In a speech at the Mansion House tonight, the chairman of the Financial Services Authority, Lord Turner, will say that to design an effective regulatory response to the financial crisis, we need to move beyond the demonization of over-paid financial traders and recognise the fundamental mistakes made by policy makers.
"In finance and economics", he will say, "ill-designed policy is a more powerful force for harm than individual greed and error".
He will argue that the crisis had many causes, including "absurd bonuses for excessive risk taking" and "an explosion of exotic socially useless product development", but that underlying these problems were prudential rules and an entire philosophy of market regulation which failed to identify and address the dangers of excessive leverage, and which too confidently relied on supposedly efficient and rational markets always to produce good results.
Addressing that failure requires the implementation of three major sets of reform: significant increases in bank capital and liquidity requirements; clear strategies to ensure that banks will not be bailed out by tax-payers; and macro-prudential tools which can slow down excessive credit growth. But applying these tools will sometimes have unpopular consequences for the supply of credit which society needs to be willing to accept.
Given these priorities, Lord Turner will welcome the decisions reached on the Basel III package of capital and liquidity reforms. Responding to suggestions that the package was weaker than ideal, he will point out that the total impact derives from changes to the definition of capital and the definition of risk weights, as well as to the ratio itself, with the combined effect being considerably larger than the headline increase from 2% to 7% suggests.
He will accept that if philosopher kings were designing a banking system entirely anew for a greenfield economy, they would choose still higher ratios, but argue that starting where the world economy is today, the Basel III reforms will significantly improve the resilience of the global banking system without harming prospects for economic recovery.
But while Basel III is vital, Lord Turner will stress that it is not the end of global regulatory reform. In future, he will say, tax-payers should not have to bail out those systemically important financial institutions which in the past have been judged ‘Too Big to Fail’. Options to achieve this while ensuring that systemic shocks to confidence and lending capacity are minimised, include capital surcharges for systemically important banks, or debt instruments smoothly convertible to equity as firms approach failure.
No set of permanent rules can, however, guard against all financial risks, which evolve in form and change through the cycle. For this reason, Lord Turner says he regards the creation of the new Financial Policy Committee as the most important element in the Government’s reform package. The FPC will fill the “macro-prudential underlap” which existed between the FSA and the Bank of England, and move beyond a rule driven approach to financial policy to recognise the importance of judgement and discretionary powers to constrain excessive credit growth. Doing that, however, will not always be popular. To be effective, the FPC will therefore require robust independence, and to be supported by public recognition that constraints on easy credit are sometimes in everybody’s interest
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