How Do Bank Regulators Determine Capital-Adequacy Requirements?

Regulators require banks to maintain capital above a certain level in order to correct the incentives to make excessively risky loans. However, it has never been clear how regulators determine how high or low the minimum capital–asset ratio should be. An examination of US regulators’ justifications for five regulations is-sued over more than thirty years reveals that regulators have never performed a serious economic analysis that would justify the levels that they have chosen. In-stead, regulators appear to have followed a practice of incremental change de-signed to weed out a handful of outlier banks.

This approach resulted in signifi-cant regulatory failures leading up to the financial crisis of 2007–2008.