This would further reduce default probabilities among the biggest banks, thereby lowering the expected system-wide losses associated with big bank failure. Taking the earlier illustrative example, to reduce materially expected system-wide losses for the world’s largest banks would require a capital surcharge several times larger than its current upper limit. Interestingly, this would take bank capital ratios to levels not dissimilar to recent quantitative estimates of their optimal value (Miles et al (2011), Hellwig et al (2011)). Placing limits on bank size is a second option. By reducing balance sheet exposures, this measure would reduce directly system-wide losses in the event of big bank failure. The Dodd-Frank Act includes an explicit limit on the maximum deposit market share of US banks, capping it at 10%. But this does not prevent banks rising to a scale, relative to GDP, at which they could imperil state solvency. For that reason, limiting bank size relative to GDP has recently been proposed by a number of commentators and policymakers (Fisher (2011), Hoenig (2012), Johnson and Kwak (2010)), Tarullo (2012)). Full structural separation of investment and commercial banking, a modern-day GlassSteagall Act, has continued to attract support. The main benefit this would bring, relative to structural ring-fencing, is that it would eliminate loopholes from the ring-fence and better ensure that the distinct cultures of retail and investment banking were not crosscontaminated. That would lessen the risk of basic banking activities being starved of human or financial capital, both ahead of and during crisis.

Governor Nout Wellink, the Chairman of the Basel Committee on Banking Supervision, has recently said that the committee is currently considering measures to strengthen Basel II by supplementing it “with simple, transparent gross measures of risk”. 22 Last month, the German Council of Economic Experts advised the German government and parliament to introduce a leverage ratio as a robust supplement to Basel II. 23 Other countries may also find it worthwhile to consider introducing a leverage ratio, even if any formal international agreement should fail to materialise. In doing so they would not only enhance financial stability in their own banking systems, but would also contribute to a more stable international financial system. Finally, it is encouraging to note that a number of banks have made voluntary commitments not to exceed certain predefined leverage limits. Adding a leverage ratio to Basel II will reinforce banks’ capital and strengthen capital regulation. However, we must remain realistic. Introducing a leverage ratio doesn’t solve everything. A leverage ratio addresses excessive leverage in the banking system. It does not  22  Nout Wellink, “The Importance of Banking Supervision in Financial Stability”, speech given on 17 November 2008. 23  German Council of Economic Experts, “Mastering the Financial Crisis – Strengthening the Forces for Growth”, 12 November 2008. BIS Review 158/2008  7  address credit concentration, excessive maturity mismatch or undue reliance on asset market liquidity. Financial crises, let alone financial cycles will never be eliminated.