The Basel capital adequacy ratios lost credibility with financial markets during the crisis. This paper argues that failure was the result of the reliance of the Basel standards on overstated asset values in reported equity capital. The United Statesâ?? stress tests were able to assist in restoring credibility, in part because they could capture deterioration in asset values. However, whether stress tests will prove equally valuable in the next crisis is not clear. Some of the weaknesses in the Basel ratios are being addressed. Moreover, the U.S. tests' success was the result of a combination of circumstances that may not exist next time.
JEL classification: G01, G21, G28, E50
Key words: Basel capital ratios, stress test, financial crisis
The author thanks Scott Frame, Gillian Garcia, Bev Hirtle, and participants at the Banking Law Symposium Workshop "Who Wants Big Banks?" for helpful comments on an earlier version of this paper. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
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