Abstract
This paper addresses questions about prudential capital regulation that are critical to regulatory policy. The discussion is organized as a set of nine specific questions, which build in logical sequence. We divide the discussion of these key questions into five broad sections: Section II summarizes theoretical perspectives on the need for capital in banking, the need for equity capital ratio regulation, and the costs and benefits of raising minimum equity capital ratio requirements (questions 1–3). Section III discusses some empirical evidence about those costs and benefits (question 4). Section IV assesses the adequacy of current capital requirements in light of these considerations (question 5). Section V identifies the pitfalls of relying on book equity requirements as a regulatory tool (question 6). Section VI considers how to mitigate those pitfalls by combining minimum book equity ratio requirements with other prudential tools (questions 7–8). Section VII connects the prior discussion of "micro-prudential" issues in capital regulation (related to the safety and solvency of regulated banks) to the recent advocacy of using capital regulation for "macro-prudential purposes" — namely, to stabilize aggregate lending, to contain asset price bubbles, or to have other macroeconomic influence on the financial system or the economy (question 9). Section VIII concludes.
Organizing the discussion in this way allows us to build a case for a particular approach to prudential capital regulation economically and clearly. The paper should not be mistaken, however, for a thorough review of the literature. We do not attempt to include all relevant issues or all points of view, nor do we present theoretical and empirical evidence in great detail. Rather, we summarize what we regard as some of the most important theoretical and empirical perspectives, and integrate them within a coherent framework. For the sake of brevity, and to maintain a clear expositional focus, we do not explain here the relative shortcomings of all alternative points of view about regulatory policy (e.g., the Basel III system). For the same reasons, we do not address every relevant question about capital standards.