It is not difficult to see that a crisis that reduces output by  BIS Review 140/2010  5  between 5% and 10% for a number of years, and occurs once every fifty years, amounts to an annual cost several multiples of the revenue that will be generated by the UK bank levy (Haldane, 2010). But how can we be certain of correctly establishing what the tax should be when we are trying to internalise costs that occur so infrequently? So although there is a sound case for a levy directed at the size of short-term borrowing, it would be foolish to regard that as the main tool to align costs and benefits of risky balance sheet activity. If setting the appropriate price is hard, then some form of controls on quantities might be a better answer (Weitzman, 1974). For example, limits on leverage have much to commend them. And for a generation, the quantitative control of this type that regulators have embraced was embodied in the capital standards set within the Basel framework. Last month a new concordat on such standards was reached in Basel – the so-called Basel III requirements. The challenge here is to set the requirements in a way that will materially affect the probability of a crisis. Other forms of quantitative intervention include functional separation to reduce the costs of maturity transformation by ring-fencing those activities that we are most concerned to safeguard from disruption. If successful, the costs of any failure of financial institutions would be reduced.
That is what happened in 2007–08. As the IMF have pointed out differences in capital ratios failed to predict which financial institutions would be vulnerable in the crisis (IMF, 2009). Only very much higher levels of capital – levels that would be seen by the industry as wildly excessive most of the time – would prevent such a crisis. Second, the Basel approach calculates the amount of capital required by using a measure of “risk-weighted” assets. Those risk weights are computed from past experience. Yet the circumstances in which capital needs to be available to absorb potential losses are precisely those when earlier judgements about the risk of different assets and their correlation are shown to be wrong. One might well say that a financial crisis occurs when the Basel risk weights turn out to be poor estimates of underlying risk. And that is not because investors, banks or regulators are incompetent. It is because the relevant risks are often impossible to assess in terms of fixed probabilities. Events can take place that we could not have envisaged, let alone to which we could attach probabilities. If only banks were playing in a casino then we probably could calculate appropriate risk weights. Unfortunately, the world is more complicated. So the regulatory framework needs to contain elements that are robust  6  BIS Review 140/2010  with respect to changes in the appropriate risk weights, and that is why the Bank of England advocated a simple leverage ratio as a key backstop to capital requirements.