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Several approaches to setting bank capital requirements are competing for policymakers’ favor: the current risk-weighted approach embedded in Basel III and variants; a leverage ratio; and the use of stress tests. In practice, as is currently true in the US, some combination of these will be used.
This paper answers the following questions:
A key point of this paper is that the sophisticated banks that dominate the financial system will directly incorporate the effects of capital regimes into their internal pricing models. This will result in the incentive effects flowing directly through to almost all decisions about business mix and pricing. Thus, incentive effects will be much more than academic constructs, they will play through into actual business decisions via banks’ internal markets much as changes in monetary policy trigger substantial changes in market prices in the economy as a whole