The City of London Corporation's Annual Reception for the City Office speech
6 October 2009
Speech by Adair Turner, Chairman, FSA
The City of London Corporation’s Annual Reception for the City Office
We have been through a major financial crisis. There were many different causes of that crisis and many aspects of the reform programme needed in response. But among the most important and most difficult are those related to the international nature of the financial system. The essential challenge is that we have a global financial system with global banks and investment banks, global capital flows and global capital markets, which move together global surges and setbacks of confidence; but that governments, regulations and supervisory approaches are national, and that when banks get into trouble it is national fiscal resources which are employed to rescue them or compensate depositors. In Mervyn King’s phrase ‘global banks are global in life but national in death’. And global markets are global in their behaviour and inter-connectedness but regulated by national rules.
This dichotomy poses complex choices at the global level. It requires us to think about both global and national responses. At the global level we are attempting to agree common rules on capital and liquidity: we are intensifying the operation of global supervisory colleagues: we are aiming to agree cross-border crisis coordination and wind-down plans: we have even agreed a global approach to remuneration policies. But we are also considering the option of strengthening the national focus on standalone capital and liquidity, increasing the likelihood that individual national banks could survive the failure of an overall global group, increasing the resilience by reducing inter-connectedness but without undermining the benefits of the global flow of capital, management skill and ideas. It is not an easy balance – deciding whether to be more global or more national – there are no easy solutions: we need an element of both.
Within this spectrum of ‘more international or more national’ the European Union occupies an intermediate position and the balance of the answer can therefore be different within Europe than across the world. The world lacks a global government or even, in the sphere of financial regulation, a global treaty based organisation equivalent to the World Trade Organisation for international trade. But the European Union is a treaty-based organisation with institutions that have a governance role in respect to some aspects of policy, and there are many laws and regulations which apply across the Union, including many in the sphere of financial regulation. And this greater degree of coordination and integration that exists at European level than at global level, has been essential because Europe has also chosen to go further down the route of economic integration than exists at global level, with total free movement of goods and services and capital and labour, freedom of establishment - a complete single market.
Europe is both more economically integrated than the global economy, and has a much stronger degree of political coordination.
But the crisis revealed that the European balance, applied to financial services, has some serious deficiencies and fault lines, and particularly so in respect of cross-border retail banking.
In accordance with the standard single market rules which apply to any sector of the economy, retail banks from one European Economic Area country have enjoyed the right to operate as branches in other countries, their supervision in most respects the responsibility of the home country government, and retail depositors looking to relevant home country deposit insurance schemes and, in extremis, to home country government fiscal support in the case of failure.
But in the case of the Icelandic banks, which had aggressively gathered internet deposits in several other EEA countries, neither the Icelandic Deposit Insurance Scheme nor Icelandic government had the money to support depositors. Big banks or even middle sized banks from small EEA countries can be 'too big to rescue'.
For us in Britain this was a wake-up call. Our past approach to European financial services integration had been largely to argue that Europe should extend single market freedoms while limiting to the absolute minimum pan-European regulatory integration and supervisory integration. After the crash, as I wrote in my review earlier this year (The Turner Review A regulatory response to the global banking crisis) it was obvious that that philosophy had to change. I therefore argued that at least in retail banking, we could not avoid either ‘more Europe or less Europe’ ie, greater coordination to make a single banking market safer, or limits to single market rights, with host country powers to demand bank subsidiarisation , local capital and local liquidity.
I expressed the dilemma as ‘more Europe or less Europe’ but the fact is that we always knew and accepted that the choice made would be primarily on the more Europe side and indeed should be. And the FSA therefore proposed a major change in the structure of regulatory and supervisory cooperation in Europe, through the creation of a European Financial Regulatory Authority, with significant rule making powers, and working closely with the European System of Central Banks to address macro-prudential issues. In fact the chosen way forward has been in terms of formal structure slightly different than we proposed – reflecting instead the de Larosière Group’s recommendation that the existing level 3 committees should be turned into formal authorities. But the essential objectives set out in my review and in the de Larosière report were the same – to introduce greater integration and coordination where that will contribute to financial stability and a more efficient single market, while keeping at national level those supervisory activities which are best delivered close to the markets and to supervised institutions. It is essential that we achieve these objectives. 'And I would therefore like to set out what the FSA believes will be the crucial determinant of success in meeting them. As so often, what will really matter is not simply the formal definition of the responsibilities of different organisations, but their approach, their skills and their detailed operating procedures.
