On 18 March 2009 the FSA’s Chairman, Adair Turner, delivered his much anticipated Review setting out a number of recommendations to deal with what many have called the greatest crisis in the history of finance capitalism. In this briefing note we take a high level look at the Turner Review.  

Introduction  

Last October the Chancellor of the Exchequer asked the FSA’s Chairman, Adair Turner, to review the causes of the financial crisis and make recommendations on the changes in regulation and supervisory approach needed to create a more robust banking system for the future.  

On 18 March Lord Turner published his much anticipated Review together with a Discussion Paper which set out in more detail some of the recommendations. In addition, the FSA published Consultation Paper 09/10: Reforming remuneration practices in financial services.  

Many have agreed with Lord Turner’s remark that the financial crisis has been “the greatest crisis in the history of finance capitalism”.  

Layout of the Review

The Review has four key chapters which cover:

  • Chapter 1 – what went wrong and the extent to which the crisis challenges previous intellectual assumptions about the self-correcting nature of financial markets.
  • Chapter 2 – a summary of proposals for changes to banking regulation and supervisory approaches (more detail is in the Discussion Paper).
  • Chapter 3 – a wider set of issues raised by the crisis, and a wider set of possible policy responses requiring debate.
  • Chapter 4 – discusses the implementation of the proposals, distinguishing between what the FSA can do alone and where European and International cooperation is needed.

Summary of the proposals

On pages 7 to 9 of the Review there is a summary table setting out the suggested action that should be taken to create a stable and effective banking system. This has been reproduced in the annex to this briefing.  

Part 1 - What went wrong, global failures and UK specific failures

What went wrong  

Chapter 1 of the Review has four sections which present an analysis of what went wrong and the extent to which the crisis challenges previous intellectual assumptions about the self-correcting nature of financial markets.  

Global failures

It begins with a discussion regarding the core of the financial crisis which was an interplay between global macro-imbalances which grew rapidly over the last decade and financial market developments and innovations which had accelerated economic growth in the last 15 years.

The Review argues that the global system of securitised credit intermediation, which had been lauded as a device for diversifying and reducing risks, achieved the precise opposite effect. Its development was stimulated by large global macro-imbalances, by very low real interest rates, a search for yield uplift, and the perception that the whole global economy had become less risky. It entailed rapid growth of risky lending and an explosion of financial innovation (structured credit and credit derivatives).

The Review states that regulatory reform needs to address the factors that drove the initial over extension of credit and the factors that played an important role in increasing the length and severity of the financial crisis. These factors include:

  • The massive growth and increasing complexity of the securitised credit model.
  • Extensive commercial bank involvement in trading activities.
  • High leverage in multiple forms.
  • Expanded maturity transformation dependent on the marketability of assets.
  • The complexity and opacity of the structured credit and derivatives system.
  • Hard-wired procyclicality.
  • Lack of adequate capital buffers.

UK specific failures

The Review then goes on to describe those aspects of the financial crisis that are specific to the UK. These include:

  • Banks’ business models moving away from traditional banking business to more risky business which was overly reliant on wholesale funding.
  • The rapid growth in mortgage lending and the extension of mortgage credit to social categories which would not have previously enjoyed access.

Part 2 - Global in life but national in death, bank branch passporting and market discipline failure

Global in life, but national in death

The Review discusses the shortcomings in the regulation of international and cross-border banks in light of Lehman Brothers and Landsbanki. The essence of the problem was picked up by the Governor of the Bank of England, Mervyn King, who stated that “global banking institutions are global in life, but national in death.” The problem is that decisions about fiscal and central bank support for the rescue of a major bank are ultimately made by home state national authorities that focus on national rather than global considerations. To address these problems the Review suggests a combination of:

  • More international cooperation in ongoing supervision through, for instance, colleges of supervisiors and more intense international cooperation and coordination in crisis management.
  • Increased use of host state powers to require strongly capitalised local subsidiaries, ring fenced liquidity and restrictions on intra-group exposures and flows.

Bank branch passporting

In its discussion of bank branch passporting and the Icelandic banking crisis the Review supports both an increase in home state power and more European coordination. Home state power would be increased by:

  • The restriction of branch passporting rights and the requirement that retail deposit gathering be conducted through fully capitalised subsidiaries supervised by the host state regulator.
  • Host state supervisory powers to conduct a whole bank assessment and to refuse local branches the right to operate if not satisfied.

