In the event of a bad state of the world – default by the reference entity in a CDS context – the writers of the insurance suffer a significantly negative payoff, eliminating the apparent alpha earned in good states (Figure 3). This was, in effect, the AIG strategy. AIG is believed to have written around $ trillion of CDS protection. This strategy delivered large apparent “alpha” returns during the disco years. But when the music ceased and true beta was revealed, AIG required state support of around $ These five strategies are the latest incarnation of efforts by the banking system to boost shareholder returns and, whether by accident or design, game the state. For the authorities, it poses a dilemma. Ex-ante, they may well say “never again”. But the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop. The “St Petersburg paradox” explains how a gambling strategy which starts small but then doubles-up in the event of a loss can yield positive (indeed, potentially infinite) expected returns. Provided, that is, the gambler has the resources to double-up in the face of a losing streak. The St Petersburg lottery has many similarities with the game played between the state and the banks over the past century or so. The banks have repeatedly doubled-up.
Chart 8: LCFIs’ trading portfolios and financial leverage – 2007  Line of best fit  80 70 Total assets/Tier 1 Capital  UBS 60  Deutsche  SocGen Barclays BNP  50 40  RBS  30  Citi BofA  20  Credit Suisse HSBC JPM  10 0 0.0  0.1  0.2 0.3 0.4 0.5 0.6 T rading assets/total assets  0.7  0.8  Sources: Published accounts and Bank calculations  BIS Review 139/2009  17  Chart 9: Leverage and risk-taking in international banks – 2007 Total Adjuste d Asse ts/Tier 1 Capital 80  4% T 1 capital ratio  70 60  UBS  Deutsche  Credit Suisse  SocGen RBS BNP Citi Barclays  50 40 30  BoA  20 HSBC JPM  10 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 ighted Assets/Total Adjuste d Asse ts Sources: Published accounts and Bank calculations. Notes: These adjustments aim to ensure a common accounting treatment of exposures between US and European banks.