The FSA has published a speech that Adair Turner (Chairman, FSA) gave at the recent Turner Review Conference. The speech is entitled Large systemically important banks: address to fail problem. In his speech Lord Turner focuses on how to regulate large systemically important banks.

Lord Turner begins his speech by discussing what is meant by ‘fail’. When a non-systemic, medium size bank fails there is usually a wide range of resolution options available, such as break-up and sale or controlled wind-down, and all who have provided funding other than insured depositors may suffer some loss. However, in the last two years, when large banks deemed systemically important have been in danger of failure, only one model of rescue has been followed. This involves government capital injunctions and guarantees to keep the entire bank safe as a going concern, with equity holders losing because of dilution, but all other fund providers, including debt capital providers, being protected. In short ‘too-big-to-fail- means a bank which is too big to be allowed to fail in a fashion which includes options other than whole bank rescue and in a fashion which imposes losses on people other than equity providers.

Lord Turner then discusses the policy response to the risks created by banks which are deemed to be ‘too-big-to-fail’. The response falls into three categories:

  • Actions to reduce the probability of failure, while leaving the scale and span of activities unchanged.
  • Actions which make banks either smaller, or less interconnected between each other or less integrated within themselves.
  • Actions which increase the range of resolution options available, by setting out in advance resolution and recovery plans (living wills).

Lord Turner states that the optimal policy is likely to include a combination of different policies. He then states that the probability of failure of large systemically important banks must be reduced and the key lever in achieving this is the capital and liquidity requirements imposed on them. The FSA is committed to higher capital across the whole banking system, but feels that there is a strong case for demanding even higher capital standards from the largest systemically important banks.

Lord Tuner also discusses the creation of policies which more directly address the issues of interconnectedness and complexity and focuses on:

  • Reducing interconnectedness in counterparty relationships.
  • The narrow banking option.
  • Whether to think about large cross-border groups as integrated groups or as constellations of standalone national banks.

According to Lord Tuner the first option is uncontroversial and would include the migration of as many derivative contracts as possible to central counterparty clearing systems, and by requiring more stringent risk management of the remaining bilateral deals.

The second option would be to bring about the legal separation of banks between those which are involved in narrow utility activities and those involved in proprietary trade. There are two approaches to this option:

  • A model proposed by Professor John Kay in which banks take in insured retail deposits, provide retail payment systems and invest all of their assets in government bonds.
  • The new "Glass-Steagal" option which Paul Volcker has expressed some support.

However, Lord Turner pointed out that these two approaches are based on entirely different theories as to the drivers of financial instability and therefore the arguments for and against them are completely different. He also stated that it is not clear if either option is both desirable and practically achievable through legally defined distinctions.

Lord Turner then discussed the treatment of large cross-border groups and the ‘too-big-to-rescue’ problem. The problem derives from the current convention in which when large banking groups have been in trouble the home country government has seen itself as responsible for the rescue via capital support and guarantees of the entire global group.

In Lord Tuner’s view part of the way forward in dealing with this for some banking groups will be a greater focus on standalone national subsidiaries. He also believes that there may well be some necessary trade offs:

  • With predominantly wholesale banks, the approach based primarily on a standalone subsidiary model may be impractical. It may be that regulators have to demand more capital at the group level, and resolution and recovery plans which allow differentiation as much by type of business as by location.
  • With cross-border banks which do organise themselves as constellations of standalone subsidiaries, regulators may have less need to demand very high capital levels at global group level, focusing instead on national positions.

At the end of his speech Lord Turner stated that the 'too-big-to-fail' problem would have to be faced by an overall policy response that involved trade-offs between multiple policy instruments rather than by searching for a "nonexistent silver bullet" and summarised that response:

  • There is a strong case for tighter capital and perhaps liquidity standards for systemically important banks.
  • These could be combined with greater focus on standalone national subsidiaries, and there may be a trade off here – between greater internal separation and higher levels of whole group capital.
  • The interconnectedness in wholesale traded markets needs to be dramatically reduced, via the use of central counterparties and better capital and margin arrangements for bilateral contracts.
  • A fundamental review is needed of the trading book capital regime and a bias to conservatism for riskier and purely proprietary activities.
  • Resolution and recovery plans need to drive internal structure simplification, which could lead to something close to an internal Glass Steagall divide, and with a potential trade off between the implications of the living will for the feasibility of orderly wind down and the capital surcharge required at whole group level.

View Large systemically important banks: addressing the too-big-to-fail problem, 2 November 2009