So instead they did the next worst thing: they sought higher return on equity by increasing the riskiness of their asset pool. This explains their venture into sub-prime and leveraged lending and various kinds of securitised exotica. Chart 9 looks at the leverage and risk positions of European versus US banks. European banks lie in the North West, as they exploited the absence of a leverage constraint to expand their balance sheets in search of higher return on equity. US banks, by contrast, located themselves in the South-East with lower leverage but higher risk per unit of assets. For US banks, this was a best response strategy for boosting shareholder payoffs. When risk on these high-default assets materialised, however, the result was the same as for European banks – deep losses, often cushioned by the state. •  Out-of-the-money options: The payoffs to high-risk lending can be replicated using an alternative strategy of writing deep out-of-the-money options. This can be achieved, for example, by selling protection in the CDS market. The writer of that protection receives an insurance premium and thus a steady source of income in  14  Keynes (1931). 15  Haldane (2009), Beale et al (2009). 6  BIS Review 139/2009  good states of the world. Because of that, this strategy appears to generate “alpha” – excess returns – during the good times. In fact, this strategy is a wolf wrapped in sheep’s clothing; it is beta dressed up as alpha.
5 Two sets of initiative are discussed here: changes to the regulation of banks’ risk-taking; and changes to the terms of the social safety net to improve its time-consistency. It is too early to know whether these measures will be sufficient. But recent events suggest some mix of these measures is surely necessary. 2. Evolution in the banking safety net  The three longest standing state insurance devices for the banking system are liquidity insurance, deposit insurance and capital insurance. These offer protection to different parts of banks’ capital structure, respectively wholesale deposits, retail deposits and equity. So how have risks to banks’ balance sheets – in effect, the “insurable interests” of the state – evolved over time? And how, in turn, has this evolution shaped the design of the banking safety net? The UK provides a useful historical case study. Chart 1 plots UK banks’ balance sheet against GDP since 1880. The ratio is flat for almost a century, at around 50%. Over this period, banks’ assets grew roughly in line with money spending. But from the early 1970s, this pattern changed dramatically. By the start of this century, bank balance sheets were more than five times annual UK GDP. In the space of a generation, the insurable interests of the state had risen tenfold. By itself, this expansion of balance sheets need not imply that the state was bearing greater implicit risk. For example, banks could have self-insured by holding larger buffers of capital and liquidity.