Lord Turner has spoken on the causes of the global financial crisis and its implications for regulation. He identified urgent short-term priorities to design policies that at least limit the adverse impact of deleveraging and deflation on the real economy (including many elements covered in the Government's latest package). But also he looked at how regulation can reduce the probability and severity of a future crisis.
The key long-term regulatory initiatives are:
- a new approach to capital, primarily the counter-cyclical requirements proposed already by the Basel Committee to build up buffers in good times. He noted that, anyway, Basel II would have addressed some of the problems which arose under Basel I. Going further, FSA sees the need for a fundamental review of how trading books are defined and how risks in trading books are estimated;
- a new liquidity regime that takes account of market-wide risk. Increased reporting is key as are regulations to make banks focus on the combined liquidity effect of various holdings; and
- ensuring an approach to financial activity that emphasises economic substance rather than legal form. The key is to make sure that institutions that are not banks, but act like them, receive appropriate regulatory treatment. This will particularly affect the US, in particular the mutual fund market. However, hedge funds may also be affected: specifically regulators must have access to ready information so they can develop appropriate prudential regulation for those that get too big.
Lord Turner identified various past problems, including how market conditions and downturns were disguised so as either to appear costless or, worse, to give bankers and traders the impression they were doing the right thing. He spoke of the problems caused by innovations in the securitisation markets which led to a cycle of inadequate credit spreads and less consideration of volatility risk driving up the value of various instruments. There is still a future for securitisation, and for the originate and distribute model, but it must be less complex and more transparent. He is not convinced there is a need to revert to the Glass Steagel model of separation of commercial and investment banking although clearly regulators need to take action.
He spoke of the scale of proprietary trading, which created risks. He noted that credit that was securitised and taken off one bank's balance sheet was either bought by the proprietary trading desk of another or technically sold but with the original bank retaining part of the risk. Some banks, he said, were doing "acquire and arbitrage" rather than "originate and distribute". This meant most of the risk was still within banks but not transparently so.
He looked at the role and benefits of the social function of maturity transformation, traditionally held by banks but increasingly held by SIVs and Conduits or at least off-bank balance sheet. Mutual funds began to act more like banks in holding long-term assets with immediately available redemption. But when they began to sell rapidly to meet redemptions, this reinforced the liquidity crisis elsewhere. He looked at how the IMF, in 2006, praised how banks' dispersion of credit risk to a broader and more diverse set of investors had helped to make the financial system "more resilient".
Finally he spoke of how the growth in the securitised credit markets has been accompanied by an incredible growth in the relative size of the wholesale financial services market within the overall economy. As people grow more sophisticated, their appetite for more complex products develops. But the importance of financial services has been swollen by the illusion arising from mark to market profits in a rising market and "rent extraction" which the securitised markets now have to do to get themselves down to the size in the overall economy they really merit.