The FSA has published a speech given by Adair Turner (Chairman, FSA) entitled Something old and something new: Novel and familiar drivers of the latest crisis.
At the start of his speech Turner discusses the origins of the financial crisis. He states that the primary causes of the crisis came from within the financial system and not from the factors which laid behind, for instance, the crisis of the 1970s - inflationary fiscal and monetary policies, inflexible labour markets and over powerful trade unions, politically induced swings in commodity prices.
Turner states that understanding what went wrong requires theoretical analysis, empirical analysis of the crisis and analysis of past history.
According to Turner financial and economic history, together with theory, show three key things:
- That financial markets and systems, and more broadly still, monetary relationships and the artifice of money itself, play a central role in market economies.
- That financial intensity itself creates the potential for instability, and one key driver of that potential instability is that financial markets are inherently susceptible to momentum and herd effects, to over-shoots, to self re-enforcing irrational exuberance and then irrational despair.
- It is clear that some booms and busts matter more than others, and that in particular, booms and busts in credit pricing and credit supply are far more important than those in specific commodities or in equities.
Turner then states that there is a fairly good understanding of the features that make credit contracts different and potentially more disruptive than, for instance, equity contracts. Four features are important: specificity of tenor, specificity of nominal value, the irreversibility and rigidities of default and bankruptcy, and the credit/asset price cycle.
Turner argues that whilst the financial crisis had both new and old factors, all of them were rooted in the highly specific nature of credit contracts. He says that the “crucial question is how we design policy to reduce the likelihood or the severity of a similar crisis in the future.” Three broad categories of policy response are envisaged:
- The first approach focuses on parametric reform - on changing the numeric rules which govern capital leverage and liquidity. Such reform is at the core of the global regulatory agenda, with major decisions to be made this year by the Basel Committee, the Financial Stability Board and the G20.
- The second category of approach focuses on issues relating to the structure of the banking system. One clear priority is to address the problem of banks that are too big to fail which, if the market perceives this, are free from market discipline which might otherwise constrain their risk taking. Another issue is volatility in the supply of credit, first over-exuberantly supplied at too low a price and then restricted.
- The third category of response, which Turner called macro-prudential, would focus on the volatility of credit extension and its relationship with asset prices, a problem which lies at the interface between central banking and prudential regulation, an interface which in the years before the financial crisis became a gap.
Turner stresses that a fundamental analysis of the financial crisis is needed which is rooted in theory, empirical analysis and history to help decide the appropriate balance of parametric reform, structural reform and new macro-prudential approaches that should form the response. However, Turner also argues that fundamental questions need to be asked about the role and size of the financial system in the real economy.