The Momentum For Reform Must Be Maintained

(Editor’s Note: The post below by Lord Adair Turner is a transcript of his remarks at London’s City Banquet, on September 22, 2009.)

It’s a year and four days since Callum McCarthy spoke here on his second last day as Chairman of the FSA. I know he always received a warm welcome here and I am grateful, Lord Mayor, for your kind words, given that I now seem to be regarded as somewhat of a heretic in certain quarters of the City.  Heretics used to be burned at Smithfield, not far from here, so perhaps I should have been worried coming here. But I will not be recanting this evening. I will try, however, to be socially useful by addressing head on the complexities involved in distinguishing the benefits of a vibrant financial sector from the problems of excess and instability.

To say a lot has changed in the year since Callum stood before you is inadequate.  Callum’s speech came a few days after Lehman’s collapse, but before we understood the full consequences.  When I became Chairman two days later, I didn’t know I would spend my first three weeks at the FSA amidst the biggest financial crisis for at least 70 years.

Today the world looks much less scary than it did then.  The financial system is no longer fragile: growth is returning in many countries, confidence to many markets.  I say that with some trepidation because, of course, there may be setbacks and unexpected events.  But it is important to recognise the positives: a bias to over-cautious pessimism in official statements can be as harmful as a bias to unjustified optimism.

The banking system is stable. House prices have fallen much less than anticipated. The big emerging economies have proved far more robust than we feared.  The Bank of England mid-point forecast suggests fairly robust UK growth over the next three years.

But even if that is the case – even indeed if the path of growth, unemployment and housing prices turns out to be better than current expectation – we must not forget what occurred last autumn.   This was the worst crisis for 70 years – indeed potentially it could have been the worst in the history of market capitalism.  Real disaster – a new Great Depression – was only averted by quite exceptional policy measures.  Despite these measures major economic harm has occurred. Hundreds of thousands of British people are newly unemployed; tens of thousands have lost houses to repossession; and British citizens will be burdened for many years with either higher taxes or cuts in public services – because of an economic crisis whose origins lay in the financial system, a crisis cooked up in trading rooms where not just a few but many people earned annual bonuses equal to a lifetime’s earnings of some of those now  suffering the consequences.  We cannot go back to business as usual and accept the risk that a similar crisis occurs again in ten or 20 years’ time.

We need radical change.  Regulators must design radically changed regulations and supervisory approaches, but we also need to challenge our entire past philosophy of regulation.

And parts of the financial services industries need to reflect deeply on their role in the economy, and to recommit to a focus on their essential social and economic functions, if they are to regain public trust.

The financial system plays vital roles in a market economy and particularly so in a complex global economy of global trade and global capital flows. It encompasses many specific activities: life and general insurance, both broking and underwriting; equity trading and research and primary issuing: commodity and foreign exchange trading; basic commercial banking, trade finance and project finance and private equity, and market making and liquidity provision in numerous traded instruments.

And many of these services have been delivered efficiently and without creating undue risks throughout the crisis; many are not bust and don’t need fixing.

And the City is a centre of huge expertise in the full range of these activities.  It is, and will continue to be, a major provider of wholesale financial services to the rest of Europe and the world.  And it will continue to create many high-paid high-skilled jobs.  And it will continue to change and innovate.

And it is important to understand, amid the public suspicion of traders and trading rooms, that market making and liquidity provision in key markets is an important economic function, delivering important indirect economic benefits – even when the traders involved are focused day by day simply on making money, even though their activities look to some people like pure speculation, even though they do indeed entail position taking for speculative gain.  Adam Smith’s insight that good economic results can flow from the private pursuit of profit remains valid and vital.

But it’s possible to say all of that, and also recognise that not all financial innovation is valuable, not all trading plays a useful role, and that a bigger financial system is not necessarily a better one.  And, indeed, there are good reasons for believing that the financial industry, more than any other sector of the economy, has an ability to generate unnecessary demand for its own services – that more trading and more financial innovation can under some circumstances create harmful volatility against which customers have to hedge, creating more demand for trading liquidity and innovative products; that parts of the financial services industry have a unique ability to attract to themselves unnecessarily high returns and create instability which harms the rest of society.

That is what I said in a recent interview for Prospect Magazine, which caused quite a stir.  The editor of Prospect was delighted: small circulation intellectual magazines devoted to the 4,000-word essay don’t often get that publicity. Others were less happy.  One City practitioner declared himself ‘appalled, disgusted, ashamed and hugely embarrassed that I should have lived to see someone who commands a senior and crucial important position as head of the UK regulatory regime, making such damaging and damning remarks’.

Well, I am sorry I spoilt his breakfast, but I do not apologise for being correctly quoted as saying that while the financial services industry performs many economically vital functions, and will continue to play a large and important role in London’s economy, some financial activities which proliferated over the last ten years were ‘socially useless’, and some parts of the system were swollen beyond their optimal size.  And if you disagree with that, you have a bone of contention not only with me, but with the Chairman of the British Bankers’ Association, Stephen Green, who has said exactly the same thing in very similar words, when he argued that ‘in recent years, banks have chased short-term profits by introducing complex products of no real use to humanity’, and when he recognised that ‘some parts of our industry have become overblown’.

