Capital rules, long considered the backbone of a safe and sound banking system, are evolving to meet other policy goals.

Chief among them: forcing the largest banks to get smaller.

Federal Reserve Board officials have made it clear in recent speeches that the central bank will continue to ratchet up capital requirements until the megabanks get the message and start shrinking.

The goal "seems to be to motivate institutions to get less systemic," Susan Krause Bell, a former regulator now at Promontory Financial, said at an industry conference last week. "I think that is a very important change in the policymaking."

Sources tend to speak more bluntly when they are not being named, so here is another version of that comment from a different former regulator: "The goal isn't safety and soundness. The goal is downsizing the banks. That's really a different purpose for capital regulation."

This policy shift seems to be happening because it's easier than finishing other rules that tackle systemic risk more directly.

The Dodd-Frank Act of 2010 is full of these tools, including the power to limit how much exposure one giant bank can have to another. These "single-counterparty credit limits" would go a long way toward reducing systemic risk, but they have languished since being proposed in December 2011.

Yet there are consequences to using capital rules at the expense of other, more precise policies.

"Incentives are being created for banks not to have balanced, diversified books but barbell books where you have a high number of low-risk assets, some of which are mandatory, and then in order to compensate, a big batch of higher-risk assets at the other end and much less in between than a bank might choose to hold itself," said Adam Gilbert, head of regulatory policy at JPMorgan Chase, at a conference last week sponsored by two industry groups.

In other words, efforts to reduce systemic risk might actually increase it.

Capital regulation is a sprawling, uncertain mess. Dodd-Frank laid out its own mandates, while the Basel III rules layer on another set. Neither of these has been finalized yet, but the presumption is that in addition to higher and stronger minimums, the largest banks will face a series of surcharges designed to make being bigger, or being more systemic, more expensive.

At a retail banking conference in March I heard Wells Fargo CEO John Stumpf say his initial Basel surcharge will total $15 billion. "That's a huge cost," he said.

And it's likely to increase.

Fed Gov. Jeremy Stein called the Basel surcharge "a reasonable starting point" and added: "If after some time it has not delivered much of a change in the size and complexity of the largest of banks, one might conclude that the implicit tax was too small, and should be ratcheted up."

Stein said he endorses the "turning-up-the-dials" approach but noted that its "gradualist nature" presents a challenge, namely: "sustaining a level of regulatory commitment and resolve sufficient to keep the dials turning so long as this is the right thing to do."

That's a really important question. How will policymakers identify the line between the "right thing to do" and the wrong?

And before we use capital rules to shrink the largest banks, shouldn't we have some idea how small we want them to get? Or if you prefer, how much less "systemic" do the largest financial institutions have to get to satisfy regulators?

"I have not heard one person in this entire debate say what they mean by small enough," says Lawrence Baxter, a law professor at Duke University. "Exactly where do you draw the line? There is no science.

"The underlying assumption is the regulators can get that right, and I think that's the unsaid concern of so many people. Do the regulators really know themselves?"

Baxter also noted that size alone doesn't define a company's systemic importance.

It's a point Fed Chairman Ben Bernanke made in a speech last month.

Systemically important companies, he said, "tend to be large, but size is not the only factor used to determine whether a firm is systemically important; other factors include the firm's interconnectedness with the rest of the financial system, the complexity and opacity of its operations, the nature and extent of its risk-taking, its use of leverage, its reliance on short-term wholesale funding, and the extent of its cross-border operations."

Exactly.

Maybe we should obsess a bit less about capital and size and pay more attention to these other issues.

Barb Rehm is American Banker's editor at large. She welcomes feedback to her column at Barbara.Rehm@SourceMedia.com. Follow her on Twitter at @barbrehm.

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