Although they are second in the risk-bearing queue, debt-holders as well as equity-holders would be expected to shoulder, and hence price, this balance sheet risk. This could be done either by raising its cost or by restricting its quantity. Either way, debt would then serve as a restraining device on riskhungry, rent-seeking shareholders. In theory, this debtor discipline mechanism ought to work like a dream. Under the assumptions of Modigliani and Miller (1963) (MM), the pricing of risk by debt-holders ought to neutralise fully any effect of increased leverage on the value of the firm. Provided  12  Anglo-Continental Guano Works v Bell (Surveyor of Taxes) (1894) 3 TC 239. 13  Farmer (Surveyor of Taxes) v Scottish North American Trust, Ltd (1912), AC 118. 14  For example, the introduction of a separate corporate tax schedule in the UK in 1965 led for a time to the double taxation of equity. 15  These investors account for perhaps half of the US equity market and two-thirds of the UK equity market. 6  BIS central bankers’ speeches  shareholders maximise firm value, and the world behaves according to MM, debtor discipline ought to defuse completely incentives to gear-up. Figure 3 illustrates the point diagrammatically, showing payoffs to debt and equity. They are a mirror-image. The downside risk avoided by equity is assumed by debt and vice-versa for upside returns. In principle, then, combining debt and equity would lead to offsetting payoffs, neutralising risk-taking incentives.
US Treasury (2011), “Financial Stability Oversight Council 2011 Annual Report” available at http://www.treasury.gov/initiatives/fsoc/Documents/FSOCAR2011.pdf Walker, D (2009), “A review of corporate governance in UK banks and other financial industry entities”, available at http://www.hm-treasury.gov.uk/d/walker_review_261109.pdf  BIS central bankers’ speeches  17  Figure 1: Payoff profile for bank equity  Figure 2: Payoff profile for bank equity with higher leverage  18  BIS central bankers’ speeches  Figure 3: Payout profiles for bank equity and debt  BIS central bankers’ speeches  19  Chart 1: Estimated distribution of UK banks’ assets to GDP  Source: Sheppard, D.K (1971) and Bank of England. (a) Data before 1974 are from Sheppard, D.K (1971). The definition of UK banking sector assets is broader after 1966, but using a narrower definition throughout gives the same growth profile. (b) Data after 1974 include total assets of UK resident banks from Bank of England data. Assets of the Bank of England’s Issue department and Asset Purchase Facility are excluded. Notes: The density estimates are based on a normal kernel function and a number of observations in each subsample. Chart 2: Estimated distribution of UK banks’ return on assets  Source: Capie, F and Billing, M (2004), BBA and Bank calculations. Notes: The density estimates are based on a normal kernel function and a number of observations in each subsample. There is a definitional change in the sample in 1967 and again in 2010.