Mansion House Speech

21 Sep 2010

Speech by Adair Turner, Chairman, FSA
Mansion House Speech, London

It is a great pleasure to be here this evening. When I spoke last year, you kindly organised a heckler to spice up the proceedings. I await with interest to see whether you have one lurking this evening and to which particular bit of my speech he or she will take greatest offense.

Last year I spoke after a year of dramatic change – the near collapse of the global financial system. Fortunately this last year has been not quite as eventful, a year not of crisis and collapse but of worrying aftershocks, tentative recovery, and work to make sure it doesn’t happen again.

That work will bring major changes in our domestic regulatory structure and in the global regulatory regime. Both will help deliver a more stable financial system better able to serve the needs of the real economy: on both there is more hard work still to come.

Domestic structural reform was announced by the Chancellor here at the Mansion House in June. For the FSA it means major change. Within two years we need to divide the organisation between a Prudential Regulatory Authority and a Consumer Protection and Markets Authority, with the PRA a subsidiary of the Bank, and the CPMA a powerful independent authority.

That division should eventually deliver major benefits – on both the prudential and conduct side – and it’s on potential benefits that I will focus tonight. But implementing it will not be easy. The FSA starts with integrated systems, support functions, and supervisory teams, and with some individual staff doing both prudential and conduct supervision. And while the new structure will resolve problems created by the present division of responsibilities between the Bank and the FSA in the prudential arena, it will inevitably create new problems between the PRA and the CPMA in the several areas where the distinction between prudential and conduct issues is not clear cut.

So there are bound to be some transitional problems: all operational demergers entail some costs as well as benefits, and some risk to current operations. But what I can assure our regulated firms is that we have a very clear program to manage the transition as effectively as possible. By spring we will move to an internal organisation which distinguishes the two separate functions of prudential and conduct regulation and supervision. Over the subsequent year we will identify and address any problems arising from that split. We are focused on minimising the disruption for regulated firms, and on ensuring that the ongoing cost of the two separate organisations is no higher than it would be for the integrated FSA. And we will build on the FSA’s achievements over the last three years, as we have implemented intensive supervision, more effective enforcement and major changes in prudential policy.

I am therefore confident that within two years we will have a new structure which works well, laying the basis for more effective approaches to both prudential and conduct regulation.

On the prudential side, whatever we do in the UK is within the global and European context. And major reform of the global regulatory regime – for all financial institutions, but above all for banks and shadow banks – is essential. At the core of that reform are new capital and liquidity rules which will change the dynamics of credit supply, with consequences which all of society, consumers, politicians and businesses need to understand and accept.

The crisis had many causes – including those on which popular attention often focuses. There were some absurd bonuses for excessive risk taking: there was an explosion of exotic product development which last year I labelled as ‘socially useless’, a phrase from which I in no way draw back. There were failures in risk management practices and systems which top management and boards should have put right, and which the FSA, as we have openly admitted, should more aggressively have challenged.

But underlying all of these problems, and far more fundamental, were prudential rules and an entire philosophy of market regulation – embraced by policy makers throughout the world – which failed to identify and adequately address the dangers of excessive leverage and maturity transformation, and which too confidently relied on supposedly efficient and rational markets always to produce good results.

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We do need appropriate regulation of bonuses to reduce incentives for excessive risk taking, and the FSA has been at the forefront of defining and implementing such rules, but we also need to move beyond the demonisation of overpaid traders and their unnecessary CDO squareds, to recognise that, in finance and economics, ill-designed policy is a more powerful force for harm than individual greed or error, and to ensure that we address the fundamentals of what went wrong.

A major step forward was taken nine days ago with the decisions on Basel III, requiring over time very major improvements in bank capital and liquidity.

In response, some commentators have made two criticisms: first that the new standards amount to only minimal change: second that that shows the dangerous lobbying power of the banks, watering down obviously essential reform. Both criticisms are simplistic.

On the first, what many commentators fail to grasp is that we reform capital regimes not only by changing the ratio of capital to risk-weighted assets, but by changing the numerator of the ratio (what we count as equity capital) and by changing the denominator (how we quantify the risks that need to be covered). And the combined impact of all the changes made is much greater than implied by the increase in minimum equity requirement from 2% to, effectively, 7%: itself not a trivial change.

On the second challenge, meanwhile, what I think many commentators fail to consider is the dilemmas we face in getting out of the hole into which we should never have fallen. We allowed an excessively risky system to develop, with over-leveraged financial institutions, providing in some markets too much credit too cheaply, and based on risky maturity transformation. It failed and was rescued with exceptional public support. The challenge now is to wean it off that exceptional public support and make it robust for the future while still enabling it to supply adequate lending to a still fragile economy.

