Irrelevance of Bank Capital Regulation: Return to the Generic Behavior of Capital

Abstract

There is a deep-rooted mistrust that left to them; banks will default on depositors' payment and lending commitment, which will create panic leading to runs that may damage the socio-economic fabric of a society. Hence, banks are kept under strict regulation; the latest plank in the regulatory architecture is the capital adequacy requirement. The most important rule of market economy is that capital moves to an industry and finds its own level in terms of the risk-return structure of that industry. Historical decline of capital-assets ratio of US banks, till various forms of capital regulation came into place, should be explained within the framework of risk-return behaviour of equity capital. As against contemporary belief, the fall is found to be due to rise in riskiness of banking, increase in bank assets propelled by increasing rate of return and consequent rise in ROE. Any interference with the market laws by regulatory arbitrariness would prevent the capital from exploiting fully its risk-return capacity. This will lower down the productivity of capital with adverse consequences for the economy, not to speak of depositors' protection. Risk management in banks is typically a strategic issue while movement and level of equity capital are embedded in economic laws. A bank regulator, as an economic strategist, is required to see that these laws are not impinged upon. The regulator should, therefore, abandon the capital regulation; instead it should focus on value maintenance. For this, the regulator needs only to specify and ensure that at any time the gross rate payable on deposit liability is less than either the net rate of return receivable on risk-assets or the rate available from risk-free-assets.