Creating a more stable world
banking system: the regulatory challenge
By Lord Turner, Chairman, Financial Services Authority
Last October the Chancellor of the Exchequer asked me to deliver a Review which would analyze the origins of the financial crisis, assess whether deficiencies in regulation contributed to it, and make recommendations for change. The Review was published on 18 March 2009. Seven features first helped create the securitized credit boom and are now making its aftermath so economically harmful. These are:
- Massive growth in the scale and complexity of securitized credit, facilitated by inadequate capital requirements for trading activity.
- Extensive commercial bank involvement in trading activities, which meant that big trading book losses had consequences for confidence in the core banking system.
- Increases in leverage in several different forms, which amplified both the upswing and the downswing we now face.
- New forms of maturity transformation within the banking and shadow banking sectors, with increasing dependence on “liquidity through marketability”.
- A misplaced reliance on apparently sophisticated math to manage the risks.
- Excessive reliance on ratings which hard-wired the system to be unstable, both on the way up and the way down.
- Inadequate bank capital buffers, leaving banks with an impaired ability to keep lending to the real economy when the downturn came.
The Review explores faultlines which the crisis revealed in the regulation of crossborder banks. The FSA’s supervisory philosophy, shared with regulators around the world, was that major global banks and investment banks should be allowed to gain the benefits of global scale operation and flexibility. But the collapse of Lehman Brothers showed us that global banks are global in life but national in death – that decisions on fiscal support to prevent failure are national, and that national legal entities and national bankruptcy procedures have major implications for creditors. Those facts have major implications for the future supervision of global banks.
The Review addresses a number of fundamental propositions derived from our analysis – that: financial markets are susceptible to irrational herd effects and more liquid markets are therefore not always better; securitized credit creates inherent risks but securitization is here to stay and can be made safer by appropriate regulation; many important risks cannot be managed by sophisticated mathematics at the firm level, but have to be constrained by appropriate regulation; market discipline on banks is often ineffective; and much financial innovation has been of minimal social value, representing instead economic rent extraction which has swollen some parts of the financial sector beyond their economically efficient size.
To tackle these we need radically to change our regulatory approach. Six key things relating to capital, accounting and liquidity will be particularly important:
- The banking system of the future should operate with more and higher quality capital, reducing its vulnerability to shocks.
- There should be very major changes to trading book capital, increases of three times or so, since this is the key area where the existing regime was seriously deficient, failing to require adequate capital against risky trading activities.
- We need to make the banking system a shock absorber in the economy not a shock amplifier. This requires actions to ensure that the introduction of the Basel II capital adequacy regime does not introduce unnecessary pro-cyclicality. But we should also introduce a new counter-cyclical element to the capital regime, with capital buffers built up in good times to be drawn on in economic downturns.
- Counter-cyclicality moreover should be reflected in published accounts through an Economic Cycle Reserve which anticipates future potential losses.
- There should be a backstop maximum gross leverage ratio, limiting the total size of bank balance sheets relative to capital, since when crises arise the bigger the balance sheet the bigger the problem.
- Liquidity regulation has to change fundamentally.
But there is a danger that as we tighten regulation on banks, activities might move to non-regulated sectors. That makes it essential that we regulate according to economic substance not legal form, that we do not again allow off-balance sheet SIVs to run large risks without adequate controls, or investment banks to escape leverage ratio constraints. If an activity looks like a bank and sounds like a bank, we regulate it like a bank. And if there are activities, such as hedge funds, which are not at present bank-like or clearly systemically important, but could evolve in that direction in future, we need to gather the information required for regulators and central banks to assess the systemic impact of these institutions, and powers to extend prudential regulation to them if needed. We also need for the future a regulatory approach focused on the big picture, with analysis of system-wide macro-prudential risks resulting in actions to offset those risks. In the past that macroprudential focus was missing, in the UK and across the world. In future, both the Bank of England and the FSA must be intensively and collaboratively involved in analyzing macro-prudential developments and deciding between them the necessary measures – such as the use of counter-cyclical capital or liquidity levers – to head off risks before they crystallize.
