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.

First, although weaknesses in the design of certain capital risk weights, such as those noted above, led to some risky exposures, most banks had ample capital prior to the financial crisis.

A much bigger problem at many large banks was that they underestimated their liquidity positions. An equally important problem was internal mismeasurement of risk, which meant that returns for certain instruments and businesses were far thinner than banks realized. It also meant that internally required capital was too low. Instituting a high minimum leverage ratio will only make this problem worse, as banks seek out higher returns. The appropriate, and critically important, policy prescription for this is to improve risk management and measurement, particularly the requirements found in Pillar 2 of the Basel II framework regarding internal capital adequacy assessment.

Though it is not a particularly popular sentiment these days, banks must make real profits for their investors, and most of them must do so over time if we are to have a stable banking system. A large increase in the overall level of capital requirements will mean banks will have to have higher average returns in order to maintain acceptable investor profits. How will they get these higher returns? By one, or some combination, of two methods: either they will shed their lower-return (and safer) assets, or they will seek new higher-return activities, which have higher risk. This will have two effects: borrowing will become more costly, and new instruments will emerge that are off the radar screen of the supervisors and do not yet have a risk-based-capital weight commensurate with the risk.

Ironically, raising overall capital requirements too much also would undermine one of the objectives most policymakers share: to extend the regulatory umbrella to currently underregulated financial services. The ability of financial market participants to continuously innovate is well known, and the more onerous the regulatory framework, the more incentive there will be to seek higher returns either through less regulated instruments that escape the capital requirements, or through shadow banking firms that emerge. This tension will always exist, even if we get the balance of regulation right. But if requirements are needlessly onerous, the attempts to evade regulation will be even more prevalent and successful.

It is understandable that policymakers want to advocate change that makes banks safer in the eyes of the public. That is the proverbial motherhood and apple pie. However, raising capital requirements is no panacea and can be counterproductive if it is overdone. Even appropriate capital regulation alone will not prevent another boom-bust cycle without also implementing sensible, forward-looking provisioning, sound risk measurement and significant improvements in risk and capital management practices.

If we have learned anything in this crisis, let us hope it is to look beyond the short-term benefit and take a long view as we make decisions.

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