The reforms will create a European Systemic Risk Board (ESRB), charged with identifying major trends in the financial system and major threats to financial stability. Its focus will be on macro-trends and macro-prudential issues, not the micro-prudential risk assessment or supervision of individual firms. And it could play a very useful role. One of the most crucial things that went wrong in the run-up to the crisis was that the global central banking and regulatory community, those in different ways responsible for financial stability, failed to see the big picture of emerging financial risks: the regulators too exclusively focused on institution by institution threats, and the central banks too exclusively focused on meeting the sole objective of low and stable inflation over the medium term. And as a result we failed to identify how the development of complex credit intermediation had created new risks, failed to spot new and dangerous forms of maturity transformation in the banking and parts of the shadow banking sectors, and failed to warn against and take action against out of control housing and commercial real estate booms in several countries. So the idea that in future we should have a body at European level, focused specifically on identifying these big picture risks makes sense. And this body will need input from both central banks and from national supervisors - so it has both a ‘top-down’ and a ‘bottom-up’ perspective. But creating such an institution will be the easy bit; making sure it really adds value will be more challenging:
- Because we have to remember that in the years before the crisis, the world already had bodies charged with identifying the big picture risks, but that either we still missed the risks or we didn’t take action on them. The IMF’s Article IV Reports on several countries did point out unsustainable macroeconomic imbalances, too rapid credit growth, but large developed-economy nations, not dependent on IMF lending, found it easy to ignore those warnings. And the IMF’s Global Financial Stability Report in April 2006, far from warning that the world of complex securitised credit had created dangerous risks, included a paean of praise to how complex securitisation had reduced risks and increased the resilience of the system. Two lessons follow; the success of the ESRB will depend on:
- The quality of its analysis, the quality of its debates and, in particular, the creation of mechanisms to ensure that conventional wisdoms about the way the world works are continually challenged.
- And the willingness of politicians to take its warning seriously and to countenance potentially unpopular responses, such as action through counter-cyclical capital requirements to slow down an unsustainable but, for as long as it lasts, thoroughly enjoyable credit and property price boom.
A second key objective of the reforms will be to ensure a commonly agreed and commonly enforced rule book – covering many key issues of financial regulation, but of particular importance in respect to the core prudential concerns of capital and liquidity. In ensuring that these rules are well designed and well enforced – not only over the next few years as we implement the many changes in the global regulatory regime now being debated and agreed in the Financial Stability Board, the Basel Committee and other key fora – but over time as the financial systems and markets continually evolve, we need to get three balances right:
- The balance between political oversight and delegation to technical experts. Much of the detail has to be worked out by technical experts and the success of the European Supervisory Authorities (ESAs) will depend crucially on creating an espirt de corps of technicians devoted to good regulation and supervision as ends in themselves, independent of apparent national interests (such as influencing the location of activities), independent of short-term political concerns, and informed by the economic analysis of markets. But equally we have to recognise that decisions on the overall balance of regulation are not politically neutral, they embed assumptions about the appropriate balance between innovation and risks, growth and stability, producers and consumers, which need to be considered as best possible at the political level.
- The balance between prescriptive rules expressed in detailed rule books, and the definition of required outcomes, leaving discretion to national supervisors on how those outcomes are achieved.
- And the appropriate balanced approach to consultation with industry participants, sufficient to gain clear understanding of the difficulties and complexities of implementation, sufficient to gain the insights which industry participants can help provide into the likely impact of regulation, but with the regulatory authorities still making the ultimate decisions in the public good.
- A third key element of the reform proposals, is the creation of a robust process of peer review between supervisory authorities, extending not just to whether each of us at national level is implementing EU requirements, but also looking at our resourcing and our detailed supervisory processes. Accepting this openness to challenge and to the exchange of ideas on how to do supervision, will at times be uncomfortable, but it is inevitable if we are to have confidence in one another, and confidence therefore in the firms which, through passporting rights, are allowed to operate in each host country on the grounds that their home country is supervising them effectively.
However much we improve confidence in supervisory processes across Europe, that can never wholly exclude the risks created to host country depositors by cross-border operation, nor the dangers to the system in the case of large banks headquartered in smaller countries which might lack the resources to rescue them in extremis. This is a difficult issue, and we have to recognise that in addressing it there are only two intellectually pure ways forward. One would be to accept full supervisory integration, underpinned by one pre-funded European deposit insurance scheme and by a shared European fiscal responsibility for a rescue if ever required and appropriate. The other would be to remove branch passporting rights, with host countries free to demand separate subsidarisation of potentially stand alone national operations. Each of these intellectually pure answers would achieve an alignment of responsibility with power, but in two radically different ways.
