Strengthening and Streamlining Bank Capital Regulation

Abstract

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.

A Structural Model of Interbank Network Formation and Contagion

“…There is a specialist literature regarding optimal regulation in financial markets (Duffie, 2017;Baker and Wurgler, 2015;Greenwood et al, 2017;Batiz-Zuk et al, 2016). Our primary contribution is that by considering bank default risk we are able to evaluate bank regulation comprehensively.…”

Regulatory Changes and the Cost of Capital for Banks

“…However, it is also interesting to understand the distribution of the cost of capital. Greenwood et al (2017) hypothesize that if banks are subject to multiple capital constraints that the industry will be pushed towards increasingly similar business models, particularly for the largest banks. We use beta as a simple metric to capture the similarity of business models.…”

How do Capital Requirements Affect Loan Rates? Evidence from High Volatility Commercial Real Estate

“…We address this concern that we are not observing a supply response to the rule by exploiting variation across banks. Banks for whom risk-based capital constraints are slack should be less affected by the change in risk weights (see Greenwood et al (2017)). Instead, it should be the banks closer to a risk based constraint which would need to raise additional equity in order to fund an HVCRE loan as a result of the rule.…”