Rules, Standards, and Complexity in Capital Regulation

This article considers two fundamental issues in the design of bank capital regulation--the choice of a rule or standard and the level of complexity in that rule or standard--by revisiting the historical adoption of minimum-capital requirements and risk-based capital requirements. Both theory and the historical evidence suggest that a minimum-capital requirement is optimal when bank regulators seek to manage risks that are costly to estimate and that a risk-weighted capital requirement, in contrast, requires a precise understanding of both bank risk and the strategic response of banks to regulation. This article uses historical evidence to illustrate how cost-benefit analysis can be useful in forcing regulators to confront their theories with evidence. The analysis of rules, standards, and complexity that it develops can also inform capital regulation even when the conclusions of cost-benefit analysis are ambiguous.