FSA chairman spells out regulatory challenges beyond Basel III

Lord Turner, chairman of the Financial Services Authority (FSA), will say this evening that already agreed regulatory reforms will have a major beneficial impact but further reforms are needed to make the financial system stable. He will also say that regulators need to recognise that the financial system will continually mutate, creating new risks, and requiring a continually evolving regulatory regime.

"The pre-crisis delusion was that the financial system, subject to the then defined set of rules, had an inherent tendency towards efficient and stable risk dispersion. The temptation post-crisis is to imagine that if only we can discover and correct specific imperfections - such as bad incentives or industry structure - that a permanently more stable financial system can be achieved."

Lord Turner will argue that while popular anger often focuses on the direct costs of public rescue of banks, these are likely to be small relative to the overall harm produced by financial crises. This harm derives from volatile credit supply, first too easily and cheaply available then restricted, producing a credit crunch and recession. Such volatile credit supply could moreover, arise in a world where no large banks ever failed or needed public support.

He will also argue that regulators must recognise that financial instability is caused not only by poor incentives (such as too big to fail status or unfair bonuses) but by investors' myopia and irrationality, and by the sheer complexity and interconnectedness of the financial system.

He will say that three conclusions for public policy follow:

1. While the Basel III capital standards are a major step forward, in an ideal world equity capital requirements would be set much higher - at something more like the 15-20% of risk weighted assets illustrated by Professor David Miles in a recent paper.
   
   "Today's regulators are the inheritors of a half century long policy error, in which we have allowed private sector banks to pursue their private interest in maximising leverage levels, at times influenced by a deep intellectual confusion between private costs and social optimality.
   
   "In fact transition challenges - the danger that moving rapidly to higher capital requirements will slow economic recovery - make the ideal unattainable. But we need to recognise that as a result the system remains more vulnerable than is ideal.
2. Fixing the too big to fail problem by making all banks, however large, resolvable is an absolutely essential but not sufficient element in the reform agenda. It will improve market discipline and would fully address problems created by individual failures of large banks. But it cannot in itself guard against a systemic crisis of the sort seen in 2008, since the imposition of losses on bank debt holders could itself drive a self-reinforcing crisis.
   
   In addition to making banks resolvable, regulators must therefore agree equity surcharges for systemically important banks high enough to reduce the probability of failure to minutely low levels.
3. As the events of 2007 to 2008 showed, financial instability can be created by shadow banking activities as much as by banks. And as regulators impose higher capital and liquidity requirements on banks, there is a danger that activity will again shift to shadow banking markets and institutions, such as money market mutual funds and hedge funds.

The Financial Stability Board is therefore developing recommendations on how to monitor and, if necessary, regulate developments in shadow banking. Among the policy options to be assessed are the regulation of minimum margin requirements in repo and other secured financing markets.

Lord Turner will say that each of these conclusions illustrated that the fundamental determinants of financial instability were (i) the overall balance between debt and equity in the real economy and within the financial system, and (ii) the aggregate extent to which the financial system performs maturity transformation. Both leverage levels and aggregate maturity transformation increased significantly in the pre-crisis years, but regulators did not adequately track and respond to that development, wrongly believing that we could assume that rational investors in free financial markets would ensure that risk was dispersed in an efficient and stable fashion.

In future it will be essential to:

• Monitor far more effectively overall developments in leverage and maturity transformation; and
• If necessary respond with policy levers - such as countercyclical capital or variable loan-to-value ratios - which can be varied through the cycle.

Finally Lord Turner will argue that policy makers and regulators cannot avoid the issue of whether increased financial intensity and innovation has delivered increased allocative efficiency or whether some financial activities simply transfer income from the non-financial to the financial sector.

"Many of the measures we could take to increase stability - such as higher capital requirements against trading activities or against intra-financial system complexity, (both of which are issues on our agenda beyond Basel III) - might well reduce the scale of trading activity and the liquidity of some markets. If these activities and related liquidity are value creative we may need to make a trade off between stability and allocative efficiency. If they are zero sum or rent extracting there is no such trade off."

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