The hand-wringing over bank capital levels is pulling the spotlight off a bigger issue: effective oversight of the largest firms.

In the wake of the crisis, regulators have forced banks to hold both a higher level and a higher quality of capital. They've created a tangle of complicated rules.

Capital edicts either on the books or in the implementation process include Basel 1, 2, 2.5 and 3; the Collins amendment; the leverage ratio; a domestic as well as an international surcharge for systemically important institutions; and something called a conservation buffer that's supposed to counter the procyclicality tendencies of supervision.

And don't forget the rules merely establish minimums — examiners have authority to tell any institution that it must hold more capital. Should one of these giants fail, Dodd-Frank requires the others to chip in and cover the costs.

And yet the headlines are full of angst over capital, with hardly a word about supervision.

Federal Reserve Board Gov. Daniel Tarullo rocked markets, not to mention the C-suites of all the large firms, when he suggested capital requirements may need to be double the amounts laid out in Basel III. Witnesses at a congressional hearing last week argued that requiring too much capital will put U.S. firms at a competitive disadvantage, hinder lending and stall an economic recovery. Other experts claim that's all hogwash and the capital levels remain too low.

I'm not taking sides on the too much, too little question, but the debate ignores the role of supervision. Strong capital is the foundation of sound oversight. We should accept that and build from there.

The Dodd-Frank Act gave the federal agencies some great new tools like living wills and credit exposure reports and forced broader use of existing methods like stress testing. If vigorously adopted, all three would give examiners vastly more information about and insights into the largest companies and their interconnections.

But the best supervision is so much more than rule-writing and enforcement. It is well-trained examiners who earn the respect of a bank's executives and directors by providing valuable advice and direction. Without crossing the line into bullying or into running the company, it is examiners who are experienced enough and, yes tough enough, to spot trouble in the making and force senior management to act.

British regulators gave a nod to this aspect of oversight in their recently released blueprint for reform: "Tick-box compliance with rules has been shown to be of limited use as a model of supervision. Regulators must be empowered to look beyond compliance, to supervise proactively, and to challenge."

Unfortunately, few people believe that's the kind of oversight we have now, and that's part of what's feeding an obsession with capital.

The financial crisis undermined regulators' credibility. The agencies allowed subprime lending and securitization to spiral out of control and only noticed the foreclosure mess when it became a national nightmare.

And implementation of Dodd-Frank has hardly been inspiring. Nearly a year after the law's enactment, the Treasury Department (under the guise of the new, underwhelming Financial Stability Oversight Council) has yet to identify which firms are "systemically important" and thus subject to the law's tougher oversight.

What is so hard about this task? Anyone paying attention for the past three years could draw up that list in about five minutes. And there is nothing to keep the government from adding more firms down the line. But start somewhere. Give the public some assurance rather than publishing endless proposals that don't provide any progress.

And while Congress in Dodd-Frank rejected a consolidation of regulatory agencies, it feels as though the agencies took that "victory" as a free pass to bulk up. The Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. all have separate divisions devoted to large-bank supervision. Throw in the FSOC and the Office of Financial Research, which Dodd-Frank created to spot systemic risks but that the Obama administration has all but ignored, and there are plenty of resources being thrown at the systemically important firms. But none of it feels coordinated.

JPMorgan Chase & Co.'s chief risk officer, Barry Zubrow, testified before Congress last week that between 75 and 135 examiners from an array of agencies are in the bank at any given time.

"We underwent 218 examinations in 2010, and will see more this year," Zubrow said. "It is difficult to overstate the increase in supervisory oversight for large financial firms."

I don't know how many examiners it takes to provide quality oversight of JPMorgan Chase, but I wonder how closely all those examiners are working.

Acting Comptroller of the Currency John Walsh agrees that's a risk.

"The struggle we are going to face in the next three to five years is going to be trying to work out sensible working relationships with the other agencies that don't have us falling over each other and doing things three or four times," he said in an interview. "We already see some evidence of that. It will be really silly if we just wind up doing the same work multiple times and second-guessing one another."

There's a pretty clear reason, however, why everyone focuses on capital over supervision.

Capital is "quantitative and supervision is qualitative," said Karen Shaw?? Petrou, managing partner of Federal Financial Analytics Inc. "Tangible common equity is about the only thing on which you think you can compare banks."

But Petrou says confidence in capital ratios is overstated, mainly due to an overemphasis on the numerator. Capital levels are not purely objective; supervision plays a critical role in just how strong a bank's capital looks.

The regulatory minimums are expressed as ratios — some form of capital over some measure of assets. The simplest is total capital divided by total assets, but in the Basel calculations the denominator is weighted to reflect the riskiness of a firm's assets.

Of course there's a lot of debate over just how risky any asset or class of assets actually is and U.S. regulators are generally harsher in their assessments than European regulators. But it is another indication of the critical role supervision plays.

"This is a supervisory issue: How good are your models and how do you estimate the probability of default?" Petrou said. "You can measure TCE [tangible common equity], but then you have to divide it by the denominator, and the denominator remains completely discretionary."

Jon D. Greenlee, a former Fed official who is now a managing director at KPMG's financial services regulatory practice, agrees capital should not be allowed to overshadow oversight.

"Some people think if we get enough capital in there then we don't really have to worry about supervisors missing risk, and I am not sure that is going to give you a satisfactory answer during the next downturn," he said. "You can't just focus on capital alone. There is still a very important role for the supervisory process."

Finally, I wonder if all the rules being written in the U.S. are meaningless if regulators in other countries don't adopt similar measures.

Treasury Secretary Tim Geithner has repeatedly assured the industry recently that other countries will follow our lead. But why, when we're only talking about a few dozen companies that operate globally, aren't national regulators collaborating now to design a supervisory system for these firms?

Such suggestions are met with a roll of the eyes and a comment about naivete, but why is that? It would make a lot more sense for countries to figure out how to jointly supervise and resolve financial firms that operate across borders than to have each construct its own rules now and be forced to reconcile differences someday down the road.

"To effectively wind down a global institution, you really need to have a global framework," Greenlee said. "You can't have it one way here and 35 different ways around the globe and make it work."

Bottom line: Let's stop arguing over capital and focus on how to oversee global institutions.



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