What Does Increasing Capital Requirements Actually Mean?

If you're trying to understand what President Obama did at last week's G-20 Economic Summit, you could do a lot worse than reading Joe Nocera's column, wherein he imagines Obama's efforts to cajole his reluctant world counterparts on behalf of Treasury Secretary Tim Geithner:

What I really like about Tim’s ideas about capital is that even without other reforms, they have the potential to change bank behavior. If a bank wants to be so large that it is too big to fail, it can do so — but it will have to put up much more capital than a smaller competitor. If a bank wants to dabble in derivatives, it will have to pay a price in higher capital requirements. If a bank wants to invest in risky assets — ditto.

Banks hate higher capital requirements because they depress profits. So they’ll have to make a choice: risky assets or lower capital requirements. They won’t be able to do both.

That gets the administration's theory just about right.

-- Tim Fernholz