Kling’s Law of Bank Capital Regulation

Thomas L. Hogan, Neil Meredith, and Xuhao Pan write,

we find that the standard capital ratio is significantly better than the RBC ratio as an indicator of bank risk and performance and that using both ratios simultaneously does not produce better results. Taken in conjunction with the other available evidence, our findings indicate that RBC regulations lead to more risk-taking by individual banks, and more overall risk in the banking system, without improving the effectiveness of the Fed’s capital regulations.

RBC = risk-based capital. Kling’s law is that the capital measure used by regulators will, over time, come to be outperformed by a measure that the regulators are not using. So, if you are using standard capital, risk-based capital measures will better predict bank risk, and conversely.

The reason can be found in my essay, The Chess Game of Financial Regulation.

Regulatory systems break down because the financial sector is dynamic. Financial institutions seek to maximize returns on investment, subject to regulatory constraints. As time goes on, they develop techniques and innovations that produce greater returns but which can also undermine the intent of the regulations.

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