Jon Danielsson writes,

Risk-sensitive capital can be dangerous because it gives a false sense of security. In the same way it is so hard to measure risk, it is also easy to manipulate risk measurements. It is a straightforward exercise to manipulate risk measurements to give vastly different outcomes in an entirely plausible and justifiable manner, without affecting the real underlying risk. A financial institution can easily report low risk levels whilst deliberately or otherwise assuming much higher risk. This of course means that risk calculations used for the calculation of capital are inevitably suspect.

This is true enough. But it reminds me of the argument against mark-to-market accounting. Both risk-based capital and mark-to-market accounting have their flaws. But there is no flawless system, and anyone who lived through the savings-and-loan crisis knows that failure to mark to market and failure to differentiate for risk is a fatally flawed way to regulate banks. Just because risk-based capital faces implementation problems does not mean that reverting to simple leverage ratios would be a solution.

I keep coming back to the following points:

1. All centrally-designed incentives systems degrade over time. Within a firm, the goal of the manager is to maximize the change in employees’ behavior and to minimize the expense of getting that behavioral change. The goal of the employees is the opposite. As employees learn how to game the system, any given set of compensation rules becomes dysfunctional and has to be changed. The same goes for regulation. If you keep a system in place long enough, banks will naturally learn to game it and it will become dysfunctional.

2. If we are going to have financial institutions that are given government backing, then they cannot be given free-market privileges. You cannot have Freddie Mac, Fannie Mae, or deposit-insured banks given complete freedom. We also cannot count on letter-of-the-law regulation to keep them from abusing their privileges, for the reasons given in the preceding paragraph. Therefore, I believe that government-backed financial institutions also need spirit-of-the-law rules. Executives of those institutions should feel the threat of prison if their firms fail, even if they obey the letter of regulations. You want government-backed institutions to attract executives who value safety and are naturally risk-averse. Let the risk-takers gravitate toward institutions that do not expect a government bailout if their gambles go awry.