As the world's financial markets begin to stabilize, government leaders are under significant pressure to make our financial institutions immune from a recurrence of the losses they experienced. While challenges abound in this effort, one of the most easily overlooked challenges may be to avoid an overreaction by imposing excessive requirements in the name of safety. The crisis has so disturbed our faith in the stability of the financial system that strong responses seem almost mandatory. In particular, there is much talk of considerably raising capital requirements — after all, the thinking goes, capital is what stands between a viable bank and a failed bank, and therefore, more is not only better, but necessary to avoid a repeat of the crisis.
To be sure, capital required for certain banking activities was too low going into the crisis, and needed changes have already begun to be adopted. For example, the Basel Committee recently issued revisions to the Basel II capital framework, including raising the risk weights for resecuritization exposures and certain trading exposures. These changes address very real weaknesses in the capital regime that encouraged ill-advised risk taking and will appropriately strengthen the capital base of many institutions. Beyond these targeted revisions, however, efforts that are emerging to significantly raise the overall level of required capital — particularly through a simplified leverage ratio — would be misplaced, for several reasons.