CRS Report – Belts and Suspenders: Analysis of Large Bank Capital Standards, July 26, 2023: ” One way regulators ensure that banks operate in a safe and sound manner is by establishing capital requirements that banks must meet. Bank capital serves as a layer of protection against losses, and in doing so it promotes public confidence in banking institutions. This reduces the likelihood of bank failures, which is important to policymakers, because the federal government provides a financial safety net to protect depositors and the broader economy, which exposes taxpayers to potential losses. Capital rules are set through regulation by the federal bank regulators—the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve, and the Office of the Comptroller of the Currency (OCC)—and are modeled on international agreements made by the members of the Basel Committee on Bank Supervision. Banks face two sets of capital requirements: (1) risk-based requirements based on the risk of a bank’s assets and (2) leverage requirements based on the size of the bank. The reason regulators use risk-weighted assets (RWA) is because some assets are inherently riskier than others. Without risk weighting, banks would have an incentive to hold riskier assets, as the same amount of capital must be held against riskier and safer assets. But risk weights may prove inaccurate. For example, banks held highly rated mortgage-backed securities (MBSs) before the 2008 financial crisis, in part because those assets had a higher expected rate of return than did other assets with the same risk weight. MBSs then suffered unexpectedly large losses during the crisis. Thus, leverage requirements, which are based on size rather than risk, can be thought of as a backstop to ensure that incentives posed by risk-weighted capital ratios do not result in a bank holding insufficient capital. Further, leverage ratios act as a “belt and suspenders” approach to capital regulation that guard against the risk of a particular institution as well as the potential systemic impact a larger asset portfolio may have on the financial system should it succumb. Leverage ratios also proved to be more transparent and therefore instilled more confidence during financial crises.”