Journal of Economic Literature 2014, 52(1), 197-210



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205

Myerson: Rethinking the Principles of Bank Regulation

such questions. Admati and Hellwig offer 

a shocking perspective on how the bal-

ance sheet of JPMorgan Chase Bank on 

December 31, 2011, would be affected by 

a change of accounting standards from the 

generally accepted accounting principles 

(GAAP) used in the United States to the 

international financial reporting standards 

(IFRS) used in the European Union. Under 

both accounting standards, the bank’s net 

equity value could be reported as $184 bil-

lion. But under the IFRS standards, the bank 

would have to report $1.79 trillion more of 

assets and liabilities from swaps and other 

derivative trades that could be netted out 

under the GAAP standards. This discrep-

ancy is almost ten times larger than the total 

equity of the bank. Under GAAP standards, 

JPMorgan Chase Bank could claim that its 

equity value was about 8 percent of assets, 

but under IFRS standards this fraction 

would shrink to a mere 4.5 percent.

When such technical details of account-

ing can make such a great difference to the 

representation of a well-known bank, one 

may be tempted to give up and concede 

that it is all too complex for the layman 

to hope to understand. This has to be the 

wrong answer. Banks are in the business of 

issuing deposits that people can count on as 

safe. The process of assuring depositors and 

taxpayers (if they offer deposit insurance) 

that these deposits are safe must involve 

some form of communication that the gen-

eral public can understand. Of course, the 

average depositor or taxpayer wants profes-

sional regulators to do the work of moni-

toring our banks’ balance sheets, and we 

want our elected officials of government to 

make sure that the professional regulators 

do their jobs. But with so much money in 

the banking system, our hope that regula-

tors and officials will not be induced to 

falsely certify unsafe banks must depend 

on confidence that a failure of appropriate 

regulation could be discovered, reported 

in the press, and understood by voters well 

enough to cause a ruinous scandal for the 

responsible officials.

We want our country to have a banking 

system that can reliably channel millions of 

people’s savings into credit for investments 

in our growing economy. But this requires 

that the banking system be able to main-

tain broad public trust, so we need a bank 

regulation system that operates according 

to reliable principles of accounting that can 

give people some sense of the risks that their 

banks have undertaken. If there are abstruse 

financial transactions that generate risks 

which cannot be adequately represented 

in standard public accounting statements, 

then perhaps such transactions should be 

off limits for banks that are in the business 

of issuing reliably safe deposits. Otherwise, 

there is a danger that regulated banks may 

be attracted to some transactions precisely 

because they enable the banks to hide risks 

off of their balance sheets. If society needs 

marketmakers for such abstruse transactions, 

then perhaps we should let other specialized 

corporations fill that role.

Many forms of creative accounting have 

been devised to keep assets and liabilities 

off of balance sheets. But one advantage of 

basing capital requirements on liabilities 

rather than assets is that it can be easier to 

motivate full reporting of liabilities on the 

balance sheet when regulators have the right 

to restrict a distressed bank’s payouts on any 

unreported liabilities. Off-balance-sheet 

transactions only work for the bank if it can 

use its good credit to reassure the parties 

who hold the bank’s liabilities. By accepting 

the transaction in a form that the bank can 

keep off its regulated balance sheet, however, 

those parties are undermining the reliability 

of the regulatory system for others, even 

though they want to rely on it themselves. 

It may be appropriate, then, to deter such 

investors from funding  

off-balance-sheet 

liabilities by a threat that a regulator could 



Journal of Economic Literature, Vol. LII (March 2014)

206


prevent them from getting their funds when 

they want them.

4

5.  Dangers of Risk-Weighting Assets in 



Capital Adequacy Formulas

In the work of the Basel Committee on 

Banking Supervision to coordinate interna-

tional standards for bank regulation, a major 

theme was the effort to make equity capital 

requirements more finely calibrated to the 

risks of the bank’s investments. The effort 

to define the minimal equity requirement 

as precisely as possible would make sense 

if there were some substantial social cost to 

requiring banks to have more equity than 

they need. But Admati and Hellwig have 

cogently demonstrated that, from the per-

spective of society as a whole, bank equity 

is not a particularly costly source of funds 

for economic investments. Indeed, Admati 

and Hellwig lead us to ask whether the 

entire Basel-led attempt to fine-tune capi-

tal requirements may have done more harm 

than good.

The first Basel standards from 1988 called 

for a bank’s equity capital to be at least 8 

percent of its total risk-weighted assets. 

Risk weights were introduced into this cal-

culation to reduce the required equity for 

a bank that made safer investments. Assets 

that were considered safe were given small 

risk weights of less than one. Then the 

required equity under this system would 

be computed by multiplying the value of 

each asset by its appropriate risk weight, 

summing these weighted asset values, and 

Such a provision for regulators to block payments on 



a distressed bank’s unreported liabilities could require a 

more conservative form of regulatory accounting for deriv-

ative contracts, each with a liability equal to the maximal 

potential cost of the contract for the bank in a worst-case 

scenario, and with a corresponding asset value equal to the 

surplus of the contract’s current expected (mark-to-mar-

ket) value for the bank over this worst-case scenario.  The 

reported maximal liability would have to be clearly stated 

also to the counterparty in the contract.

then requiring equity to be worth at least 8 

percent of the total. At the low end, loans 

to sovereign governments of high-income 

nations could even get risk weights of zero, 

and so this system would allow a bank to 

make arbitrarily large investments in sov-

ereign debt financed entirely by borrowing. 

In later Basel standards, the concept of risk-

weights was refined by more sophisticated 

formulas that could be based on the bank’s 

own models of risk.

Presumably, the original idea behind the 

risk-weighted capital adequacy formulas was 

to encourage banks to make safer invest-

ments by offering to relax equity require-

ments when a bank made investments that 

seemed safe. But this idea should have been 

considered a very questionable way to pro-

vide such an incentive, as the basic reason for 

requiring some minimal fraction of equity in 

a bank is to guarantee that the bank’s own-

ers have a substantial incentive to invest 

prudently. Worse (as critically observed by 

Haldane and Madouros 2012), we should 

recognize that any such attempt to codify 

what kinds of investments should be con-

sidered safe by regulators can itself create 

serious systemic risk for the entire financial 

system when a class of assets turns out to 

have been incorrectly categorized as “safe.”

We may assume that regulators, being 

sophisticated professionals, are often right in 

their evaluations of what is safe, but they will 

be wrong occasionally. When that happens, 

normal investors’ concerns about risk may 

make them less willing to hold these assets 

that have been wrongly categorized as “safe,” 

so the expected rates of return on these assets 

may begin to increase. Then banks through-

out the financial system will be tempted to 

borrow at low rates of interest and earn sur-

plus profits from the higher rates of return on 

these officially “safe” assets.  The temptation 

to do so increases when the amount invested 

becomes large enough that it could cause the 

bank to fail if the officially unrecognized risk 



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