In practice, the opposite happened (Charts 2 and 3). Capital and liquidity ratios have fallen secularly in the UK and US for over a century. Since the start of the 20th century, capital ratios have fallen by a factor of around five in the US and UK. Liquidity ratios have fallen by roughly the same amount in half that time. Taken together, these balance sheet trends indicate a pronounced rise in banking system risk and hence in potential demand for state insurance. They have also affected the returns required by bank shareholders. As banks moved up the risk spectrum, the return required by shareholders has predictably increased. Between 1920 and 1970, the return on UK banks’ equity averaged below 10% per annum, with low volatility of around 2% per year (Chart 4). This was roughly in line with risks and returns in the non-financial economy. The 1970s signalled a sea-change. Since then returns on UK banks’ equity have averaged over 20%. Immediately prior to the crisis, returns were close to 30%. The natural bedfellow to higher return is higher risk. And so it was, with the volatility of UK banks’ returns having trebled over the past forty years. 4  Indeed, contract incompleteness is one of the reasons banks exist in the first place (Rajan (1998)). 5  See, for example, King (2009). 2  BIS Review 139/2009  This regime shift upwards in the risk and return profile of UK banks can be explained by the fall in their capital ratios.
Plainly, there has been a dramatic expansion in both the scale and scope of state liquidity insurance to the banking system. This pattern has been repeated in the majority of recent systemic banking crises. In a study of 42 systemic banking crises between 1970 and 2007, Laeven and Valencia find peak liquidity provision of almost 30% of total deposits. Drastic times clearly call for drastic measures. Harman’s description of last resort lending in 1825  6  Thorton (1802), Bagehot (1873). 7  Quoted in Bagehot (1873). 8  The sample ends before quantitative easing began, so base money growth is not affected by recent monetary policy actions in the UK. 9  Committee on the Global Financial System (2008). BIS Review 139/2009  3  would not look out of place today. Except, crucially, the decimal point would have changed place. Deposit insurance and capital insurance have a shorter history. Deposit insurance was first introduced in the US in 1934, to protect retail depositors scorched by the experience of the Great Depression. It failed to catch on internationally. By the early 1960s, the US was still the only developed country with an explicit deposit insurance scheme. Since then, there has been a steady rise in the number of adopting countries (Chart 6). By 2009, almost 100 countries globally had such a regime. Typically, the introduction and extension of deposit insurance regimes has been a response to banking crisis. This time’s crisis has been no exception. Australia and New Zealand have both introduced deposit guarantee schemes.