These included the migration of activity and risk to unregulated “shadow banks” (Adrian and Ashcraft (2012)); the hard-wiring of rating agency risk assessments into the regulatory engine (Edmonds (2016)); the payment of bank CEOs in common equity encouraging “gambling for resurrection” (IMF (2014)); and the implicit subsidies conferred on “too-big-to-fail” institutions, encouraging them to become larger and more complex and connected still (FSB (2013b)). Another example of these incentive effects came in the area of capital regulation. Whichever risk-weighting scheme is in place, it is likely to give rise to incentives to adjust asset positions to maximise profits. For example, if the regulatory constraint takes the form of a leverage ratio there are incentives to alter the composition of assets towards those with higher risk weights – though the evidence on such “risk-shifting” is mixed (Sheldon (1996), Furlong (1988)). Contrarily, if assets are risk-weighted and determined by banks’ internal models, there are incentives to lower modelled risk weights over time (Mariathasan and Merrouche (2014)). In short, when setting capital standards for banks, there is a two-sided incentive problem. 28  All speeches are available online at www.bankofengland.co.uk/speeches  28  Pre-crisis, both incentives were at play, albeit to differing degrees in different parts of the global financial system. In the US, where a leverage ratio was in operation and often the binding constraint, there were incentives for banks to seek higher-risk assets rather than expand balance sheets (Chart 20).
United Kingdom: Sheppard, D (1971), The growth and role of UK financial institutions 1880-1962, Methuen, London; Billings, M and Capie, F (2007), 'Capital in British banking', 1920-1970, Business History, Vol 49(2), pages 139-162; BBA, published accounts; FPC core indicators and Bank calculations  Notes: (a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets). SNL data from 1996 on, based on accounting definition of equity. (b) UK data on the capital ratio show equity and reserves over total assets on a time-varying sample of banks, representing the majority of the UK banking system, in terms of assets. Prior to 1970 published accounts understated the true level of banks' capital because they did not include hidden reserves. The solid line adjusts for this. 2009 observation is from H1. Data from 2010 onwards is based on the simple leverage ratio published by the FPC (as of September 2017) as one of its core indicators for the countercyclical capital buffer. (c) Change in UK accounting standards. (d) International Financial Reporting Standards (IFRS) were adopted for the end-2005 accounts. The end-2004 accounts were also restated on an IFRS basis. The switch from UK GAAP to IFRS reduced the capital ratio of the UK banks in the sample by approximately 1 percentage point in 2004.