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Speech by Adair Turner, Chairman, FSA
International Banking Seminar, Washington
13 October 2008

Our title is ‘Beyond the Current Turmoil: The Future Shape of Global Finance’ and like, I suspect, many speakers this weekend, I have had to rewrite my speech several times over the last two weeks. We keep changing our assessment of when the turmoil might end; and our assessment of what some of the features of global finance might be afterwards. For me the challenge has been particularly great. I started my role as Chairman of the FSA precisely three weeks ago: it has been like getting on board a roller-coaster.

But while there are still big uncertainties, there are some things I think we do know; there are some where we at least know what the questions are, and there are some points that need to be made to put this turmoil into context.

First I think we have a reasonable understanding of the roots of this extraordinary financial crisis – why it has happened. The roots are a mixture of the macro-economic and the financial sector specific. The key macroeconomic factors have been a period of strong global growth and the very high savings rates of Asian economies, in particular China, and of the big oil producers, combined with exchange rate policies which have resulted in much of these savings accumulating in foreign exchange reserves, which have been invested in fixed income instruments – in particular in US Treasuries and agency debt.

This high savings rate and this particular asset preference have resulted in a period of very low real risk-free interest rates and has provided a financial flow which has made possible high retail sector borrowing, in the US and the UK in particular but also in other countries. It therefore helped drive the rapid expansion of mortgage credit, often on dangerously relaxed lending standards, but also unleashed a strong ‘search for yield uplift’ – a strong desire on the part of individual and institutional investors who want fixed income rather than equity exposure – to achieve at least somewhat higher yield than the low level available on risk-free instruments.

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These macroeconomic factors then interacted with financial sector innovation and, in particular, with the development and increasing ‘sophistication’ - or at least complexity – of the originate and distribute model, of securitisation.

Securitisation has been with us for several decades. Its original proposition was that rather than accumulating all credit assets on bank balance sheets, some could be distributed directly through to appropriate end investors, allowing those investors to select desired risk return combinations and - it was supposed – reducing the risks in the financial intermediation system – by reducing the concentration of risks on particular intermediary balance sheets. But in the last decade - with macro demand on the one side and the creativity of financial sector innovation on the other - it had morphed into something much more complex, much more opaque and much riskier. Securities were packaged and structured and sliced. Derivatives were used to lay off risks, with huge unsettled counterparty exposures. And a large proportion of the securities were not in fact passed through to end hold-to-maturity investors but held and traded on the balance sheets of banks and on the off balance sheets of banks (the SIVs and conduits) and in the highly leveraged and increasingly leveraged balance sheets of investment banks.

All of which were then collectively involved in a classic self-reinforcing boom of the sort to which all traded markets can at times be susceptible – rising optimism, rising prices, falling spreads, falling risk aversion – with everyone dancing until the music stops – which it has in dramatic fashion.

That account is now familiar and I think that it is broadly right. The economic historians will doubtless debate the relative importance of these factors, but that these were the important factors at work is I think clear.

And equally I think some of what we need to do – to stop it happening on this scale in the future – is clear, but with some open issues.

Regulatory regimes will I am sure demand more capital in financial intermediation, both via higher capital requirements for banks and via more effective steps to prevent highly leveraged shadow banking entities escaping capital regimes. And there will be more focus on liquidity prudential regimes, and we will need to debate whether that is effected via principles and regulatory review and regulatory discretion, or via quantitative rules.

But then there are open issues:

• First how can we remove the dangers of procyclicality in capital adequacy regimes (which we should undoubtedly aim to do) and should we go further and have overtly anticyclical regimes, such as Spain’s dynamic provisioning approach?
• Second, what is the best balance of fair value versus accrual accounting? Within fair value, what is the balance of modeled versus mark to market approaches? And within accrual accounting should there be the option of more forward looking anticipation of future, through the cycle, losses?
• And third, moving beyond financial regulation to macro-economics and monetary policy, should monetary policy focus exclusively on the consumer price index, or be more overtly anticyclical, taking a point of view, however difficult, on the sustainability of asset prices?

So those are some certainties and some questions about the future regulatory and policy framework beyond the current turmoil. But what of the shape of global finance and the shape of financial institutions? Again I would like to suggest some high probabilities and some questions.

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Obviously we are going to see – in the major developed economy banking systems – a very significant deleveraging, reductions in the total size of the financial sector balance sheet. The process of that deleveraging raises some complex economic management issues.

• How far will it simply take the form of cancelling out inter-financial institution claims and complexities? How far will it also entail deleveraging vis-à-vis the real economy, ie less leveraged households and corporates? And, if the latter – how to manage that transition without major recessionary impact?
• But the end point of the deleveraging in terms of financial institutions is fairly clear
• A large scale disappearance of the very highly leveraged shadow banking institutions – the SIVs and the conduits – and the disappearance of most independent investment banks into either alternative ownership or default, the transformation of the remaining ones into bank holding companies with lower leverage.
• And the increasing concentration of credit extension, trading and capital market  activity into the very large universal banks.

This raises the question of whether that also means a reversal of the march of securitisation, a return to on-balance sheet lending. The answer there is ‘not necessarily’ - what instead we may see is a continuation of the originate and distribute model, but in a form more in line with the initial proposition – the packaging and distribution of credits to end investors in a sufficiently transparent and direct and simple form, that end investors, often of the hold to maturity variety, can truly understand the risk-return characteristics of what they are buying, with fewer layers of intermediation and trading.

So our financial system is going to change significantly – at least in the developed countries and, in particular, in the US and UK. And there are clearly huge challenges in managing the crisis stage of these changes. We still have to work out the remaining steps to deal with the financial crisis, while at least limiting its adverse impact on the real economy.

But let me end with the suggestion that we need to avoid overstating the change and overstating the macro-economic downside – that we need to place what is happening in context – the context of a global economy in which the major developed economies are important but not the whole story.

Highly leveraged shadow banks are going to largely disappear but there are many countries in the world where their role has been minor. There are many emerging countries, including the very big ones – China and India – where the demise of some New York investment banks is not fundamental to their financial systems.

And while the world economy is slowing under the impact of this financial crisis – as the latest World Economic Outlook suggests - if the IMF is right it is slowing to a rate, 3%, which before the extremely strong growth of the last decade, would have looked quite respectable.

And while the newspapers of the US and UK are full of comparisons with the Great Depression, I think the chances that we are going to face a disaster remotely like the Great Depression are close to nil, with the most likely result in the US and Europe, the one described by the WEO - very slow or nil growth or a small negative over the next 1-2 years, but not more dramatic than that. Because the good news is that we have learned the lessons of 1929-33. We do know that in the face of financial sector collapse, governments and central banks must take and have the resources to take exceptional measures. These measures are being and will be taken to the extent needed. Major changes in the financial system will result in the developed economies. But the world will still have a growing economy, largely organised on market principles – even if the financial sector is regulated in a more effective way.

We need to keep this perspective.

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