28 Sep 2010
Speech by Adair Turner, Chairman, FSA
Eurofi Conference, Brussels
I am delighted to join you here at the Eurofi 10th anniversary conference. This is a huge conference with a huge agenda: ‘how to optimise EU financial reforms to achieve resilience, growth and competitiveness in the EU’. The sheer range of issues being discussed over these four days demonstrate the multifaceted challenges we face – and we know that the range of issues and challenges will not go away or get simpler in the near future.
Given this context, it is crucial that amid all the different issues which merit some attention, we ensure that we focus on the issues which are most vital to ensuring that we avoid another financial crisis like that of 2008.
It’s now two years since the financial crisis hit global markets. Since then there have been various reports – from Jacques de Larosière, Paul Volcker for the G30, my own Review, among others - that have explained the causes of the crisis and proposed reforms, many now being enacted
The crisis had many causes – including those on which popular attention often focuses. There were some absurd bonuses for excessive risk taking and there was an explosion of exotic product development whose impact we did not fully understand. There were failures in risk management practices and systems which top management and boards should have put right, and which regulators and policy makers, 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. We need to make sure that reform addresses these fundamental issues.
In response to these causes, many elements of reform have been put in train, at national, EU and global level. The regulatory reform agenda is well known and covers the full range of issues: the levels of capital especially in the trading book and over the economic cycle; liquidity; crisis management; resolution and recovery; governance; hedge funds; OTC derivatives; short selling and so on. All of these reforms are important, but to me, some are more crucial than others.
Yes, we do need to address the abuse of bonuses awarded for excessive risk-taking; and we have put in place clear international rules and EU regulations to address this; but in themselves, these rules will not transform the build up of risk in the financial system. Let’s remember that the top executives of Lehman’s lost large equity stakes when the firm failed – the fact that bonuses had been deferred and were in equity didn’t stop them taking excessive risk.
Regulation of Credit Rating Agencies (CRAs) is also important. In the run up to the crisis, there were severe conflict of interest issues, and a problem of rating methodologies being extended to structured securities where they performed poorly. A basic structure of regulation and supervision is required is response – and has now been enacted. But regulation of CRAs is not going to remove the fundamental problem of procyclical credit risk assessment and credit supply – that problem could exist even in a world with no CRAs.
Back to top
Similarly, if we turn to hedge fund regulation, we need to recognise it as part of the agenda, but to place it in context and ensure that we focus on the most important issues. Hedge funds - on-shore or off-shore - did not actually play a fundamental role in this recent crisis – the key problems arose within banks and investment banks, and their off-balance sheet vehicles, run out of dealing rooms in our major financial centres. But hedge funds might play a major role in a future crisis – so the most crucial reforms are those which give regulators the power to gather information on hedge fund managers and funds, and if necessary in future, to extend prudential regulation to them. In the two decades before the crisis we failed to see that the shadow banking system – broker/dealers, money market funds, SIVs and conduits – had become systemically important. We need to guard against any such mistake in future. That is what really matters: some of the issues on which political debate has focused, such as the rules relating to non-EU funds and marketing to EU investors, are of secondary importance.
And across a number of agenda items, it is important that we do not introduce into the core debate about how to prevent financial crises, proposals which are tangential to that issue, or designed to prevent fair competition, or to drive shifts in location of activity for political purposes. Getting Over-the-Counter (OTC) derivatives as much as possible onto central counterparty clearing systems is very important; the argument that clearing in euro-denominated instruments must be cleared in some sense physically ‘within the Eurozone’ has no basis in good prudential risk management, and it is on good prudential risk management that we should focus.
So a key to success in regulatory reform is that we do not get diverted, or place too much reliance on secondary though still important issues. And that we instead focus intensively on the most important issues, which are:
- Higher capital and liquidity standards – more buffers to absorb volatility in the financial system and economy.
- Prudential and other measures which address the problems of banks perceived as ‘Too Big to Fail’.
- The need for macro-prudential analysis and policy tools to spot and lean against excessive credit growth.
Higher capital and liquidity standards across the global banking system are essential – the banking system was simply running before the crisis with too small buffers of capital and liquidity to absorb shocks – and as a result acted as a shock amplifier rather than a shock absorber. Capital against trading books was particularly deficient: we allowed the accumulation of credit security portfolios with woefully inadequate capital support, and we allowed excessive trading activity backed by insufficient capital. But in basic banking business as well we had insufficient capital support for the risks being taken and, crucially, too much risky maturity transformation. And we had a system lacking buffers which were built up in good times to be run down, supporting lending, in recessions.
Back to top
The Basel III capital regime, announced two weeks ago, is therefore central to future stability – combining a more robust definition of risks, a higher quality definition of capital, higher minimum ratios, and capital conservation and counter-cyclical buffers which will help guard against procyclicality. Agreeing that regime has involved extensive deliberation – we needed to balance the long-term need for much higher standards against the transition challenge of getting there without depressing lending to the real economy. The balance we have struck is, I believe, a good one, and the key priority for Europe now – more important than what we do on bank bonuses or hedge fund marketing passports – is developing a Capital Requirements Directive which translates this agreement fully and robustly into EU law.
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’. We need to create real market discipline – so that future taxpayers do not have to bail out banks and so that losses can be imposed on senior and subordinated debt holders as well as equity holders as necessary – while still ensuring that failing SIFIs can continue to perform vital economic functions such as lending to the real economy.
