I think this is because banks and regulators came to believe capital was very costly. In particular the Modigliani-Miller (M-M) offset (that equity becomes less risky, and so less expensive, as gearing falls) was ignored. A failure to understand the exact details of the M-M theorem is of course understandable – it is a theoretical result and one which was originally described in an academic article. But it was – and remains – surprising to me that the most basic bit of the story – that if a bank has less debt gearing then the volatility of the returns on its equity will be lower and that this will have an impact on the required rate of return on it – seems to have been largely ignored by many people running banks 4 . Anyone  4  Merton Miller (1995) makes the essential point with typical clarity: “And dearly, if a bank were earning only 8 percent on average on its loan portfolio, financing that portfolio with 12 percent money wouldn't make a lot of sense. But the cost of equity is not a fixed number; it's a function that depends both on the risk of the firm's earning assets and the degree of leverage in the firm's capital structure. The 12 percent figure I quoted is merely one point on that function reflecting the average business risk and average leverage position of American equities.
David Miles: Leverage and monetary policy Speech by Mr David Miles, Member of the Monetary Policy Committee of the Bank of England, at The Economic and Social Research Institute/Foundation for Fiscal Studies (ESRI/FFS) conference, Dublin, 12 October 2010. *  *  *  I would like to thank Jing Yang and Gilberto Marcheggiano for research assistance and to colleagues at the Bank of England for helpful comments. The views expressed are my own and do not necessarily reflect those of other members of the Monetary Policy Committee. You do not need me to stand here in Dublin this morning and tell you what profoundly difficult economic times we are going through. As an elderly New York friend of mine enquired of me recently when I offered such a thought “for such pearls we need economists?” I feebly replied that knowing how much of a mess you were in was of some use and (with rather more confidence) that thinking how you get out of the mess was something economics could help with. Today I want to talk about setting monetary policy as we emerge from one mess and how we can reduce the chances of getting into another one. I am going to focus on the UK but I think much of what I say has relevance here in Ireland and beyond. That it has been a very bad mess is clear.