Some commentators, responding to my interview and indeed to Stephen Green’s speech, have challenged whether we can ever make such judgements about the social usefulness of economic activity.  After all, they say, in a rich society there are many products and services which people buy but do not need – what of the fashion industry? What of much of media and entertainment?  What of the arts?  But there is big difference.  The products of the fashion industry are consumer products, consumed directly by individuals, and in a free and rich society, we should accept and indeed relish the fact that consumer choice is in part driven by fancy and caprice, by desire for luxury and style and indulgence, not by need.  Products and services chosen directly by customers don’t need to prove that they are useful; the fact that consumers choose them is enough.

But nobody gets up on a Saturday morning and says ‘I know it’s indulgent, but I think I’ll go out and buy one of those lovely new CDO squareds’.  And the fashion, media, or arts industries cannot create financial instability and cause economic recessions.  Financial services are different from those industries, because they are intermediate services, they are the plumbing of the economy, but a very complex plumbing, and if we get it wrong, potentially explosive.

So we must ask searching questions about whether society is getting these crucial plumbing services as efficiently, at as low a cost, and with as little risk, as possible.  Some comments on my Prospect magazine interview have suggested that any regulator ought to wish their industry to be as successful as possible and therefore as large as possible.  That is frankly a bizarre idea: nobody suggests that it is the role of Ofgem to make the electricity industry as large as possible. Obviously if there are sustainable, valuable financial services which the world needs, we should be pleased that Britain is good at delivering them. But any idea that that means that size is an objective, even if the activities are likely to harm global and UK economic stability, is absurd.

Yes, financial services form a vital industry and source of high-skilled employment.  Yes, the City will continue to play a key and vibrant role in the UK economy.  But not everything that a financial system does is socially useful; and sometimes bits of it can get too big and it would be better for society if they got smaller. Anybody who thinks those statements are contradictory is refusing to face the complex reality of financial markets.

So the FSA, on behalf of society, must consider whether the financial services industry is delivering its vital services in an efficient and risk-controlled fashion.  That does not mean we can define precisely how large the financial system should be.  It doesn’t mean that we know how much trading and liquidity creation is optimal, nor that we can easily define some products as beneficial and others as harmful.  But it does imply an important and profound shift in regulatory philosophy.

In the past, in the years running up to the crisis, it was the strong mindset of the FSA – shared with securities and prudential regulators and central banks across the world, it was almost part of our DNA – that we assumed that financial innovation was always beneficial, that more trading and more liquidity creation was always valuable, that ever more complex products were by definition beneficial because they completed more markets, allowing a more precise matching of instruments to investor demand for liquidity, risk and return combinations.  And that mindset did affect our approach – and the approach of the whole world regulatory community – to the setting of capital requirements on trading activity; it affected our willingness to demand risk reduction in the CDS market; and it influenced the degree to which we could even consider short-selling bans in conditions of exceptional market volatility.

We have had to change that mindset and we have now done so.  And that has profound implications for the regulation and supervisory approaches which will be imposed at UK and global level.

  • The world’s financial regulators, led by the new International Financial Stability Board, will require the global banking system to be more prudent, operating with larger shock-absorbing buffers of capital and liquidity, and if as a result bank equity becomes a more boring investment – lower average return but lower risk – we should not regret that.  After the last year, there’s a lot to be said for being boring.
  • And we will impose much higher capital requirements against many riskier trading activities, where the past approach was woefully inadequate, while recognising that market making in many core markets – such as FX or government bonds or equities – is both relatively low risk and an essential lubricant of a complex market economy.  We will have a bias to conservatism in our capital requirements for trading in complex and potentially risky products where the benefit to the economy is unclear. And if that means trading activity and liquidity in these specific markets shrinks, that too we should not regret.
  • And we are imposing at firm level a far more assertive style of supervision, no longer willing to assume that market discipline and incentives will always lead bank management to make optimal decisions; more willing to make judgements on whether business models and business strategies create undue risks for the whole financial system.

This reform programme amounts to a radical change in direction.  But it poses for regulators the challenge of complexity, because it involves rejecting an intellectually elegant but also profoundly mistaken faith in ever perfect and self-equilibrating markets, ever rational human behaviours; but it leaves us with no equally simple alternative philosophy.   It is much easier to proceed in life on the assumption that either all markets are axiomatically good, or all speculation evil.  The reality is more complex and requires us to make trade-offs and judgements. But there is no alternative to that complexity.

But if regulators need to change and face complex challenges, so too do bankers.  And one of their biggest challenges is to regain public trust, to rebuild public understanding that banks and financial markets perform not only socially useful but vital functions, linking savers to productive investments, allocating capital to efficient use, lubricating the flows of capital and trade in a global economy which, for all its faults, is a better system than any available alternative for delivering prosperity in a free society.