That balance will be difficult. 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’. 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. Those details are likely to involve some appropriate tailoring to national circumstances, with possibly, a different balance in different countries between straightforward equity capital surcharge, quantitative requirements for a tier of convertible subordinated debt, or contractually bail-inable debt which is written down or converts to equity to ensure that a bank is recapitalised before failure. Once the global regime for SIFIs is agreed, it will be essential to have an EU legislative implementation which requires robust action within the principles while allowing appropriate national flexibility to go beyond minimum requirements.
The new Basel III regime and new rules for systemically important firms will in themselves greatly increase the resilience of the financial system. But they will not in themselves be sufficient. That’s because reflection on the causes of the crisis leads us to two conclusions:
- First, that the nature of financial risks continually evolves, with new institutions and activities emerging, which create new risks – the growth of the shadow banking system to which I referenced earlier, for instance.
- Second, that credit extension and asset prices, in particular real estate credit and prices, can become linked in self-reinforcing cycles, which as they boom and bust cause real economic harm, and can do so even if monetary policy is successfully delivering low and stable inflation. Contrary to the conventional wisdom of the Great Moderation, monetary stability plus free financial markets do not ensure financial stability, and credit supply cycles cannot be effectively offset either by one continual set of prudential rules, nor by interest rate policy alone.
It is therefore crucial that, as well as reforming rules, we ensure macro-prudential analysis and develop macro-prudential tools. In the UK, those functions will be handed by the new government’s financial reform act to a new Bank of England Financial Policy Committee. That committee will be empowered to deploy policy levers which directly lean against excessive credit creation – through increasing counter-cyclical capital buffers, or through, possibly, the imposition of loan-to-value limits – new mechanisms, to use the famous worlds of Federal Reserve Chairman McChesney Martin, “to take away the punch bowl just when the party gets going".
Back to top
Such macro-prudential policy tools will also, however, be important within the Eurozone. Indeed arguably more important still, because when you have a large single currency union spanning somewhat heterogeneous economies and banking systems, the ability of interest rates alone to address nation financial stability issues is even lower than in a nation with its own currency and monetary policy. Ireland and Spain, as they faced the credit-fuelled property booms of the pre-crisis years, lacked even the imperfect lever of interest rate increases to lean against the wind. So macro-prudential tools within the Eurozone will need to be actually applied at national level.
But within a European, single market, both within and beyond the Eurozone, macro-prudential analysis and policy cannot be conducted on an entirely national basis; its operation in one country will have implications in others, and its effectiveness in one country can be undermined by banks from other countries – if one country limits credit expansion by its own banks, bank branches from other countries could undermine the impact by taking market share.
It is therefore essential, as de Larosière Report proposed, that we have a European level oversight of macro-prudential issues: The European Systemic Risk Board (ESRB). The ESRB is, I believe, a vitally important element of Europe’s response to the crisis. Many important issues will need to be resolved in its actual operation:
- How to ensure good independent analysis which clearly identifies emerging problems even if national politicians don’t like the message.
- How specific the ESRB will be in its conclusions – whether it will make actual recommendations on appropriate national policy measures.
- What will be the set of policy levers that national authorities will use, with what required degree of coordination.
But in principle, the commitment to macro-prudential oversight and, if necessary, action, along with Basel III and a clear strategy for SIFIs, should be at the centre of our response to the crisis.
Back to top
Finally, let me say a world about the European Supervisory Authorities, and in particular the Banking Authority. In the UK, when in 2008 we had to deal with the collapse of the Icelandic bank Landsbanki, we were forced to recognise the reality that a European single market in retail banking, with banks free to operate across borders in branch form, is dangerous if not combined with pan-European mechanisms to ensure strong bank regulation and supervision in all countries of the European Economic Area, each of which can be the home to a bank with branches in others.
That is why, in my own Review, I said we either needed “more Europe, or less Europe” – either more effective European mechanisms to ensure well enforced regulation and supervision, or acceptance that a single market in retail banking is unsustainable. In fact, I always recognised, and the FSA always recognised, that the choice would have to be more Europe, and that is why we have the European Supervisory Authorities (ESA).
The crucial need now is for the ESAs to concentrate its efforts on addressing the key deficiencies that led to the crisis – defining appropriate implementation of Europe’s prudential rule book, and ensuring, through peer review, that national supervisors are effectually enforcing it. To ensure that, it needs high technical competence and clear independence from political pressure.
So ladies and gentlemen, as I look at the huge agenda of this four days conference, my key message is that among all the reasonably important issues discussed, we keep returning to those which are most important.
It is important to regulate bankers’ remuneration and hedge funds, but if the legislation on these which we are now introducing, had been in place ten years ago, but with the global bank capital and liquidity regime as it was, the crisis would have occurred much as it did.
Conversely, if we had imposed more effective rules on trading book capital, on total capital and liquidity, and had in place appropriate macro-prudential analysis and policy tools, the crisis could have been avoided even if many bankers got paid too much for unnecessary activity.
This crisis has been so harmful to the lives of ordinary people across Europe, through lost income, lost employment and public debt burdens for the future – that we owe it to them to ensure our policy responses focus on the key changes which will prevent it happening again.
Back to top
