Lord Turner is the UK’s man for all seasons. A few years ago, he fixed pensions. Today, it is finance. The report by the new chairman of the UK’s Financial Services Authority is a turning point. The authorities of a country that used to boast of its light financial regulation have changed their minds: the UK has lost confidence in its financial sector.
“Over the last 18 months, and with increasing intensity over the last six, the world’s financial system has gone through its greatest crisis for at least half a century, indeed arguably the greatest crisis in the history of finance capitalism.” This is the report’s starting point. It advances two explanations for this disaster: exceptional macroeconomic conditions – particularly the emergence of excess savings in large parts of the world – and reliance on “the theory of efficient and rational markets”. As the report notes, “the predominant assumption behind financial market regulation – in the US, the UK and increasingly across the world – has been that financial markets are capable of being both efficient and rational”. So regulators were expected to stay out of the way. In the report’s new view, they should be in the way, instead. The financial sector no longer enjoys the benefit of the doubt: it may burn up the world.
The most important analytical points are that individual rationality does not ensure collective rationality, that individual behaviour is frequently less than rational and that, in consequence, markets can overshoot, in both directions. Above all, such failings create systemic risks: if everybody believes in the same (faulty) risk models, the system will become far more dangerous than any individual player appreciates; and if everybody relies on their ability to get out of the door before anybody else, many will die in the inferno.
To these points must be added the vulnerability inherent in borrowing “short and safe”, in order to lend “long and risky”. If we were not so familiar with banking, we would surely treat it as fraudulent. Moreover, far from reducing the frailty, securitisation enhanced it by spreading “toxic assets” everywhere.
The recommendations include: increased quality and quantity of capital, particularly against trading activities; a strongly countercyclical capital adequacy regime; a maximum gross leverage ratio; enhanced regulation and supervision of liquidity; coverage of all significant institutions; enhanced supervision of rating agencies; codes covering remuneration in systemically significant institutions; and centralised clearance of the majority of trades in credit defaults swaps.
The remainder of the article can be read here. Debate from our panel of economists appears below.
