The FSA has published a speech given by Adair Turner (Chairman, FSA) which is entitled What do banks do, what should they do and what public policies are needed to ensure best results for the real economy?

In this speech Lord Turner focuses on the role that credit can play in driving asset price cycles, which in turn can drive credit supply in a self-reinforcing and destabilising process.

However, Lord Turner also warns that using a ‘one size fits all’ policy approach to curbing asset price bubbles in commercial or residential real estate could have the unintended consequence of restricting credit to other real estate sectors of greater economic benefit.

Lord Turner further noted the growth in scale of the financial system over the last 15 years, driven by increased leverage in household and some corporate sectors, complex securitisation and trading. He said it was important to ask whether this growth had created “economic value added”. He also said that:

  • Financial innovations of complex securitisation and credit derivatives may, if purged of their excesses, have potential to improve bank risk management, but the pre-crisis argument they created major economic efficiency benefits was hugely overstated.
  • A new philosophical approach to “market liquidity” was needed which recognises that it is beneficial up to a point but not beyond that point, so more liquidity, supported by more trading, is not always beneficial.

Lord Turner then discussed how macro-prudential tools would work and considered the advantages and disadvantages of four approaches:

  • Using interest rate policy to take account of credit/asset price cycles as well as consumer price inflation.
  • Having across-the-board countercyclical capital adequacy requirements, increasing capital requirements in the boom years, on either a hard-wired or discretionary basis.
  • Having countercyclical capital requirements varied by sector, increased against commercial real estate lending but not against other categories.
  • Using direct borrower focussed policies, such as maximum limits on loan-to-value ratios, for instance, either applied continuously or varied through the cycle.

View What do banks do, what should they do and what public policies are needed to ensure best results for the real economy?, 17 March 2010

View FSA Chairman discusses potential for new macro-prudential policy tools to manage credit and asset price instability, 17 March 2010