The Chairman of the FSA, Lord Adair Turner, gave a speech on 21 January 2009 setting out his views of  the causes of the current financial crisis and outlining the future of financial regulation. Although the speech was about banking regulation, the key areas of future regulatory focus - capital adequacy and liquidity - are likely also to be applied to insurers.  

Lord Turner explained how financial innovation had combined with macroeconomic imbalances such as low interest rates, the credit expansion and a search for yield in investment circles to trigger the crisis. The sustained boom in slicing and dicing, hedging and other financial mechanisms inevitably led to a bust along the lines of previous boom and bust cycles.

"But what makes this one different - and potentially more economically destructive to the real economy - is that it is the first major global boom and bust of securitised credit instruments," Lord Turner said. He went on to look at how regulation could be improved in the future.

In general terms, he said, regulators would have to conduct more sectoral analysis and be more willing to make judgements about the sustainability of whole business models, rather than just the quality of their execution. While drastic changes were needed, he said that the 'originate and distribute model' of securitised credit, which contributed to the crisis, should not necessarily be replaced as it could help spread regional or sectoral risks to other areas. Instead, it should be reformed, making it more transparent and stable. Three key areas that would need to be focused on, he said, were capital adequacy, liquidity and the regulation of near banks.

With regard to capital adequacy, he said that a system needed to be created that introduced counter-cyclical capital requirements, enabling institutions to build up reserves of capital during periods of growth that could then be run down in harsher economic times. Such an approach would not only reduce the risk of bank failure but also would impose some restraint on over-rapid expansion in the boom. Lord Turner said such a regime would ideally be implemented at international level, and said the FSA was working with the Basel Committee on Banking Supervision and the Financial Stability Forum on this.

Lord Turner stressed that regulation of liquidity had been overlooked in the past but in the future should be at least as important as capital adequacy. An FSA Consultation Paper issued in December has already proposed major reform, such as focusing more on market-wide risk and using stress test scenarios rather than risk probability models that are based purely on past experiences. He said the new regime would result in banks holding more liquid assets and holding more of those assets in government securities.

Finally, Lord Turner said that financial activities must be regulated according to their economic substance, not their legal form. Many institutions that were not legally banks, such as special investment vehicles (SIVs), conduits, investment banks and mutual funds, had been performing the banking function of maturity transformation but were not subject to the capital, leverage and liquidity regulations which would apply to banks. In the future, Lord Adair said these near banks or shadow banks must be included in regulatory regimes.

A detailed explanation of these proposals will be available in March when  the FSA's  review of banking regulation and supervision is published. In the meantime, the full text of his speech can be found by clicking here.