European cooperation would be increased by:

  • Having European-wide processes to assess the effectiveness of home state supervision of banks wanting to conduct retail business in other member states.
  • Cross European requirements for pre-funded and ring-fenced deposit insurance, combined with more overt warnings to customers of the limits of deposit insurance.

Market discipline failure

The Review notes that in the past there has been an important school of thought that market discipline can play a key role in incentivising banks to constrain capital and liquidity risks. However, in light of the financial crisis the conclusion is that market discipline expressed via market prices cannot play a major role in constraining bank risk taking, and that the primary constraint needs to come from regulation and supervision.  

Part 3 - The proposals, shock absorber not amplifier, shadow banking, hedge funds, credit rating agencies, remuneration and CDS clearing

The proposals  

At the start of chapter 2 the Review argues that banking should have its own distinct form of regulation and supervision:  

“The future approach to banking regulation and supervision needs to be rooted in the fact that the risks involved in performing bank or bank-like functions are different not only from those involved in non-financial activities, but also from those which arise in performing non-bank financial activities, such as life insurance.”  

Shock absorber not shock amplifier

It has been recently reported in the press that Lord Turner has stated that the banking system needs to be a “shock absorber in the economy, not a shock amplifier.” In order to do this and create a sounder banking system the Review suggests changes to capital adequacy, accounting and liquidity policies. Seven key measures are:

  • Increasing the quantity and quality of bank capital. The FSA has commissioned an analysis by the National Institute of Economic and Social Research and during 2009 a paper will be published on the optimal level of bank capital. In addition, the Review mentions that a possible future regime might be one in which the minimum Core Tier 1 ratio throughout the cycle is 4 per cent and the Tier 1 ratio 8 per cent. However, the transition to higher capital requirements should be phased so as to avoid pressure on bank capital adequacy in the current economic downturn.
  • Significant increases in trading book capital. The FSA supports the proposals adopted by the Basel Committee and plans to implement them by the end of 2010. These proposals will make a major difference with: (i) requirements for stressed value-at-risk (VAR) calculations; (ii) an incremetal capital charge to cover default and credit risk mitigation; and (iii) increased charges for securitisations, particularly resecuritisations. Also the FSA proposes to go further and wants the review of trading book risk measurement and capital adequacy requirements to cover: (i) the definition of assets appropriately booked in trading and banking books; (ii) use of VAR, stressed VAR and other measures of risk; and (iii) the extent to which approaches should vary by trading book activity. The proposed review would be an international review completed within a year.
  • Avoiding procyclicality in Basel 2 implementation. The Review states that the extent to which procyclicality arisises depends on the detailed design of the risk measurement models used by banks in their Internal Ratings Based (IRB) assessments, and in particular on the extent to which their risk models are based on “point in time” rather than “through-the-cycle” estimates of loan losses likely to arise in different categories of assets. The Review states that when implementing the Basel 2 framework the FSA introduced measures to ensure that the procyclical impact of “point-in-time” based models was minimised as far as was compatible with the maintenance of a risk sensitive approach.
  • Creating counter-cyclical capital buffers. The Review states that a counter-cyclical regime has received extensive international support. Under such a regime, required and actual capital would increase in good years when loan losses are below long run averages. This would create capital buffers which would be drawn down in recession years as losses increase. The Review then discusses how the level of buffers is determined, favouring a formula driven system. This is where the required level of capital would vary according to some predetermined metric such as the growth of the balance sheet. However, the Review then states that this formula could be combined with regulatory discretion to add additional requirements if macro-prundential analysis suggested that this was appropriate.
  • Offsetting procyclicality in published accounts. Whilst the Review states that there needs to be careful international debate, the FSA believes that the counter-cyclical approach to bank capital is reflected in a significant way in highly visible published account figures. This would create strong shareholder and management awareness of the need to assess profitability in light of the position in the economic cycle.
  • A gross leverage ratio backstop. The Review states that the FSA is now committed to this and will argue for an international agreement on the appropriate definition and level.
  • Containing liquidity risks in individual banks and at the systemic level. Whilst the FSA has already published proposals for changes to the liquidity regime (Consultation Paper 08/22: Strengthening liquidity standards) it now believes that it is appropriate to consider introducing a more general liquidity rule. This would be a “core funding ratio” which could form part of an array of counter-cyclical macro-prudential tools.

