What should capital requirements be like?

I don't think the answer to the title question is clear. But some desireable criteria are becoming apparent. I suggest:

• At any point in time, larger risk should imply larger capital, i.e. there should be portfolio risk sensitivity.
  
• Overall, market wide changes in risk premiums (and in particular market crises) should not change capital requirements.
  
• An element of capital should depend on stressed liquidity, i.e. how liquid the institution's assets are in a crisis.
  
• Only limited capital reduction should be permitted for risk transfer of assets originated by the institution. This ensures alignment of interests and reduces the total amount of risk leaving the regulated financial system.
  
• Transactions which reduce capital without reducing risk should (ideally) not be possible or, if they are, forbidden by other means. Regulatory capital arbitrage should not be counternanced.
  
• Incentives should not exist for risk to move from more advanced banks to less advanced ones. The menu approach for credit risk does this at the moment in Basel 2: standardised approach banks have lower capital charges for the worst quality borrowers than IRB banks. Internal models approach should always give the same or (slightly) lower capital than standard rules in order to preserve the incentive to meet the standards for internal modelling.
  
• The capital regime should incorporate larger charges for assets of uncertain value (level 3 assets in the FAS 157 hierarchy) and lower ones for level 1 assets.