former are institutions subject to government intervention during the crisis. cds premia for all banks fell dramatically between 2002 and 2007, on average by around three - quarters. market perceptions of risk were falling at precisely the time risk in the system was building. there was also little market differentiation between the spreads of “ crisis ” and “ no - crisis ” banks : their average pre - crisis spread difference was a mere 8 basis points. the extent of risk mispricing is clear from the movements in cds premia as the crisis broke. average spreads rose by a factor of over 50 for “ no crisis ” banks. for crisis banks, they rose by a factor closer to 70. adjustments on that scale are a decisive rejection of the debt disciplining hypothesis. debtors were meant to act as a brake on risk - taking incentives. instead they had served as an accelerator. why? the answer again lies in incentives – the incentives of bank managers and policy authorities. these incentives matter most at crisis time. then, it may no longer be in the interests of either bank management or the authorities to have debtors bear risk. doing so may run the risk of making a bad crisis situation worse. as much as bank management and the authorities may pre - commit to debtor ’ s bearing risk ex - ante, they may be tempted to capitulate ex - post. economists call this a time - consistency problem. agents cannot credibly commit to stick to their guns in the midst of war. private contracts for bank debt and public policies towards bank debt suffer from a severe case of this time - inconsistency problem. having debtors assume pain is fine on paper. but crisis wars are not waged on paper. and if debtors recognise that risks in contracts will not be enforced, they will no longer have incentives to price risk and exercise discipline themselves. so it has been for well over a century. there are many examples of time - inconsistencies in the private debt contracts issued by banks. uncalled capital and reserve liability were banks ’ loss - absorbing contract of choice in the late 19th and early 20th centuries. they ultimately proved ineffective and were abolished. why? because managers feared that invoking these instruments, at precisely the time they were most needed, might make a bad situation worse. this is time - inconsistency writ large. bis central bankers ’ speeches a century on, hybrid bank debt instruments fell into the same trap. they gave bank management the option to

in a selection of developed countries. for low or tax - exempt investors, such as pension funds and non - residents, debt is typically between 30 – 40 % cheaper than ( new or retained ) equity. 15 for high - tax investors, the biases are smaller but still significant. 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 $ 100 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. although they are second in the risk - bearing queue, debt - holders as well as equity - holders would be expected to shoulder, and hence price, this balance sheet risk. this could be done either by raising its cost or by restricting its quantity. either way, debt would then serve as a restraining device on riskhungry, rent - seeking shareholders. in theory, this debtor discipline mechanism ought to work like a dream. under the assumptions of modigliani and miller ( 1963 ) ( mm ), the pricing of risk by debt -