Richard J. Herring, professor at the Wharton School, is well known for his insightful commentary on the financial system.  His paper on “The Evolving Complexity of Capital Regulation” is a good example of why.  Professor Herring presents a readily accessible and remarkably concise history of the development of global standards for bank capital, starting with the first Basel Capital Accord (Basel I—regulators are now looking at the implementation of Basel IV).  Then he walks through additions and amplifications under the Dodd-Frank Act and various regulatory innovations, each regulatory round designed to address perceived problems of previous standards.

One of Professor Herring’s observations is that, “Simplicity and comparability have clearly not been important objectives in regulatory reform.”  His paper (with a marvelous table included) totals up 39 different capital requirements applied to U.S. banks.  This was echoed in scale if not by precise number by Federal Reserve Board Vice Chairman for Supervision Randal Quarles, who in remarks delivered on January 19, 2018, reported finding 24 “loss absorbency constraints” (the purpose of bank capital) faced by large banks.  Vice Chairman Quarles observed, “While I do not know precisely the socially optimal number . . . I am reasonably certain that 24 is too many.”

Recognizing the surfeit of capital standards, Professor Herring guides us to the right question to ask:  “market participants will understandably want to know which of the ratios is most important.”  We do not need to ask whether this or that measure has value.  The more fruitful question is, which few will tell us the most?  That question may be answered by asking which measures of capital are the ones that regulators, bank management, and investors actually use?  I doubt that that they keep a fixed eye on all 39.  Professor Herring has the temerity to suggest that we might be able to do without 35 of them.

A year since Vice Chairman Quarles’ statement that 24 is too many, the banking regulators have several capital reform projects currently under way:

  • Simplification of the Enhanced Supplementary Leverage Ratio.
  • Replacement of various stress testing programs with a Stress Capital Buffer that would tie stress tests more closely to capital standards.
  • Tailoring capital and other prudential regulations for large banks.
  • Relieving highly capitalized community banks from complex Basel capital calculations.

Professor Herring concludes his paper with an observation and a question:

The problem of how to reverse the trend toward increasing complexity remains perplexing. . . . What would it take to exorcise this demon from the U.S. financial regulatory system?

How the banking regulators handle their reform projects may suggest an answer.