The financial crisis and the future of financial regulation

In a recent speech by Lord Adair Turner, Chairman of the UK Financial Services Authority he set out the causes of the current financial crisis and listed 3 changes which regulators think are essential:

  1. “new approaches to the regulation of the capital adequacy of banks. These have of course been extensively revised by the introduction of Basel 2, which has aimed to achieve greater sensitivity of capital levels to the different risks which banks are running, and there are certainly benefits to the Basel 2 approach on which the future system should build. It is important to realize that the crisis developed under the Basel 1 regime not Basel 2, and that Basel 2 would have addressed some of the problems which led to it – for instance the failure to distinguish between the capital required to support mortgages of different credit quality. But it is also clear that we will need to adjust Basel 2 in a number of ways.  The general direction of travel will be towards higher levels of bank capital than have been required in the past, and in particular capital which moves more appropriately with the economic cycle and more capital required against trading books and the taking of market risk.”
  2. New approaches to the management and regulation of liquidity are equally important. Indeed, we need to ensure that the regulation of liquidity is recognised as being at least as important as capital adequacy…Measuring and limiting liquidity risk is, however, crucial and reforms to regulation need to include both far more effective ways for assessing and limiting the liquidity risks which individual institutions face and a better understanding of market-wide liquidity risks.”
  3. “The third key priority is to ensure that in future financial activities are always regulated according to their economic substance not their legal form. One of the striking features of the years running up to the crisis, as I stressed earlier, was that a core banking function – maturity transformation – was increasingly being performed by institutions which were  not legally banks, but the off balance sheet vehicles of banks, (SIVs and conduits), investment banks and mutual funds. To different degrees in different countries these ‘near banks’ or shadow banks escaped the capital, leverage and liquidity regulation which would apply to banks. In the case of SIVs they also escaped the degree of disclosure and accounting treatment which would have applied if the economic activities were performed on balance sheet.  In future it is essential that if an economic activity is bank-like and poses a significant risk to consumer or financial stability, regulators can extend banking-style regulation. And essential that accounting treatment reflects the economic reality of risks being taken.”

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