Bank Capital as a Substitute for Prudential Regulation
Banks with high levels of equity capital relative to their assets should be allowed to avoid much burdensome prudential regulation, including costly stress tests. This proposal, which appears in the Financial CHOICE Act recently passed by the U.S. House of Representatives and is supported by the Treasury in its recent Report to President Trump, is called the off-ramp. The Financial CHOICE Act specifies that banks can opt for the off-ramp if the ratio of their equity capital to their total assets exceeds 10%.
We believe that a uniform requirement (currently proposed at 10%) would be inadequate as it could lead to substantial increases in risk by some banks opting for the off-ramp. Instead, regulators should set bank-specific thresholds and do so in a way that reflects the current and future risk of the bank’s assets and the bank’s systemic importance. This should take the form of two capital ratio requirements rather than one. One of the requirements would specify the minimum equity capital ratio as a fraction of total assets, while the other would specify it as a fraction of risk-weighted assets. For systemically important financial institutions, both required capital ratios should consider the risk that a failure of the bank would pose to the financial system.
Requiring banks to maintain capital as a fraction of risk-weighted assets does not require continuing dependence on the current Basel risk-weighting system for banks accessing the off- ramp; risk weighting could be accomplished in a simpler, more reliable way, which would be adequate for preventing abuse of the off-ramp. Finally, legislators or regulators must specify mechanisms for ensuring that banks that opt for the off-ramp continue to comply with the conditions for accessing it.