Shadow banking

The Review discusses the regulation of the “shadow banking” industry arguing that regulation should focus on economic substance not legal form. Off-balance sheet vehicles that create substantive economic risk, either to an individual bank, or to total system stability, should be treated for regulatory purposes as on-balance sheet.

Furthermore the Review argues that regulators should have the power to obtain information and identify new forms of financial activity which are developing bank-like characteristics, and if necessary extend prudential regulation to them, or restrict their impact in the regulated community.  

Hedge funds

The Review specifically states that in relation to hedge funds:  

  • Regulators and central banks should be able to gather much more extensive information on hedge fund activities and should consider the implications of this information for overall macro-prudential risks.
  • Regulators should have the power to apply appropriate prudential regulation to hedge funds or any other category of investment intermediary if at any time they judge that the activities have become bank-like in nature or systemic in importance.

Credit rating agencies

The Review confirms the FSA’s support for the regulation of credit rating agencies (CRAs) which the European Commission has proposed. However, the FSA goes one step further and suggests that national supervisory oversight of CRAs should extend to requiring that CRAs only accept rating assignments where there is a reasonable case for believing that a consistent rating could be produced.  

Remuneration  

The FSA makes it clear in the Review that in the future it will focus strongly on the risk consequences of remuneration policies within its overall risk assessment of firms. It will also enforce a set of principles which seek to align remuneration policies with appropriate risk management. Further information on these proposals are contained in Consultation Paper 09/10: Reforming remuneration practices in financial services.

CDS clearing

The Review briefly discusses netting, clearing and central counterparty in derivatives trading. The next steps will be the FSA assessing current applications for clearing licences and defining cooperation agreements with overseas regulators, with the objective of achieving a significant shift of CDS trading to central counterparty clearing during summer 2009.  

Part 4 - Macro-prudential policy

Macro-prudential policy  

According to the Review, one of the crucial failures in the UK during the years running up to the financial crisis was a failure of one of the Tripartite authorities to undertake macro-prudential analysis. The state of affairs was that:

  • The Bank of England tended to focus on monetary policy defined as using the interest rate lever to hit the inflation target.
  • The FSA concentrated too much on the supervision of individual institutions, not sectoral or economy wide trends.
  • And the analysis of macro-prudential risks fell into the gap.

The Review argues that in the future, both the Bank of England and the FSA must be intensively and collaboratively involved in analyzing macro-prudential developments and deciding between them any measures to be taken. The FSA’s preferred course of action is for the Bank of England’s Financial Stability Committee to be designated as a joint committee of it and the FSA. This Committee would then make final judgements as to macro-prudential conditions and final decisions as to appropriate poicy responses.  

Part 5 - The FSA's supervisory approach, corporate governance and supervision of large complex banks

FSA’s supervisory approach  

The Review’s discussion of the FSA’s supervisory approach describes a move in philosophy to one of “intense supervision” which will include:  

  • Much larger resources devoted to the supervision of high impact firms.
  • A shift in supervisory style from focusing on systems and processes, to focussing on key business outcomes and risks and on the sustainability of business models and strategies.
  • A shift in the approach to the assessment of approved persons, with a focus on technical skills as well as probity.
  • More intensive analysis of information relating to key risks.
  • Much greater willingness to reach judgments about the overall risks that firms are running.

Corporate governance

The FSA will wait until October 2009 for the outcome of the Walker Review before putting forward any detailed proposals on corporate governance. However, the Review does state that the “key dimensions” of required improvement are likely to be:

  • Improved professionalism and independence of risk management functions.
  • Risk management considerations embedded in remuneration policy.
  • Improvements in the skill level and time commitment of non-executive directors.
  • Shareholder discipline over corporate strategies.

Interestingly the Review raises the question (without answering it) of whether the governance arrangements appropriate for banks are different from those that apply to the generality of companies, and whether codes and rules should go further than the Combined Code.

Supervision of large complex banks

The last part of Chapter 2 looks at the specific challenges involved in regulating and supervising large complex firms which span a wide range of different activities, and banks which span borders.

On the first of these – large complex firms – the Review notes that a debate has developed as to whether regulation should force a complete separation of “narrow banking” from “investment banking” or, as some express it, “utility banking” from “casino banking”. Whilst the Review concludes that such a separation would not be practical, it does argue that better controls on capital and liquidity, and much tighter supervision, will result in many commercial banks choosing to reduce their propriety trading activity.

