RWCR: High degree of freedom offered to banks increases incentives for gaming, especially under IRB approach. 18  All speeches are available online at www.bankofengland.co.uk/speeches  18  Risk Rapid and unsustainable balance sheet expansion  First Best Mitigant LR: Requires banks to raise capital to support credit creation, regardless of asset composition. Second Best Mitigant NSFR: Limits reliance on short and mediumterm wholesale funding to support balance sheet expansion. Sudden withdrawal of funding due to firm-specific or short-lived market-wide loss of credibility  LCR: Assures available buffer of liquid assets to meet immediate outflows enabling survival of first stages of run/preparation for resolution if appropriate. Sustained loss of funding due to market-wide liquidity stress leading to slowburn insolvency  NSFR: Matches liquidity of assets against stability of liabilities to ensure bank is broadly resilient to a medium-term funding run. Crystallisation of systemic liquidity risk leading to a fire sales, liquidity hoarding, and/or a contraction in lending  NSFR: Reduces banks’ vulnerability to mediumterm liquidity risks and hence the probability of them being required to deleverage rapidly in periods of stress to shore up their liquidity position. NSFR: Reduces runnable fraction of liabilities, thus decreases ex-ante risk of being exposed to a run, but does not directly ensure bank has a buffer of usable shortterm liquidity. LCR: Assures available buffer of liquid assets to meet immediate outflows, but not that maturity transformation is sustainable beyond 30 day horizon. LCR: Reduces reliance on the most unstable short-dated liabilities.

These included the migration of activity and risk to unregulated “shadow banks” (Adrian and Ashcraft (2012)); the hard-wiring of rating agency risk assessments into the regulatory engine (Edmonds (2016)); the payment of bank CEOs in common equity encouraging “gambling for resurrection” (IMF (2014)); and the implicit subsidies conferred on “too-big-to-fail” institutions, encouraging them to become larger and more complex and connected still (FSB (2013b)). Another example of these incentive effects came in the area of capital regulation. Whichever risk-weighting scheme is in place, it is likely to give rise to incentives to adjust asset positions to maximise profits. For example, if the regulatory constraint takes the form of a leverage ratio there are incentives to alter the composition of assets towards those with higher risk weights – though the evidence on such “risk-shifting” is mixed (Sheldon (1996), Furlong (1988)). Contrarily, if assets are risk-weighted and determined by banks’ internal models, there are incentives to lower modelled risk weights over time (Mariathasan and Merrouche (2014)). In short, when setting capital standards for banks, there is a two-sided incentive problem. 28  All speeches are available online at www.bankofengland.co.uk/speeches  28  Pre-crisis, both incentives were at play, albeit to differing degrees in different parts of the global financial system. In the US, where a leverage ratio was in operation and often the binding constraint, there were incentives for banks to seek higher-risk assets rather than expand balance sheets (Chart 20).