This requires financial institutions to internalize the costs of their risk-taking activities up front and to hold capital and liquidity buffers sufficient to handle a plausible range of adverse outcomes. Finally, on occasions when these buffers prove inadequate and a financial firm does reach the brink of failure, the official sector needs the capacity to smoothly wind down such firms so that future taxpayer-funded rescues prove unnecessary. Regulatory and supervisory efforts to accomplish these goals are proceeding down several distinct but related paths:   Increase the capital and liquidity standards for all internationally active banks, measured by both quantity and quality of capital and liquidity, so that they are better able to absorb financial shocks without disrupting the flow of credit to the real economy.   Introduce a credible resolution mechanism for managing the failure of a large systemic bank or nonbank financial institution, to reduce the economywide costs of such failures and, by making them less disruptive, further reduce moral hazard by diminishing expectations of future public support.   Ensure that the largest and most interconnected financial institutions – whether or not they are chartered as banks – face even more stringent prudential standards, in order to reduce moral hazard for the largest firms and lower the probability of their failure to below that of smaller and less systemically important institutions.   Strengthen financial market infrastructures so that when failures inevitability occur, the shocks generated by these failures are dampened, not amplified as they propagate through the financial system.

This is important because the crisis demonstrated that bank investors and debt holders have a strong presumption that only common equity is truly loss absorbing outside bankruptcy. In the crisis, as losses climbed, Tier 1 capital ratios were eroded from the bottom, with tangible common equity ratios sometimes shrinking to levels that raised questions about a bank’s viability and its ability to access the equity and debt markets. Although common equity is typically a higher-cost form of capital for banks, it absorbs losses on a going-concern basis and so preserves an institution’s viability in the eyes of the market much better than other forms of Tier I capital, such as perpetual preferred stock or trust preferred securities (TRUPS). Second, the standards create a new definition of what constitutes common equity. The emphasis is on the ability of common equity to be loss absorbing. For that reason, there are limits on the amount of the assets that are not readily saleable or loss absorbing that can be counted toward a bank’s tangible common equity. These include assets such as mortgage servicing rights and deferred tax assets. Also, there is strict treatment of equity tied up in the form of minority interests. That is because this invested equity is not immediately available to the parent company to absorb losses in that company’s operations. Third, the minimum required ratio of total tangible common equity to risk-weighted assets will be increased significantly. Once the new standards are fully phased in, it will have to equal 4.5 percent of risk-weighted assets.