And the state has underwritten any losing streak. Clearer practical examples of a policy timeconsistency problem are unlikely to exist. 4. Resolving the time-inconsistency problem  In addressing this time-consistency problem, two broad approaches are possible: redesign of the financial system to reduce the scale of insurable risks; and redesign of the social safety net to make it less susceptible to gaming. (a)  Redesigning the financial system  What options best tackle excessive risk-taking incentives? A number suggest themselves, some modest, others more radical. •  Introducing leverage limits: One simple means of altering the rules of the asymmetric game between banks and the state is to place heavier restrictions on leverage. European banks were not subject to a regulatory leverage ratio in the runup to crisis. They exploited that loophole. Closing it would bring about a clockwise rotation in banks’ payoff schedule, lowering the beta of banks’ equity returns and reducing risk-taking incentives. This is an easy win. Simple leverage ratios already operate in countries such as the US and Canada. They appear to have helped slow debt-fuelled balance sheet inflation. The Basel Committee is now seeking to introduce leverage ratios internationally. To be effective, it is important that leverage rules bite. They need to be robust to the seductive, but ultimately siren, voices claiming this time is different. That suggests they should operate as a regulatory rule (Pillar I), rather than being left to supervisory discretion (Pillar II). It is important, too, that leverage limits are set at the right level.
Trading assets are marked to market prices, thereby increasing their sensitivity to aggregate market fluctuations (beta). To illustrate, assume that a bank holds 90% of its assets in the banking book (with a beta of zero) and the remainder in the trading book (with a beta of one). That gives an asset beta of 0.1 and an equity beta of unity (Figure 1). But if the size of the trading book is doubled to 20% of assets, this doubles the equity beta of the bank (Figure 2). Chart 8 plots a cross-section of global banks’ trading assets as a fraction of their total assets against their leverage. It suggests that efforts to expand balance sheets through higher leverage were focussed on trading assets. In the first part of this  13  Barro (1979). BIS Review 139/2009  5  decade, rising asset prices delivered mark-to-market gains on banks’ expanding trading assets. This boosted their profitability and returns on equity. As long as asset prices rose, this created an Alice in Wonderland world in which everybody had won and all had prizes. But when asset prices fell, reality returned. The same institutions suffered enormous mark-to-market trading book looses. Across global banks, trading book losses since the start of the crisis total over $ In a number of cases, these losses necessitated state support. Trading book expansion also allowed banks to import the upside and export some of the downside.