According to simulations on the impact of such an approach for the Euro-area countries, aggregate riskadjusted FISIM would stand at about 60% of current aggregate FISIM for the Euro-area countries over the period 2003–7 (Mink (2008)). (ii)  Measuring risk  Adjusting FISIM for risk would better capture the contribution of the financial sector to the economy. The fundamental problem is, however, that risk itself is unobservable ex-ante. The methodology described above measures risk in a relative way; it effectively assumes that if  3  Wang et al (2004), Wang (2003), Mink (2008), Colangelo and Inklaar (2010). BIS Review 95/2010  5  banks deviate from prevailing market rates, this is to compensate for the services they provide to borrowers and depositors. But at no point is there an assessment of the ability of the financial system to price risk correctly in an absolute sense. This might not be the objective of statisticians when measuring output. But it is essential when gauging the contribution of finance to economic well-being. To see this more clearly, consider an alternative example (Table 3). A bank lends £ to a corporate borrower. But the bank incorrectly assesses the credit risk of the corporate to be A-rated, when the true credit risk is BB-rated. Assume for simplicity that the corporate, knowing that its credit risk is greater than A, is prepared to pay a spread higher than that on an A-rated credit risk (say 2%). The market spreads for A-rated and BB-rated credits are 1% and 2% respectively.
During much of this period, banks internationally were engaged in a highly competitive ROE race. Therein lies part of the explanation for these high returns to labour and capital in banking. 4. Explaining aggregate returns in banking – excess returns and risk illusion How do we explain these high, but temporary, excess returns to finance which appear to have driven the growing contribution of the financial sector to aggregate economic activity? In this section we discuss potential balance sheet strategies which may have contributed to these rents. Essentially, high returns to finance may have been driven by banks assuming higher risk. Banks’ profits, like their contribution to GDP, may have been flattered by the mis-measurement of risk. The crisis has subsequently exposed the extent of this increased risk-taking by banks. In particular, three (often related) balance sheet strategies for boosting risks and returns to banking were dominant in the run-up to crisis:   increased leverage, on and off-balance sheet;    increased share of assets held at fair value; and    writing deep out-of-the-money options. What each of these strategies had in common was that they generated a rise in balance sheet risk, as well as return. As importantly, this increase in risk was to some extent hidden by the opacity of accounting disclosures or the complexity of the products involved. This resulted in a divergence between reported and risk-adjusted returns. In other words, while reported ROEs rose, risk-adjusted ROEs did not (Haldane (2009)).