Differences on this scale provide strong tax-based incentives to increase leverage. They also generate strong incentives to simultaneously avoid tax and arbitrage regulation. One recent example was hybrid bank capital instruments. These counted as capital for regulatory purposes, but benefitted from interest deductibility for tax purposes. In short, they were winwin. The UK hybrids market grew to around $ billion between 2000 and 2007. By then, they accounted for around 25% of UK banks’ tier 1 capital. Up until the 1990s, empirical evidence had tended to find little effect of tax on firm leverage (Graham (2008)). But a raft of recent studies has found tax effects on corporate financing behaviour which are both statistically and economically significant. Pooling the results from existing studies, de Mooij (2011) finds a marginal tax elasticity of 0.28. In other words, a fall in the tax shield by 10 percentage points would lower the debt-to-asset ratio of a typical firm by 2.8 percentage points. This elasticity is based on a range of firms with an average debt-to-asset ratio of 0.5. Banks rely much more heavily on debt, which provides closer to 95% of their financing. That would imply a marginal tax elasticity closer to 0.5 – double that for non-financial firms. At these levels, tax biases are likely to have had a material amplifying effect on bank incentives to increase leverage. Debt and discipline In principle, these balance sheets risks (higher asset volatility and leverage) ought to have had a natural counterweight – the disciplining effect of debt.

That is doubly unfortunate, as it means debtor discipline will be weakest among institutions for whom society would wish it to be strongest. Worse than that, bigger banks will then benefit from an implicit state subsidy, for cheaper debt means fatter profits. That might itself encourage further risk-taking. There has been considerable recent interest in the scale of this too-big-to-fail subsidy. Indeed, eliminating this subsidy has been taken as a bellwether of the authorities’ success in tackling the too-big-to-fail problem (Treasury Committee (2010)). Various attempts have been made to quantify this subsidy (Oxera (2011), New Economics Foundation (2011), Haldane (2010)). The two most popular approaches use credit ratings or option-implied distributions. The ratings-based approach looks at the difference between the standalone (“no support”) and “support” ratings of a set of banks. It uses this difference to determine how much higher funding costs would have been in the absence of support (Haldane (2010), New Economics Foundation (2011)). The options-based approach builds on Merton’s framework (Kou (2004)). A distribution is fitted to banks’ assets. Whenever assets fall below a certain threshold, the probability of government support can be estimated. Table 1 looks at some empirical estimates of the implicit subsidy using the two methods, for a sample of the four largest UK banks and 22 large international banks. The estimates are shown over the period 2007–2010. For UK banks, under either measure, the implicit subsidy amounts to at least tens of billions of pounds per year, often stretching to three figures.