The Review notes that the problem with global banks is that there is a global financial system but no global government, and that dichotomy is not going to disappear. The FSA asserts that the appropriate response combines as much global coordination and cooperation as possible, with an increased focus also on the sustainability of local legal entities.

From a European perspective the Review states that the current system of passporting rights is “unsafe and untenable”. Sounder arrangements are needed with a combination of increased national powers and a greater degree of European integration. The extent to which more national powers are needed depends upon how effective European integration is. The Review’s recommendations are :

The creation of a new European institution into which the 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. An increase in national powers to restrict the aggressive growth of retail deposit taking branches.  

Part 6 - Wider issues

Wider issues

Chapter 3 of the Review suggests some wider issues and open questions, including:

  • Whether the FSA should be involved in mortgage market regulation for either customer protection or prudential reasons. In September 2009 the FSA will publish a paper covering mortgage market reform.
  • Whether some wholesale financial products should be subject to regulation. In the Review the FSA gives arguments for and against the regulation of structured credit and credit derivatives.
  • Whether there is a need for other counter-cyclical tools apart from capital and liquidity levers.
  • How to balance the benefits of liquidity with the dangers of instability, for instance in decisions about short-selling.

Part 7 - Response and timetable

Response  

There has been some criticism of the Review in the press.  

For instance in The Financial Times on 20 March 2009 the argument was that the Review suggests that the “stable doors are to be locked tight, though only after a herd of horses have already bolted”. The FT further commented that the Review left several important questions unanswered and these were:

  • It does not explain why we can hope to contain the behaviour of companies too important to fail.
  • It does not demonstrate that regulators can contain regulatory arbitrage by profit-seeking financiers.
  • It does not deal with risks posed by institutions that may be too big to rescue by some host countries.
  • It does not explore the room for charging heavily for guarantees.
  • It does not consider the incentives towards excessive leverage inherent in the tax system.

However, the FT did acknowledge that the Review was a milestone and should help catalyse much needed global discussion of regulatory reform. The FT urged other countries, particularly the US, to commission a comparable anayses of their own regulatory failures.  

Timetable  

The deadline for comments on the Review and its accompanying Discussion Paper is 18 June 2009.  

Annex – Summary of the Review’s action points

Capital adequacy, accounting and liquidity  

  • The quality and quantity of overall capital in the global banking system should be increased, resulting in minimum regulatory requirements significantly above existing Basel rules. The transition to future rules should be carefully phased given the importance of maintaining bank lending in the current macroeconomic climate.
  • Capital required against trading book activities should be increased significantly (eg, several times and a fundamental review of the market risk capital regime (eg, reliance on VAR measures for regulatory purposes) should be launched.
  • Regulators should take immediate action to ensure that the implementation of the current Basel II capital regime does not create unnecessary procyclicality; this can be achieved by using “through the cycle” rather than “point in time” measures of probabilities of default.
  • A counter-cyclical capital adequacy regime should be introduced, with capital buffers which increase in economic upswings and decrease in recessions.
  • Published accounts should also include buffers which anticipate potential future losses, through, for instance, the creation of an “Economic Cycle Reserve”.
  • A maximum gross leverage ratio should be introduced as a backstop discipline against excessive growth in absolute balance sheet size.
  • Liquidity regulation and supervision should be recognised as of equal importance to capital regulation:
    • More intense and dedicated supervision of individual banks’ liquidity positions should be introduced, including the use of stress tests defined by regulators and covering system-wide risks.
    • Introduction of a “core funding ratio” to ensure sustainable funding of balance sheet growth should be considered.

Institutional and geographic coverage of regulation

Regulatory and supervisory coverage should follow the principle of economic substance not legal form.

  • Authorities should have the power to gather information on all significant unregulated financial institutions (eg, hedge funds) to allow assessment of overall system wide risks. Regulators should have the power to extend prudential regulation of capital and liquidity or impose other restrictions if any institution or group of institutions develops bank-like features that threaten financial stability and/or otherwise become systemically significant.
  • Offshore financial centres should be covered by global agreements on regulatory standards.  

