The current regulatory capital standard for banks – the Basle Accord – is a lose/lose proposition. Regulators cannot conclude that a bank with a nominally high regulatory capital ratio has a correspondingly low probability of insolvency. On the other hand, because the Accord often levies a capital charge out of proportion to the true economic risk of a position, banks must engage in “regulatory capital arbitrage” (or exit their low risk business lines). Since such arbitrage is costly, the capital regulations keep banks from maximizing the value of the financial firm. Regulators need to answer three questions: (1) What are the goals of prudential regulation and supervision? (2) How should bank “soundness” be defined and quantified? (3) At what level should a minimum “soundness” standard be set in order to meet the (perhaps conflicting) goals of prudential regulation and supervision? Possible answers to these questions are attempted, then the paper analyzes the two leading proposals for rationalizing the Accord – a “modified-Basle” (or ratings-based) approach and a “full-models” approach.