But the one certainty in the debate has been that there is no support for either of these intellectually pure solutions – and that instead we will continue to seek to combine a single market with a still national approach to ultimate fiscal responsibility, and with supervision delivered by national authorities which are close to the operations of the regulated firms. That compromise, which reflects indeed the essential character of the whole European Union project – less than a full pooling of sovereignty, but far more than a free trade area or customs union – can I believe be made to work and deliver stability. But it requires that alongside greater coordination and cooperation through the ESAs, we also ensure that legitimate host country national interests are recognised by:
- making it clear that host states have the right to receive all prudential information about entire groups; and
- allowing host states to take proportionate and measured steps to restrict the activities of branches in response to clear prudential weakness not adequately addressed by the firm or its home supervisor ahead of any crisis – and the FSA would argue, extending to the banking area, the MiFID processes which allow host states to act vis-à-vis branches to protect their depositors or markets. We appreciate that there may be concern that powers of this sort could be abused and used for commercial or protectionist measures (rather than for market confidence or consumer protection reasons), and we are willing to debate how best to reduce the possibility of abuse, for example through the ability of home states to appeal to the ESA.
So I have talked of a strong focus of the ESRB on identifying key systemic risks and challenging conventional wisdoms: a common rule book evenly enforced, focused on outcomes: a really effective peer review process: and a recognition that effective cross-European rules and processes cannot be a substitute for some key host country rights. These are among the key features the FSA believes will be required to ensure that the major reforms now being implemented in the European regulatory architecture achieve their effect.
But, of course, well ahead of the implementation of these new structures, there are pressing issues we need to address today, at both national and European level. In dealing with these issues – just as with dealing with questions of the future EU regulatory architecture and framework – it is important to take account of the fact that the EU market is part of a wider global market.
One such issue is the effective operation and risk management of the OTC derivative market, where the FSA is very actively involved. The Commission is expected to publish its conclusions shortly, at the end of its consultation process (the joint Treasury and FSA response is available on our website). We very much support reducing risk within the system through improved transparency, achieving greater use of central counterparty clearing, and more robust risk management for non-centrally cleared trades, which requires that we look carefully at the details of margin requirements and at capital requirements. To achieve this less risky system for the future requires robust action by regulators but also much detailed implementation work by firms. This really is an area where the devil is in the detail. And therefore this is an area where we need to ensure as much global cooperation as possible, so as to deliver solutions in Europe which are compatible with solutions elsewhere, avoiding the dangers of regulatory arbitrage.
Another crucial running issue of course is the appropriate regulation of alternative investments – in particular hedge funds – with the alternative investment fund management directive now progressing through the system. Again, I know that colleagues of mine are very much engaged with many of you on this. There are many aspects of this directive which we support.
- In particular, as The Turner Review on regulation set out, it is clear to the FSA that we do need to empower regulators to gather information about hedge fund activity sufficient for us to understand their individual and collective contribution to systemic risk, and the power for regulators to extend to hedge funds capital and liquidity requirements if at any time they are becoming systemically important. This is not because hedge funds played a crucial role in creating this particular crisis: indeed it is clear that they did not: the key problems lay within banks and investment banks which in several key respects were regulated poorly with inadequate capital and liquidity requirements. But finance continually evolves and the role of institutions change: and indeed over the last three decades regulators failed to respond adequately to the fact that investment banks had evolved from non-systemically important broker dealers to hugely systemic quality banks. We need to be able to spot any similar evolution in future of any part of the financial system. And we should remember that while hedge funds did not play a major role in this crisis, the failure of LTCM was central to the near-crisis of 1998.
So the overall thrust of the directive makes sense. But again in this issue, there is devil in the detail, and we have sought to explain our concerns that some of the provisions create the danger of overly prescriptive regulation; for instance via a too simplistic approach to assessment of sustainable leverage, too little differentiation between types of alternative investment fund, and impractical restrictions on those who provide services to hedge fund managers and other alternative fund managers – including those supporting service providers based outside the EEA. This point brings me back to my earlier comments about the need for a global perspective on how the industry operates, and the need for regulators to recognise these practicalities in the solutions that we develop. Effective regulation can tackle risks without imposing particular operational structures where these are neither necessary nor best suited.
And alongside our work to build a more effective European regulatory system it is essential that we work with international colleagues to build a more robust global system. That system will need to balance common global rules and intense international supervisory cooperation with a recognition of the still essential role of national supervisors, national governments, and national, or in the Euro zone case European, central banks. Financial regulation in a global economy without global government is inherently complex, but we need to meet the challenge of that complexity to create a sounder system for the future.