Raising capital requirements as a part of regulatory reform — once the crisis is over — is a good idea, provided increases in capital requirements are aimed at bigger institutions.

Two years ago the idea that big banks might need more capital than small ones would have been laughed out of court in most circles. The argument against it was that big banks could diversify themselves and manage their risks better — wider portfolio choices, stronger controls, more risk transfer tools and greater expertise.

Today, however, we know that many large banks did poorly at diversification and risk management. Their size seems to have obscured the risk concentrations that built up in their mortgage portfolios and trading activities. Structured investment vehicles and other off-balance-sheet strategies hid risks instead of reducing them. And the sophistication of their risk analytics lulled some senior managers and shareholders into a false sense of security about the underlying quality of their assets.

So big banks may need more capital against assets and measured risks, because their true risks may be bigger than they seem. But on top of that, higher capital requirements for bigger institutions make systemic sense. Capital acts as a buffer against insolvency, and bigger buffers for institutions whose failures are likely to be more disruptive is a good idea. Regulators are rightly averse to the insolvency of institutions whose failure can generate far-reaching collateral damage, and they would be justified in requiring them to hold more capital.

Let's take a look at how it might work.

The accompanying chart illustrates a plan for setting capital requirements according to size. On the vertical axis is the Tier 1 capital asset ratio, the ratio of capital to assets required by regulators. On the horizontal axis is the size of risk-weighted assets.

As the dotted line on the chart shows, Basel II currently specifies a ratio of 4% of risk-weighted assets, regardless of size. The three lines above that represent a proposal of how capital requirements should be raised progressively, so larger banks are required to have more capital. That margin or systemic risk premium, as some have called it, would rise steadily with time until some target schedule is reached.

For example, the ratio for the smallest institutions would remain at 4% in 2012. For those with $500 billion to $1 trillion of assets, the Tier 1 requirement would still be quite low — around 5%. But it would rise to 10% for institutions with at least $3 trillion. In other words, the systemic risk premium above the base rate of 4% would rise from zero for the smallest institutions to 6% for the largest.

By 2015, the premium would become more serious. A $1 trillion institution would need to maintain a capital adequacy ratio of 6%, and a $3 trillion institution would need a ratio of 20%. By 2018, a $1 trillion institution would need to maintain a 7% capital buffer, and a $3 trillion institution would have to hold capital equal to 30% of its assets.

Numbers this high are meant to illustrate not just the idea of raising capital with size, but that it may be a good idea to create an incentive for the managers and shareholders of large institutions to find ways to break them up into smaller pieces. Even if a $3 trillion institution had extraordinary economies of scale and scope, a sophisticated suite of products and services and a great global brand, the prospect of such a high capital ratio could make their business model untenable, and they might well be forced to downsize before the end of the next decade.

Would that be so bad?

If this crisis has made one thing clear, it is that some financial institutions have simply grown too big. Whether it is Fannie Mae, Royal Bank of Scotland or American International Group, these mammoth institutions are not just "too big to fail." They are also too powerful politically, too big to manage efficiently, too big to be understood by external stakeholders — even by senior managers — and far too big to cope with in a crisis. A future with more small institutions and fewer behemoths is an attractive one.

One final point: Putting a specific cap on the size of institutions or dividing them into size-based groups for the purpose of setting capital adequacy ratios would be bad policy. We can never know exactly where such lines should be drawn.

Schedules of the kind shown in the chart create an incentive to moderate growth a little more whenever size increases a little more. And they leave it up to managers and shareholders to decide how and when to divvy up a successful business into successful parts.

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