What is the optimal level of capital that a bank should hold? The new Basel III agreement sets a minimum level of 7% core Tier 1 capital, whose definition has been sufficiently tightened to consist almost largely of common equity. Under the Basel II rules, a bank could get away with just 2% common equity. But if Bank of England Monetary Policy Committee member David Miles is to be believed, regulators should really be forcing banks to hold as much as 20% core Tier 1 capital.

Using mathematical models, Miles concludes that any increase in the cost of capital to the economy arising as a result of requiring banks to hold core Tier 1 capital of between 17% and 20% of risk-weighted assets would be more than offset by the benefits of reducing the probability of systemic banking crises. Indeed, his models simply confirm what history already tells us; after all, banks in the past made far greater use of equity funding yet economic performance wasn't obviously worse.