See www.bankofengland.co.uk/publications/speeches/2009/speech374.pdf  BIS Review 85/2009  3  difference between landing in the red rather than the black. In that sense, stress tests are not something it is possible definitively to “pass” – though experience suggests they are somewhat easier to “fail”. On thresholds, determining the optimal level of capital for a bank is an area which has been chronically, and perhaps surprisingly, under-researched. Policymakers have repeatedly ducked this question. Aggregate amounts of capital in the financial system have been fixed at the same levels which prevailed at the time of the first Basel Accord. And academics have, to my knowledge, no definitive quantitative answer to the optimal capital question. Longer runs of data, while interesting, are far from definitive. Over the past 150 years, capital ratios among US commercial banks have fallen roughly by a factor of ten (Chart 7). Is the optimal capital ratio to be found from experience in the 1990s – roughly, 5%? Or from the interwar years – roughly 10%? Or from the latter half of the 19th century – between 20% and 40%? Answering those questions will mean reassessing the validity of the Modigliani/Miller (MM) theorem in today’s capital markets. 3 MM states that firms’ debt/equity ratios are essentially irrelevant to their total cost of capital. Why? Because a rise in leverage generates offsetting movements in the cost and risk of banks’ capital, in a frictionless world leaving the riskadjusted cost of capital unchanged. By revealed preference, owners and managers of banks have rejected the MM hypothesis.
The second is a measure of gambler’s luck in gearing up those assets. In effect, ROE is skill multiplied by luck. So which has been the dominant determinant of banks’ ROE, historically and recently? Chart 2 looks at the decomposition given by equation (1) for UK banks over the period since 1920. Movements in leverage have clearly been the dominant driver. Since 2000, rising leverage fully accounts for movements in UK banks’ ROE – both the rise to around 24% in 2007 and the subsequent fall into negative territory in 2008. Chart 3 looks at the same decomposition across a panel of 70 global banks at the end of 2007. The vertical axis measures return on assets and the horizontal axis leverage. The curves are iso-ROE lines, drawn at 5%, 20% and 40%. The distribution of points lies along a downward-sloping curve. Two implications follow from this. First, the downward slope is consistent with global banks targeting a ROE, perhaps benchmarked by peers’ performance. The Bank’s market intelligence in the run-up to crisis suggested that such “keeping up with the Jones’s” was an important cultural influence on banks’ decision-making. Second, Chart 3 suggests that banks kept up in this competitive race by gearing-up. Banks unable to deliver sufficiently high returns on assets to meet their ROE targets resorted instead to leveraging their balance sheets. During the golden era, competition simultaneously drove down returns on assets and drove up target returns on equity.