The cost of capital of business enterprises is determined by providers of debt and equity. It generally rises with increasing leverage and business risk, and this contributes to an efficient allocation of capital. Strangely, unlike other companies, banks appear to have a cost of capital that does not rise with increasing risk. Most banks enjoy a lower cost of debt than, say, the National Grid, a monopoly with no business risk and significantly less leverage. There is a paradox here that goes to the heart of how banks take investment decisions and has implications for investors, taxpayers and the economy.

For banks, the cost of deposits is reduced by an explicit guarantee provided by the state. For “systemically important” financial institutions, the state also provides an implicit guarantee to other creditors. Little if anything is charged for these. This has allowed the largest banks to have almost unlimited borrowing capacity at a cost that reflects the state’s creditworthiness, not their leverage or business risk. The state attempts to control leverage by requiring banks to hold minimum amounts of equity capital for different types of assets – but critically requires almost no capital at all for a wide variety of supposedly risk-free assets. The combination of unlimited cheap debt with minimal capital constraints permitted the largest banks to create huge proprietary trading books almost entirely financed by debt. This is the wholesale banking model that has developed during the past decade.