In particular, five such strategies were clearly in evidence: •  Higher leverage: The simplest way of exploiting the asymmetry of payoffs arising from limited liability is to increase leverage. For example, if the capital ratio of the hypothetical bank were to halve from 10% to 5%, the beta of the bank’s equity would double (Figure 2). In that event, the imbalance between privatised gains (above the zero axis) and socialised losses (below the zero axis) would increase. Private investors would harvest more of the upside and export more of the downside. There is clear evidence of this strategy being pursued over long sweeps of history (Chart 2). Chart 7 looks at the behaviour of UK banks over the past decade; it plots their leverage against the riskiness of their assets. UK banks migrated North-West over the past ten years, with balance sheet expansion financed by higher leverage. Because UK and European banks were not subject to any regulatory restriction on simple leverage, there was no effective brake on this leverage-fuelled expansion. Higher leverage fully accounts for the rise in UK banks’ returns on equity up until 2007. It also fully accounts for the subsequent collapse in these returns. The highleverage strategy pursued by UK and European banks rather effectively privatised gains and socialised losses. •  Higher trading assets: An alternative means of replicating the effects of higher leverage is to increase the proportion of assets held in banks’ trading books.
Chart 6: Number of deposit insurance schemes and crises 100 90  Number of adopters  80 70 60 50 40 30 20 10  1934 – Great Depression (US) 1977 – Banking crisis (Spain) 1982 – Banking crisis (Kuwait) 1985 – Banking crisis (Kenya) 1994 – Banking crises (Czech Republic, Uganda)  2008  2004  2000  1996  1992  1988  1984  1980  1976  1972  1968  1964  1960  1956  1952  1948  1944  1940  1936  1932  0  1995 – Banking crises (Brazil, Bulgaria) 1996 – Banking crises (Belarus, Lithuania) 1996-1998 – Asian crisis (Indonesia, Korea, Malaysia, Thailand) 1998 – Banking crisis (Ukraine) 1999 – Banking crises (Ecuador, El Salvador)  Source: Demirgüç-Kunt, A., Kane, E., and Laeven, L (2008); Laeven, L. and Valencia, F (2008). 16  BIS Review 139/2009  Chart 7: Leverage and risk-taking in UK banks Total Asse ts/Tier 1 Capital 80  2005-2008  70  2001-2004 1997-2000  60 50 40 30 T ier 1 ratio of 4%  20 10  T ier 1 ratio of 8%  0 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Risk We ighte d Asse ts/Total Assets Source: Published accounts and Bank calculations.