Deposit insurance

  • Retail deposit insurance should be sufficiently generous to ensure that the vast majority of retail depositors are protected against the impact of bank failure (note: already implemented in the UK).
  • Clear communication should be put in place to ensure that retail depositors understand the extent of deposit insurance cover.  

UK Bank Resolution

  • A resolution regime which facilitates the orderly wind down of failed banks should be in place (already done via Banking Act 2009).  

Credit rating agencies

  • Credit rating agencies should be subject to registration and supervision to ensure good governance and management of conflicts of interest and to ensure that credit ratings are only applied to securities for which a consistent rating is possible.
  • Rating agencies and regulators should ensure that communication to investors about the appropriate use of ratings makes clear that they are designed to carry inference for credit risk, not liquidity or market price.
  • There should be a fundamental review of the use of structured finance ratings in the Basel II framework.

Remuneration

  • Remuneration policies should be designed to avoid incentives for undue risk taking; risk management considerations should be closely integrated into remuneration decisions. This should be achieved through the development and enforcement of UK and global codes.

Credit Default Swap (CDS) market infrastructure

  • Clearing and central counterparty systems should be developed to cover the standardised contracts which account for the majority of CDS trading.  

Macro-prudential analysis

  • Both the Bank of England and the FSA should be extensively and collaboratively involved in macro-prudential analysis and the identification of policy measures. Measures such as counter-cyclical capital and liquidity requirements should be used to offset these risks.
  • Institutions such as the IMF must have the resources and robust independence to do high quality macro-prudential analysis and if necessary to challenge conventional intellectual wisdoms and national policies.  

FSA supervisory approach

The FSA should soon complete the implementation of its Supervisory Enhancement Program (SEP) which entails a major shift in its supervisory approach with:

  • Increase in resources devoted to high impact firms and in particular to large complex banks.
  • Focus on business models, strategies, risks and outcomes, rather than primarily on systems and processes.
  • Focus on technical skills as well as probity of approved persons.
  • Increased analysis of sectors and comparative analysis of firm performance.
  • Investment in specialist prudential skills.
  • More intensive information requirements on key risks (eg, liquidity).
  • A focus on remuneration policies.

The SEP changes should be further reinforced by:

  • Development of capabilities in macro-prudential analysis.
  • A major intensification of the role the FSA plays in bank balance sheet analysis and in the oversight of accounting judgements.

Firm risk management and governance

The Walker Review should consider in particular:

  • Whether changes in governance structure are required to increase the independence of risk management functions.
  • The skill level and time commitment required for non-executive directors of large complex banks to perform effective oversight of risks and provide challenge to executive strategies.

Utility banking versus investment banking

New capital and liquidity requirements should be designed to constrain commercial banks’ role in risky proprietary trading activities. A more formal and complete legal distinction of ‘narrow banking’ from market making activities is not feasible.

Global cross-border banks

International coordination of bank supervision should be enhanced by:

  • The establishment and effective operation of colleges of supervisors for the largest complex and cross-border financial institutions.
  • The pre-emptive development of crisis coordination mechanisms and contingency plans between supervisors, central banks and finance ministries.

The FSA should be prepared to use its powers more actively to require strongly capitalised local subsidiaries, local liquidity and limits to firm activity, if needed to complement improved international coordination.  

European cross-border banks

A new European institution should be created which will be an independent authority with regulatory powers, a standard setter and overseer in the area of supervision, and will be significantly involved in macro-prudential analysis. This body should replace the Lamfalussy Committees. Supervision of individual firms should continue to be performed at national level.  

The untenable present arrangements in relation to cross-border branch passporting rights should be changed through some combination of:

  • Increased national powers to require subsidiarisation or to limit retail deposit taking.
  • Reforms to European deposit insurance rules which ensure the existence of pre-funded resources to support deposits in the event of a bank failure.

Open questions for further debate

Should the UK introduce product regulation of mortgage market Loan-to-Value (LTV or Loan-to-Income (LTI)? Should financial regulators be willing to impose restrictions on the design or use of wholesale market products (eg, CDS)?

Does effective macro-prudential policy require the use of tools other than the variation of counter-cyclical capital and liquidity requirements eg,

  • Through the cycle variation of LTV or LTI ratios.
  • Regulation of collateral margins (“haircuts”) in derivatives contracts and secured financing transactions?

Should decisions on for instance short selling recognise the dangers of market irrationality as well as market abuse?