Regulators around the world are working to put banks under much stricter capital adequacy rules. If banks hold more capital, it is argued, the banking system can withstand bigger future losses, and the world will enjoy greater financial stability.

I share the determination to prevent a repeat of the financial crisis. I also believe capital adequacy regulations have a key role in our prevention efforts. Medicine, however, should be prescribed properly, as any effective medicine has side-effects as well. Suppose stronger regulations make banks issue more equity. Then the capital market will expect greater profits in return, and bank management may be tempted to meet such profit pressure by taking more risks. Was this, however, not the cause of the catastrophe?