How Do Bank Regulators Determine Capital Adequacy Requirements?

Abstract

Minimum capital regulations play a central role in banking regulation. Regulators require banks to maintain capital above a certain level in order to correct incentives to make excessively risky loans and investments. However, it has never been clear how regulators determine how high or low the minimum capital-asset ratio should be. An examination of U.S. regulators’ justifications for five regulations issued over more than 30 years reveals that regulators have never performed (or at least disclosed) a serious economic analysis that would justify the levels that they chose. Instead, regulators appear to have followed a practice of what I call “norming” — incremental change designed to weed out a handful of outlier banks. This approach resulted in a significant regulatory failure because it could not have given, and did not give, banks an adequate incentive to increase capital. The failure of banking regulators to use cost-benefit analysis in order to determine capital requirements may therefore have contributed to the financial crisis of 2007-2008.