To regain trust, banks need to refocus their energies not on those over-complex products of no real use to humanity of which Stephen Green spoke, but on their core functions of providing savings and credit and payment products to customers, whether individuals, companies or institutions.

But focusing on the socially valuable is not straightforward.  Because, as I said earlier, it is in the nature of markets that there are some things which are indirectly socially useful, but which in the short-term will look to the external world like pure speculation.  Market making does have an important social function – but that benefit is achieved indirectly and market making requires some position taking.  And a vibrant global economy probably does require an important role for securitised credit a recovery indeed of securitised credit markets, but securitised credit extension needs to be underpinned by at least some trading activity.

So rebuilding trust in the necessary and socially useful functions of banks cannot mean an end to all trading activities nor, much as some might like it, an end to well-remunerated traders.

But it does mean that the top management of banks, and in particular of any banks which are involved both in complex trading activities and in retail banking activities – need to operate within limits.  They need to be willing, like the regulator, to recognise that there are some profitable activities so unlikely to have a social benefit, direct or indirect, that they should voluntarily walk away from them.  They need to ask searching questions about whether the complex structured products they sold to corporate and institutional customers, truly did deliver real hedging value or simply encouraged those institutions into speculative and risky exposures which they did not understand: and, if the latter, they should not sell them even if they are profitable.  They need to be willing to accept the capital and other requirements which will be imposed on activities of little value and considerable risk, rather than deploy lobbying power to argue against such constraints on the basis of a simplistic assertion that all innovation is always valuable.

The regulator can impose the rules which will guard against risk.  But only the banks themselves can restore public trust in and appreciation of the vitally important functions which they perform.

And restoring that trust, in the immediate future in particular, carries implications for the vexed issue of bonuses.  For regulators, the key long-term issue is not the level of pay but the structure of payments and the incentives they produce.  And it is possible to overstate the importance of bonus structures in the origins of the crisis: they were, I believe, much less important than huge failures in capital adequacy and liquidity regulation.  But it is still important to get these incentives right for the long term.  The new FSA rules aim to ensure a tight link between the design of bonus structures and the management of risk – for the first time requiring that remuneration committees make the risk consequences of remuneration structures a key consideration. The FSA has led the world in introducing these rules, and the International Financial Stability Board is now finalising a global standard whose details are closely in line with the FSA approach.

These new rules will make a useful contribution to better risk control, but they will not – and are not designed to – influence the overall level of compensation.

But it is clear that popular concern is actually focused on the level, and in particular is now focused on talk of very large bonuses in major trading banks, only a year after a financial crisis, and after the public underwriting of large losses through guarantees, central bank liquidity support and capital injections. Two considerations make these very large profits a legitimate matter of social interest, rather than an entirely private matter.

  • First, these high profits are, to a significant extent, being earned because of a set of specific post-crash circumstances: increases in the market share of the survivors; government guarantees and central bank liquidity support; very low interest rates; volatility; and large government debt issues.
  • And second, that in order to prevent a repeat of the crisis, we need to ensure that our major banks build stronger capital buffers, meeting higher future minimum capital requirements, and putting away reserves in good years to ensure stability in downturns.

In these circumstances, the Financial Stability Board will this week state in its Report to the G20 leaders, that it is essential that the priority use of high profits should be to rebuild the capital needed to support lending, allow official measures to be removed, prepare institutions to meet higher capital requirements, and that bonus and dividend policies should be consistent with this priority. And over the long term there will be a legitimate interest of regulators in aggregate bonus payment rates if and when these payments have implications for capital conservation.

I hope the banking industry will embrace this globally agreed priority, and welcome a global agreement which will make it easier for individual firms, where appropriate, to moderate bonus payments in the knowledge that similar pressure is being placed on their major competitors.

And I hope that all in the banking industry will understand why society expects the industry to engage in serious debate about the vitally important economic functions which we need the industry, safely and profitably, to perform.  I quoted earlier the upset City practitioner who was ‘appalled, disgusted and ashamed’ at my words.  I wonder whether this thoughtful soul realises that those sentiments are precisely what some of the victims of this recession feel about the excesses of some specific parts of the financial system.

An industry that recognises the need to moderate excesses, rebuild trust and embrace reforms to prevent another crisis will prosper. The real enemies of the City’s success and of the market economy, with all its great potential to spread prosperity and opportunity, are not those who raise these issues, but those who want to ignore them, as if the near-death experience of our financial system only 12 months ago had simply never occurred.

I am sure that the City of London in its many facets will remain a vibrant and major force in the UK economy.  From a personal point of view, as a British citizen and a Londoner, I hope it will.  But it is not my job as Chairman of the financial regulator to be the industry’s cheerleader.  Energetic and effective promotion of the City is, however, a very important and useful function, which others can and should perform. Indeed, Lord Mayor, that has been one of your traditional roles. It is one into which you have put great energy over the last year, and it is one which I am sure all here will agree, you carry out with great distinction.

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