In a report which identifies three underlying causes of the global crisis - macro-economic imbalances, financial innovation of little social value and important deficiencies in key bank capital and liquidity regulations – Lord Turner, chairman of the FSA, also admitted that the FSA’s regulatory approach of the past decade had failed.
Speaking at the launch of the report, Lord Turner said: 'Until the crisis struck, the FSA's approach was based on an overt philosophy that markets are in general self correcting, that market discipline is effective, and that management and boards are better placed than any regulator to identify business system risks, provided that processes, structures and systems are appropriately designed.”
Lord Turner said that the changes recommended in the report are profound and that the banking system of the future will be different from that of the last decade. “The world’s economy will be better served as a result,” he said.
The FSA’s proposals include giving the regulator the power to insist on greatly increased capital requirements for banks – both in terms of quality and quantity. The regime should also be ‘counter-cyclical’, says the report, by forcing banks to put away more in the good years, rather than relying on banks’ complex risk modelling systems.
The report also says that banks would be forced to hold much higher levels of capital against risky trading book activities and that banks would be further constrained via the imposition of a gross leverage ratio, which would act as a “backstop discipline against excessive growth in absolute balance sheet size”.
In a significant change from its existing approach, Lord Turner floated the concept of specific product regulation - in particular, the idea of imposing a maximum loan-to-value or loan-to-income on residential mortgages. Further details will not be available until a separate discussion paper has been published in September.
There are other suggestions which constitute a break with the FSA’s existing regime. These include: allowing the regulator to gather information on significant unregulated financial institutions that may be a systemic risk, such as hedge funds, and the power to extend regulation to cover these areas if it is warranted; introducing global agreements on standards for offshore financial centres; introducing a registration and supervision scheme to manage conflicts of interest and other problems within ratings agencies; forcing firms to ensure their pay structures take account of long term risk; the creation of a new Europe-wide regulator to providing non-binding guidance and advice to national regulators; developing a closely monitored central clearing operation for credit default swaps.
The report marks a turning point for the FSA, which has been roundly criticised as having failed to regulate the banks properly during a prolonged period of excess.
“The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built, and in particular the theory of rational and self-correcting markets,” said Lord Turner. “Much financial innovation has proved of little value, and market discipline of individual bank strategies has often proved ineffective.”
Lord Turner said that he still believes a global market economy is the best means of delivering global prosperity, but he admitted that it requires a global banking system focused on serving the needs of businesses and households, not in taking risks for quick return.
“Major changes in regulation and in supervisory approach are required to deliver that. The approach has to build on a system-wide perspective: failure to look at the big picture was far more important to the origins of the crisis than any specific failures in supervising individual firms. And it must reflect the reality of a global financial system without a global government; we need both far more intense international cooperation and greater use of national powers.”
