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.
In particular, five such strategies were clearly in evidence: •  Higher leverage: The simplest way of exploiting the asymmetry of payoffs arising from limited liability is to increase leverage. For example, if the capital ratio of the hypothetical bank were to halve from 10% to 5%, the beta of the bank’s equity would double (Figure 2). In that event, the imbalance between privatised gains (above the zero axis) and socialised losses (below the zero axis) would increase. Private investors would harvest more of the upside and export more of the downside. There is clear evidence of this strategy being pursued over long sweeps of history (Chart 2). Chart 7 looks at the behaviour of UK banks over the past decade; it plots their leverage against the riskiness of their assets. UK banks migrated North-West over the past ten years, with balance sheet expansion financed by higher leverage. Because UK and European banks were not subject to any regulatory restriction on simple leverage, there was no effective brake on this leverage-fuelled expansion. Higher leverage fully accounts for the rise in UK banks’ returns on equity up until 2007. It also fully accounts for the subsequent collapse in these returns. The highleverage strategy pursued by UK and European banks rather effectively privatised gains and socialised losses. •  Higher trading assets: An alternative means of replicating the effects of higher leverage is to increase the proportion of assets held in banks’ trading books.