The Turner review (pdf) of financial regulation (pdf) is intended to be the first words on the subject, not the last. It leaves open several questions. For me, the main ones are:
1) How do we get from here to there? Turner wants banks to have higher capital-asset ratios - even higher than Basel II ones. But banks are now under-capitalized; in my day job, I’ve estimated, from Bank of England data (table B1.2) that banks need over £80bn of capital just to return to 2006’s capital-assets ratio. How can banks raise their ratios so much? Turner says we need a “lengthy transition” period to ensure that his proposals don’t cause a halt to lending. But this period might be very long indeed. Not does he say how banks are to raise such capital, without further government help.
2) Turner wants banks to have counter-cyclical capital requirements, building up reserves in good times. But are these really enforceable?
Imagine the next boom, in which banks restrain lending. Young people will complain of being unable to get on the housing ladder. Firms will complain of being starved of finance to invest in profitable new equipment. Banks will resent the foregone profits. And everyone will downplay the probability of a recession - that’s what happens in booms. Can regulators or governments really resist these pressures to abandon counter-cyclical requirements?
3) Won’t regulatory arbitrage circumvent these problems, for example as offshore lenders step in to fill the gaps left by banks? Turner says that purely national regulation is “by far second best”, and calls for “internationally agreed” regulation. But isn’t this rather idealistic?
4) Far from accepting calls for a Glass-Steagall style separation of “utility” and investment banks, Turner seems to want a merger of the two. His call for very high capital requirements against banks’ trading books mean that stand-alone investment banks would face huge capital costs. This would encourage banks to take them over. Is this desireable?
5) If Turner gets his way, we’ll have slower, more stable economic growth. But what are the benefits of this over higher, more volatile growth? It’s easy to forget that booms can have lasting benefits - for example by bequeathing us a higher stock of physical capital or houses, or giving some of us nice capital gains as a result of irrational exuberance; I speak as one who sold a London flat for silly money a year ago.
6) Is Turner really wise to downplay the role of inadequate management structures in this crisis? He points out that managers’ big equity stakes did not stop Lehmans‘ collapsing. But he doesn’t point out that unrestrained hubristic chief executives (Dick Fuld, Fred Goodwin etc) played a role. And, aside from calling for banks to use some counter-conventional wisdom academic research, Turner doesn’t ask how to break up the deference to individual leaders or groupthink that led banks to so willingly take on high risks.
And herein lies the paradox of the report. The dominant theme of it is that banks are incapable of managing themselves. But to Turner, the solution is not a change of ownership (the N-word isn’t mentioned as far as I can see), nor or management structure, and certainly not the introduction of more market forces. Instead, it’s management at arm’s length, by regulators.
1) How do we get from here to there? Turner wants banks to have higher capital-asset ratios - even higher than Basel II ones. But banks are now under-capitalized; in my day job, I’ve estimated, from Bank of England data (table B1.2) that banks need over £80bn of capital just to return to 2006’s capital-assets ratio. How can banks raise their ratios so much? Turner says we need a “lengthy transition” period to ensure that his proposals don’t cause a halt to lending. But this period might be very long indeed. Not does he say how banks are to raise such capital, without further government help.
2) Turner wants banks to have counter-cyclical capital requirements, building up reserves in good times. But are these really enforceable?
Imagine the next boom, in which banks restrain lending. Young people will complain of being unable to get on the housing ladder. Firms will complain of being starved of finance to invest in profitable new equipment. Banks will resent the foregone profits. And everyone will downplay the probability of a recession - that’s what happens in booms. Can regulators or governments really resist these pressures to abandon counter-cyclical requirements?
3) Won’t regulatory arbitrage circumvent these problems, for example as offshore lenders step in to fill the gaps left by banks? Turner says that purely national regulation is “by far second best”, and calls for “internationally agreed” regulation. But isn’t this rather idealistic?
4) Far from accepting calls for a Glass-Steagall style separation of “utility” and investment banks, Turner seems to want a merger of the two. His call for very high capital requirements against banks’ trading books mean that stand-alone investment banks would face huge capital costs. This would encourage banks to take them over. Is this desireable?
5) If Turner gets his way, we’ll have slower, more stable economic growth. But what are the benefits of this over higher, more volatile growth? It’s easy to forget that booms can have lasting benefits - for example by bequeathing us a higher stock of physical capital or houses, or giving some of us nice capital gains as a result of irrational exuberance; I speak as one who sold a London flat for silly money a year ago.
6) Is Turner really wise to downplay the role of inadequate management structures in this crisis? He points out that managers’ big equity stakes did not stop Lehmans‘ collapsing. But he doesn’t point out that unrestrained hubristic chief executives (Dick Fuld, Fred Goodwin etc) played a role. And, aside from calling for banks to use some counter-conventional wisdom academic research, Turner doesn’t ask how to break up the deference to individual leaders or groupthink that led banks to so willingly take on high risks.
And herein lies the paradox of the report. The dominant theme of it is that banks are incapable of managing themselves. But to Turner, the solution is not a change of ownership (the N-word isn’t mentioned as far as I can see), nor or management structure, and certainly not the introduction of more market forces. Instead, it’s management at arm’s length, by regulators.
Also clearly absence is any return to the concept of a bank director having to be a "fit and proper person", both in terms of personal integrity and knowledge and experience. While integrity can sometimes be hard to judge objectively, there should at least be a requirement for demonstrated skill and experience. If the football authorities can demand that team managers have passed their coaching badges surely a requirement for senior bank executives and directors to have professional qualifications in banking or finance is not too much to ask. Running a grocery store is not an adequate qualification for becoming CEO of a major bank.
Posted by: RobertD | March 19, 2009 at 01:40 PM
Imagine the next boom, in which banks restrain lending. Young people will complain of being unable to get on the housing ladder.
Yeah, because, in the last boom, they had NO problem.
5: idle productive capacity. Increased uncertainty means higher risk premia.
Posted by: ajay | March 19, 2009 at 02:58 PM
Chris,
you've read the report (so I don't have to!) ... does it say anything about preventing banks from loading their balance sheets with each other's securitized loans, or from taking out default insurance and behaving as if this meant they were risk free?
the inspiration for these two questions comes from these two (imho) must-read articles
http://www.voxeu.org/index.php?q=node/3287
http://blogs.cfr.org/setser/2009/03/17/concretations-of-risk-plagued-with-deadly-correlations/
Posted by: Luis Enrique | March 19, 2009 at 04:52 PM
RobertD: He does hint at some kind of requirements for bank staff to be more skilled and better trained. But actually I don't think the problem here is the irrationality of bank employees. They have been all too rational, creating and exploiting big agency problems.
The real problem - which he identifies but doesn't propose to solve - is irrationality of the non-professionals in finance, investors and borrowers. I think we need some proposals for a regulator of rationality:
http://www.knowingandmaking.com/2009/03/towards-rational-exuberance.html
Posted by: Leigh Caldwell | March 19, 2009 at 05:36 PM
Luis - higher capital requirements would, indirectly, limit banks' holding each others' loans. I don't think Turner does address the CDS problem, though.
That said, I've long been puzzled by these. They seem to me to just exchange default risk with counterparty risk. It's only because the counterparty (AIG) gets bailed out that this makes sense.
Posted by: chris | March 20, 2009 at 01:08 PM