Without any asymmetries of information, banks would not be necessary, since households could invest their savings directly or through mutual funds. Therefore, by definition we cannot have banking with full transparency. 14 Fortunately, banks are not totally opaque either. Some risks can be assessed more or less readily. A US Treasury bill is clearly less risky than an unsecured loan to an obscure software company. Therefore, capital requirements can at least partially be based on the relative riskiness of various types of assets, even in our non-ideal world. “Basel I”, the first Basel Accord of 1988, introduced “risk buckets” for this purpose. For instance, loans received a risk weight of 100%, government bonds a risk weight of 0%. “Basel II” – the revision of the  10  Raghuram Rajan and Luigi Zingales (1995): “What Do We Know about Capital Structure? Some Evidence from International Data”, Journal of Finance. 11  Tier 1 capital to total assets. Source: The Banker, July 2007. 12  See, e.g., Jean-Charles Rochet (1992): ”Capital Requirements and the Behavior of Commercial Banks”, European Economic Review. 13  See, e.g., the classic article by Douglas Diamond (1984): ”Financial Intermediation and Delegated Monitoring”, Review of Economic Studies. 14  See Charles Goodhart (1988): The Evolution of Central Banks, p. 63. BIS Review 158/2008  3  first Basel Accord – which is currently being implemented, tries to go beyond what were perceived to be rather crude risk buckets. Under Basel II, risks are differentiated in more detail.
6  See John Galbraith (1990): A Short History of Financial Euphoria. 7  “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management”, Report of The President’s Working Group on Financial Markets, April 1999. 8  Q & A with Joseph Stiglitz, Columbia University and The International Herald Tribune, 11 October 2006. http://blogs.iht.com/tribtalk/business/globalization/?p=177  9  G7 Finance Ministers and Central Bank Governors Plan of Action, 10 October 2008. 2  BIS Review 158/2008  Naturally, therefore, rental cars have a much shorter life span than non-rental cars. The same reasoning applies to banks. No sane banker will intentionally manage his bank into insolvency. But he or she has a lower incentive to avoid insolvency than if he were not insured. This sub-optimal level of caution is immediately apparent in banks’ balance sheets: Banks tend to hold very low levels of capital. In a cross-sectional comparison, banks have much lower capital cushions than uninsured firms. On average, listed non-financial firms have capital-to-asset ratios of 30 to 40 percent. 10 In stark contrast, before the onset of the current crisis, all of the world’s top 50 banking institutions held, on average, only 4 percent of capital. None of them held more than 8 percent. 11 In short, banks have a preference for very high leverage. This highlights a fundamental dilemma of capital regulation: Banks don’t like it. Bankers will typically argue that high leverage is beneficial or even necessary. Therefore, banks will naturally oppose any regulation aimed at restricting leverage.