Last week, I discussed why capital requirements — requiring firms to have capital equal to some percentage of their assets — cannot prevent financial crises. Among other evasions, regulated firms can shift to riskier assets (such as subprime mortgages) within the asset categories defined by the regulations. Discretionary actions by regulators to offset such shifts during a bubble period would be extremely disruptive, requiring more foresight and political courage than we have any reason to expect from public servants.
Proposals have emerged to rectify these weaknesses of capital requirements by automating the adjustment process. This would require identifying one or more statistical measures to which capital requirements would be tied.