We want much higher capital and liquidity levels in future, but if we introduce them too rapidly we stymie economic recovery. And it is that balance – rather than the balance between an obvious optimal answer and the lobbying power of the banks – which has been debated at length over the last year by international regulators and central bankers. And with us having to take into account the different starting points of different countries, with varying degrees of reliance on bank finance, and differing degrees of freedom to offset bank credit constraints with other policy levers.

If we were philosopher kings designing a banking system entirely anew for a greenfield economy, should we have set still higher capital ratios than in the Basel III regime? Yes I believe we should. But starting from where we actually are, the Basel III reforms will significantly improve the resilience of our banking systems without harming economic recovery.

But while Basel III is vital, it is not the end of global regulatory reform. And crucially it must be combined with measures to deal with systemically important financial institutions (SIFIs) with the institutions seen in the past as ‘too big to fail’.

• It is essential that in future the taxpayer is not on the hook to bail out potentially failing banks.
• It is essential that even the largest banks can fail in a way which results in losses being imposed not just on equity holders, but on subordinated debt holders, and on senior debt holders as well if necessary, and it is essential that the market knows that in advance.
• But it is also essential that we are able to impose losses and recapitalise banks while avoiding confidence and contagion effects and while maintaining crucial functions, such as lending to the real economy.

And getting that balance right – creating real market discipline while still ensuring that failing SIFIs can continue to perform vital economic functions – is as difficult as getting the overall Basel III balance right

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The principle, however, is clear and set out in the press release which described the Basel III conclusions, ‘Systemically important banks should have loss absorbing capacity beyond the standards announced today’. This could be achieved through some combination of higher equity capital requirements: or a bigger layer of subordinated debt, convertible to equity if needed to recapitalise a potentially failing bank; or bail-in bonds, which make senior debt also able to absorb losses smoothly; or statutory resolution procedures, which increase our ability to impose losses on all categories of creditor, rapidly and with minimal business disruption.

The international Financial Stability Board will propose the broad way forward to the G20 leaders in November: working out and implementing the details is going to take us into next year. But once implemented, we will have in place rules and processes which substantially increase the resilience of our largest banks, while still enabling them to play their important and indeed socially useful role in the global economy

But while Basel III and new approaches to systemically important firms are important steps to a more resilient system, they are not in themselves sufficient. That’s partly because we cannot, without severe transitional problems, achieve the much higher capital standards which in an ideal world might make sense; but also because no one is clever enough to design a set of permanent rules adequate to address the ever evolving forms of financial system risk.

• In any financial system, however high our capital or liquidity requirements, there would still be a danger that credit supply, and in particular for lending against property, could become harmfully volatile – first too easily and cheaply available, then too restricted.
• And financial risks continually evolve, with new institutions or market structures not adequately captured by existing rules. The emergence of the shadow banking system (of SIVs, conduits and multi stage maturity transformation outside the banking system) clearly taught us that.

And that means that, alongside permanent rules, we need processes for evaluating emerging risks, for changing the rules if needed, and for pulling policy levers which are discretionary and varied through the cycle.

Which is why at the very heart of the new UK prudential regulatory system, and I believe the most important element within the government’s reforms, is the creation of the new Financial Policy Committee (FPC).

The FPC will fill the crucial gap in our past regulatory structure – the lack of macro-prudential analysis and macro-prudential policy levers. That analysis and those levers fell into the underlap between the Bank of England and the FSA. But that gap wasn’t just an accident: it reflected a dominant conventional wisdom – not unique to the UK but common across the world – that all would be well-provided free financial markets were left to operate within clearly defined and communicated rules:

• that if the Bank delivered the inflation target of 2%;
• and the FSA enforced its rule book and ensured appropriate systems and controls were in place;
• then financial markets would disperse risks efficiently, and financial stability would result.

We have learned that this conventional wisdom is not true. That monetary stability does not automatically deliver financial stability: that you cannot see the big picture of emerging risks when looking on a firm-by-firm basis: and that financial innovation is often used to circumvent rules and to create risk rather than to disperse it.

In future the FPC will fill this macro-prudential gap in two ways:

• First, by continually scanning the financial system to identify newly emerging risks and required changes in the appropriate scope and nature of rules and supervision, spotting the next variant of shadow banking, the next LTCM or AIG Financial Products before the crisis hits.
• Secondly, and crucially, by monitoring the credit cycle and the self-reinforcing links between credit extension and asset prices, and acting if needed to constrain credit booms before they end in busts.

The full toolkit to achieve that constraint is still to be defined. It will certainly include countercyclical capital buffers, increased to slow down excessive credit growth, reduced to support lending in recessions. It could include their variation by sector – constraining commercial real estate lending more than other categories: and it may need to include limits on allowable contracts, such as maximum loan-to-value ratios, rather than constraints imposed solely on aggregate lender balance sheets. And we need to resolve how macro-prudential tools are coordinated across Europe – the relative roles of the FPC and the European Systemic Risk Board, how to combine clear UK discretion to take the measures needed to address credit conditions in the UK with the complexities created by cross-border banking in a European single market.

