The Role of Capital Regulations in Combating “TBTF”

Inadequate capital relative to bank risk certainly contributed to the depth of the financial crisis and cost of government intervention.  Emerging regulation aims to eliminate the likelihood of TBTF bank failure by significantly increasing minimum capital levels.  Higher minimums will only succeed if (a) banks cannot arbitrage capital rules to circumvent these rules, and, (b) banks do not increase their risk profile in order to generate required returns on higher capital levels.  Bank incentives to arbitrage capital and increase risk are driven almost entirely by funding market discipline; bank capital regulation unravels if debt and equity investors demand no additional return from riskier TBTF banks.  Basel III represents a sound regulatory approach to ensuring adequate capitalization, but absent significant additional regulatory intervention or firm market discipline, the leverage ratio is easily circumvented by an increase in risk.  The ultimate regulatory goal – an increase in capital without accompanying increase in risk – is only achieved with equal parts capital regulation, risk measurement, and properly-functioning markets.