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The Actuary The magazine of the Institute & Faculty of Actuaries

Lord Turner signals more dynamic regulatory regime for UK banks

Lord Adair Turner, chairman of the Financial Services Authority (FSA), has set out his vision for a post-financial crisis regulatory landscape, including an increase in equity capital requirements for banks beyond Basel III levels, and a ‘continually evolving regulatory regime’ designed to halt the migration of risk to related financial institutions.

In a speech at Cass Business School earlier this evening, Lord Turner said that, while already agreed regulatory reforms will have a major beneficial impact in stabilising the financial system, he believes but that further reforms of banks and other financial institutions were needed. He also said that regulators needed to recognise that the financial system will continually mutate, creating new risks, and requiring a continually evolving regulatory regime.

"The pre-crisis delusion was that the financial system, subject to the then defined set of rules, had an inherent tendency towards efficient and stable risk dispersion. The temptation post-crisis is to imagine that if only we can discover and correct specific imperfections - such as bad incentives or industry structure - that a permanently more stable financial system can be achieved."

Lord Turner argued that while popular anger often focuses on the direct costs of public rescue of banks, these are likely to be small relative to the overall harm produced by financial crises. This harm derives from volatile credit supply, first too easily and cheaply available then restricted, producing a credit crunch and recession. Such volatile credit supply could moreover, arise in a world where no large banks ever failed or needed public support.

He believes that regulators must recognise that financial instability is caused not only by poor incentives (such as ‘too big to fail’ status or unfair bonuses) but by investors’ myopia and irrationality, and by the sheer complexity and interconnectedness of the financial system.

Lord Turner set out three conclusions for public policy to follow:

1. While the Basel III capital standards are a major step forward, in an ideal world equity capital requirements would be set much higher - at something more like the 15-20% of risk-weighted assets illustrated by Professor David Miles in a recent paper.

2. Fixing the ‘too big to fail’ problem by making all banks, however large, resolvable is an absolutely essential but not sufficient element in the reform agenda. It will improve market discipline and would fully address problems created by individual failures of large banks. But it cannot in itself guard against a systemic crisis of the sort seen in 2008, since the imposition of losses on bank debt holders could itself drive a self-reinforcing crisis. In addition to making banks resolvable, regulators must therefore agree equity surcharges for systemically important banks high enough to reduce the probability of failure to minutely low levels.

3. As the events of 2007 to 2008 showed, financial instability can be created by shadow banking activities as much as by banks. And as regulators impose higher capital and liquidity requirements on banks, there is a danger that activity will again shift to shadow banking markets and institutions, such as money market mutual funds and hedge funds.

As a result, The Financial Stability Board is developing recommendations on how to monitor and, if necessary, regulate developments in shadow banking. Among the policy options to be assessed are the regulation of minimum margin requirements in repo and other secured financing markets.

Lord Turner said that each of these conclusions illustrated that the fundamental determinants of financial stability were (i) the overall balance between debt and equity in the real economy and within the financial system, and (ii) the aggregate extent to which the financial system performs maturity transformation. Both leverage levels and aggregate maturity transformation increased significantly in the pre-crisis years, but regulators did not adequately track and respond to that development, wrongly believing that we could assume that rational investors in free financial markets would ensure that risk was dispersed in an efficient and stable fashion.

In future he said it will be essential to monitor far more effectively overall developments in leverage and maturity transformation and, if necessary, respond with policy levers - such as countercyclical capital or variable loan-to-value ratios - which can be varied through the cycle.

Finally Lord Turner stated that policy makers and regulators cannot avoid the issue of whether increased financial intensity and innovation has delivered increased allocative efficiency or whether some financial activities simply transfer income from the non-financial to the financial sector.

"Many of the measures we could take to increase stability - such as higher capital requirements against trading activities or against intra-financial system complexity, both of which are issues on our agenda beyond Basel III - might well reduce the scale of trading activity and the liquidity of some markets. If these activities and related liquidity are value creative we may need to make a trade-off between stability and allocative efficiency. If they are zero sum or rent extracting there is no such trade-off."