My new column for National Journal argues that the success of the G20's efforts to stabilise the world economy will turn on whether governments can mend the capital-adequacy regime for banks and other financial firms. [The link to the article expires in a week.]

The most important unfinished business is reform of financial regulation -- and the most crucial piece of that fix is capital requirements. To prepare the way for the Pittsburgh summit, the G-20 finance ministers met in London, and Treasury Secretary Timothy Geithner presented some good proposals. The details are complex and troublesome, of course, but the basic principles of what needs to be done are actually quite simple and not in dispute...

Regulators have let banks hold less and less capital over the years, reasoning that bankers were competent managers of financial risk. How quaint that now seems. In effect, banks were allowed to decide for themselves how much capital was needed, and even what counted as capital for regulatory purposes. Capital has a low yield -- which is why a higher capital requirement is like a tax on banks' lending -- and governments were standing by to rescue them if necessary. So they cut corners. You know the rest.

Geithner said that banks need to set aside much more capital. Big banks should reserve proportionally more than small banks. The new requirement also needs to be "counter-cyclical": Banks should have to set aside proportionally more capital when their lending is increasing quickly. There should be an overall leverage ratio, too, as a global check on capital adequacy, even if proper amounts of capital have been reserved against specific types of "risk-adjusted" lending. And there should be a liquidity requirement so that banks have a line of retreat if their ability to borrow short-term is compromised...

The Pittsburgh meeting affirmed the need for this new regime, but the timetable for reform is vague and the G-20 partners have different ideas about what happens next. Right now, U.S. banks are better capitalized than many of their European counterparts, so Europe is complaining that it will be harder for its banks to execute Geithner's proposal. This disagreement is liable to slow the introduction of new rules and might lead to their being watered down...

This is the G-20's real challenge. Forget the rest -- rebalancing global growth, rebuilding the International Monetary Fund, coordinating fiscal and monetary "exit strategies," and all the other stuff name-checked in the communique. Helpful though some of that may be, none of it is indispensable (and some of it is impossible). Stricter bank capital requirements are in a category of their own. Judge the G-20 -- and place your bets on the next financial crisis -- according to what, if anything, it achieves on this.

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