the logic invoked by those arguing for a more prominent role for a non-risk- based leverage ratio requirement. But it is useful to bear in mind the wisdom in Goodhart’s law: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” In other words, any rule, once codified ex ante , will tend to be arbitraged, and this problem cannot be easily addressed by proposing more rules. Rather, a third core principle is that regulators should explicitly aim to take an incomplete contracting approach, filling in certain contingencies ex post , once they have observed how banks are responding to the existing rules. These three principles in turn lead to the following specific policy recommendations for updating and strengthening the current capital-regulation regime: DIAL BACK THE SUPPLEMENTARY LEVERAGE RATIO (SLR): Having an SLR that is either binding or near-binding is counterproductive and distortionary. There are two broad ways that the SLR could be made to be less constraining on bank behavior. First, the minimum level of the ratio could be reduced – for example, from 5% to 3% for the G-SIBs. Alternatively, the denominator of the ratio could be adjusted to exclude the very safest assets, including central bank reserves, Treasury securities, and initial margin for centrally cleared derivatives. In principle, either approach could serve the desired purpose, though the latter has the drawback that it could create a sharp cliff between Treasuries, which would now have a zero risk weight, and near-riskless substitutes (for example, agency and highly rated corporate bonds). However, to the extent that either approach makes the SLR less likely to bind at all, this distinction will tend to matter less. Although a reduced role for the SLR is desirable, many of the concerns that have motivated its advocates are absolutely legitimate, namely: the general potential for the current risk-based regime to be gamed; the particular vulnerability to such gaming of complex model-based approaches to setting risk weights; and the lack of any risk weight at all on even relatively risky sovereign securities. The remaining recommendations attempt to address some of these concerns. INTEGRATE THE RISK-BASED CAPITAL REQUIREMENT AND THE COMPREHENSIVE CAPITAL ANALYSIS AND REVIEW (CCAR) INTO A SINGLE CONSTRAINT: One way to accomplish this integration is put forward in a recent proposal by the Fed. The idea is that there would just be a single overarching risk-based capital requirement. It would start with a baseline risk-based ratio. But then this ratio would be augmented with a “stress capital buffer” that incorporates estimates of net losses coming from the annual CCAR process. And this stress capital buffer would be subject to a 2.5% floor. In other words, each bank would now face just a single constraint, and the effective risk weight for any asset i would be the sum of a statutory time-invariant Basel-style risk weight and a component that reflects asset i ’s performance in the severely adverse stress scenario. Moreover, the latter piece would not be set in stone but could vary year-to-year. Although there would be time-variation in risk weights, the fact that there is only a single binding constraint at any point in time implies that all banks face the same cross-sectional tax rates on their activities, which is the key to minimizing the sorts of industry-level distortions described above. DESIGN ANNUAL STRESS SCENARIOS WITH REGULATORY ARBITRAGE IN MIND: At first glance, one reaction to a consolidated constraint of the sort described just above might be that it is just a relabeling of the usual risk-based capital requirement. If so, one might ask what the independent role of the stress testing process is – i.e., why do we need the CCAR when it is just being folded into the conventional risk-based capital regime? Again, the point to emphasize is that the component contributed by the CCAR to an asset’s effective capital charge, namely that coming from the stress capital buffer, is not a time-invariant constant based on a rule-making It can make good sense to set a higher overall minimum capital ratio on those banks whose failure creates larger social costs.