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But the commitment in principle to a macro-prudential approach, operated by the FPC, is a vital step, giving us policy levers to take away the punch bowl before the party gets out of hand, levers simply not available – in this country or elsewhere in the developed world – before the crisis hit.

Taking away the punch bowl, however, will not always be popular. At various points in the cycle it could mean restricting mortgage credit when individuals are buying houses in a rising market, and limiting credit to real estate investors who enjoy the rising prices which easy credit itself helps produce. It means slowing down credit booms which, as long as they last, make governments popular and swell their tax revenues.

To be effective the FPC will therefore require the independence to make unpopular decisions: but this will only be possible within the context of a public debate which recognises that constraints on easy credit are sometimes in everybody’s best interest.

And that need for a mature public debate will also be important in relation to conduct of business issues – customer and investor protection.

The creation of the CPMA represents, I believe, a major opportunity to ensure that consumer and investor protection issues receive the dedicated focus they merit. The wholesale side – the ‘MA’ part of CPMA – is extremely important and of great interest to many of you here, and we need to ensure we emerge with an integrated markets regulator able to preserve the strengths of the UK markets and to play a full role in rapidly evolving European debates. But it is on the retail side – the ‘CP’ bit, that want to comment this evening, because here a new dedicated focus needs to be combined with a change in regulatory philosophy.

The creation of the CPMA represents, I believe, a major opportunity to ensure that customer protection issues receive the dedicated focus they merit. On the retail conduct side, that focus needs to be combined with a change in regulatory philosophy.

The FSA’s past approach placed significant reliance on the assumption that rational consumers would make good choices provided markets were transparent and information fairly disclosed. In many wholesale markets a very reasonable assumption, and where things aren’t bust we don’t need to fix them. But in many retail financial markets, the imbalances of knowledge and power between consumers and providers are so profound, and the potential for perverse incentives so great, that even highly competitive markets and extensive information disclosure are insufficient to protect consumer interests.

The FSA has therefore already shifted to an approach in which we are more willing to intervene to ensure market practices that meet consumer needs.

Through the Retail Distribution Review we have, for instance, regulated allowable charging structures. And following our Mortgage Market Review, we propose to significantly strengthen the requirement for lenders to assess the affordability of mortgage loans, rather than assuming that informed customers and prudent lenders will always reach sensible decisions, an assumption sadly contradicted by some pre-crisis lending.

But as we make that shift we need to strike a balance, recognising that any regulation which protects some customers from taking on mortgages they cannot afford will inevitably affect others seeking to make sensible, affordable choices.

We cannot leave retail financial markets entirely to themselves and continue to accept the waves of mis-selling which have been such a feature of UK financial services for the last 20 years – personal pensions, endowment mortgages, split capital trusts. But nor should we swing to the other extreme and attempt to ensure that nobody ever exercises free choice to make decisions they subsequently regret.

The CPMA, like the PRA, the FPC and the global regulatory community, cannot therefore operate in a technocratic bubble, applying unquestionably appropriate rules of undoubted benefit to everybody. It will need to continually balance alternative desirable objectives: product innovation versus product safety; and intervention to protect consumers versus customer freedom to choose. And to perform that function well, it will need to explain carefully the tradeoffs it has chosen on society’s behalf and encourage open public debate on whether those are tradeoffs which command broad support.

So as we split the FSA into prudential and conduct authorities, we should also move beyond the simplistic assumptions of the past. On both the prudential and conduct side, we thought that simple rules and principles would suffice to deliver good results:

• Meet the inflation target, apply a prudential rulebook, supervise firm by firm, and free financial markets would deliver financial stability.
• Ensure fair disclosure to customers, and rational customers will buy appropriate products off the best providers.

We now know the limits of those assumptions and we need to design new approaches. On the prudential side, global authorities have to balance long-term stability benefits versus the transitional costs of getting there. The FPC will need to make judgements and pull discretionary and policy levers which at times will be unpopular. On the conduct side, there is no right answer – but trade-offs to be struck between different desirable objectives.

We need trusted authorities independent enough to make decisions on behalf of society – but also acceptance by society that there are difficult choices to be made. We can build a more stable financial system better able to serve the needs of the real economy and of consumers, but it requires choices more complex than those which last year’s heckler was capable of grasping.

I have really missed him this year, but as always Lord Mayor I have greatly enjoyed your hospitality and I have greatly admired the work which you have done throughout the past year on behalf of the City of London and the UK financial services industry. There are many parts of that industry which played no role in the origins of the crisis, but were affected by it. We need to fix the deep problems which created instability, but continue to laud the contribution which the industry makes to our national economy.

I would therefore like to ask you all to raise your glasses to toast, THE HEALTH OF THE UK FINANCIAL SERVICES INDUSTRY.

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