There was an inability to see through the veil of modern finance to the fact that the balance sheets of too many banks were an accident waiting to happen, with levels of leverage on a scale that could not resist even the slightest tremor to confidence about the uncertain value of bank assets. For all the clever innovation in the financial system, its Achilles heel was, and remains, simply the extraordinary – indeed absurd – levels of leverage represented by a heavy reliance on shortterm debt. Modern financiers are now invoking other dubious claims to resist reforms that might limit the public subsidies they have enjoyed in the past. No one should blame them for that – indeed, we should not expect anything else. They are responding to incentives. Some claim that reducing leverage and holding more equity capital would be expensive. But, as economists, such as my colleague David Miles (2010) and Anat Admati and her colleagues (Admati et. al., 2010), have argued, the cost of capital overall is much less sensitive to changes in the amount of debt in a bank’s balance sheet than many bankers claim – a proposition demonstrated forcefully by Professors Modigliani and Miller over fifty years ago (Modigliani and Miller, 1958). And the benefits to society, most obviously through greater financial stability, but also through factors such as higher tax revenue, are likely to swamp any change in the private costs faced by banks. What does reduce the cost of capital is the ability to borrow short to lend long.
Diamond and Dybvig’s analysis consciously omitted the fact that, in reality, banks’ assets are risky. And not only are banks’ assets risky, but banks are highly leveraged institutions. This leaves them heavily exposed – with very high debt-equity ratios, small movements in asset valuations are enough to wipe out their equity and leave banks insolvent. That means the distinction between illiquidity and solvency can be difficult in practice – the difference in timing might be just a few days. If a crisis is in fact one of insolvency, brought on by excessive leverage and risk, then central bank liquidity provision cannot provide the answer. Central banks can offer liquidity insurance only to solvent institutions or as a bridge to a more permanent solution. It is this structure, in which risky long-term assets are funded by short-term deposits, that makes banks so hazardous. Yet many treat loans to banks as if they were riskless. In isolation, this would be akin to a belief in alchemy – risk-free deposits can never be supported by long-term risky investments in isolation. To work, financial alchemy requires the implicit support of the tax payer. When all the functions of the financial system are heavily interconnected, any problems that arise can end up playing havoc with services vital to the functioning of the economy – the payments system, the services of money and the provision of working capital to industry. If such services are materially threatened, governments will never be able to sit idly by.