At the global level, we need to ensure that institutions like the IMF have the robust independence to do excellent macro-prudential analysis, to criticise if necessary the policies of major economic powers, and to challenge conventional wisdom. Until the crisis struck, the FSA’s approach was based on an overt philosophy that markets are in general self-correcting, that market discipline is effective, and that management and boards are better placed than any regulator to identify business system risks, provided processes, structures, and systems are appropriately defined. Therefore we focused on processes, structures and systems, and on individual institutions, not sector wide or system-wide risks. And we focused on the probity of approved persons rather than their technical competence. And we tended to focus on conduct of business issues, and not enough on core prudential risks.
We are now two-thirds of the way through a program which is changing that radically, moving to a philosophy of “intense supervision” which will entail:
- Much larger resources devoted to the supervision of high impact firms.
- A much more intense focus on business strategies and systemwide risks.
- More focus on technical competence, not just probity.
- More focus on the details of bank accounting.
- And much greater willingness to reach judgments about the overall risks that firms are running.
On large complex firms a debate has developed as to whether regulation should force a complete separation of “narrow banking” from “investment banking”. We clearly need to prevent the benefits of retail deposit insurance, lender of last resort access, and too big to fail status being used to support adventures in risky propriety trading. But it is not clear that legal separation via Glass Steagall type legislation is an effective way forward.
We cannot in practice allow investment banks to go bankrupt in a crisis – Bear Sterns and Lehman Brothers were not deposit takers and were separate from narrow banks, but they were still systemically important. And narrowness is no defense against excess as witness Northern Rock, Washington Mutual and Indy Mac, three narrow banks which failed in a big way. So instead we argue that better controls on capital and liquidity, and much tighter supervision, will and should result in many commercial banks choosing to play much reduced roles in propriety trading activity, and that commercial banks which are involved in market making and trading activities, will and should be doing so in order to support their services to corporate customers, rather than as free standing propriety activities.
The challenge with global banks is that we have a global financial system but no global government, and that dichotomy is not going to disappear. The appropriate response combines as much global co-ordination and co-operation as possible, with an increased focus also on the sustainability of local legal entities. The FSA has therefore played a major role in the development of international colleges of supervisors for the 30 largest complex and cross-border financial institutions. We are also strong supporters of an initiative by the Financial Stability Forum to ensure that we have contingency plans in place for globally co-ordinated crisis response. But we also believe that host country supervisors have to be more willing to impose local liquidity ring-fencing, and if necessary, require strongly capitalised local subsidiaries.
Turning to the European perspective, we do have a treaty-based and law making institution, the European Union, and the rights of banks to operate across borders are written into European law. But this system of passporting rights is unsafe and untenable as was shown by the fallout from the collapse of the Icelandic bank Landsbanki. Depositor protection rested on the fiscal capacity of Iceland and the resources of its depositor protection scheme.
The issue is whether the response should be more European coordination or more national powers. We propose both. We recommend the creation of a new European institution into which the three existing Lamfalussy Committees will fold, with legal powers in the area of regulation, and acting as a standard setter and coordinator in the area of supervision. But also an increase in national powers to restrict the aggressive growth of retail deposit taking branches. And we pose for debate whether some EU dimension of deposit insurance is required to manage risks to depositors when large banks from small countries are active as branches in other countries. Finally, there is the crucial issue of how to achieve implementation of all this. In some cases the FSA can act alone. In others, we are acting through international fora such as the FSF or the Basel Committee to gain global agreements, and that implies that the details which emerge may differ somewhat from the precise options we have put forward.
But there is already much global agreement on the principles and objectives; on the steps we need to take to create a more stable banking system for the future, better able to serve the needs of businesses and households, better able to be a shock-absorber in the economy, rather than a source of instability.
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