Turner: Regulation must be Trotskyite

BBC business editor Robert Peston on reining in the banks

There is not a great deal in tonight's speech by Adair Turner at the Cass Business School that he didn't say in late February at Clare College Cambridge (click here and here for my posts on that important speech).

But I would highlight a handful of newsworthy remarks made this evening by the chairman of the soon-to-be-dismantled Financial Services Authority.

First, Britain's big banks, Barclays, Royal Bank of Scotland, HSBC and Lloyds, need to brace themselves for an ordinance forcing them to hold more equity capital - to absorb potential losses - than was prescribed by last year's Basel lll global agreement on new capital requirements for banks.

Here is the relevant, resonant (for a bank) phrase from Lord Turner:

"For the UK, with major banks which are very large relative to our GDP, a key policy objective for this year is to ensure that Financial Stability Board decisions on Systemically Important Financial Institutions (SIFIs) result in higher than Basel lll equity requirements for our most systemically important banks".

Or to translate: Turner wants our mega banks to be forced to hold more shock-absorbing equity relative to the loans and investments they make.

Now our biggest banks won't like that. And they will claim their opposition stems from the short term costs to the economy of building up their capital reserves: there would be an additional constraint on their ability to lend to households and businesses in the ordained transition period for increasing the ratio of equity capital to assets (as a matter of simple mathematics, one relatively easy way to increase the ratio is to stop lending).

However some might point out that there may be another reason why banks will resist reconstructing their businesses so that they lend less relative to the equity provided to them by shareholders.

Other things being equal, it would automatically lead to a reduction in the return generated by the bank on equity capital and would therefore provide a powerful incentive for the banks' owners to insist that banks pay out less to employees in the form of salaries and bonuses.

This switch to more equity funding would also increase the taxes paid by banks, in that interest on their debt finance is tax deductible but dividends are not. Which would lead to a ratcheted squeeze in the surplus available for bonuses (don't smirk please).

For those of you who care about these things (and of course I do), it is also striking that Turner is unambiguous that equity capital is the best shock absorber.

He accepts that there is a role for improved resolution procedures, bail-ins, CoCos and so on (stay behind after class if you want any of that explained, or see earlier posts) in making the banking system safer. But, for him, "more equity is the best solution".

All that said it is the wider points on the future of regulation that are probably more important. Here are a handful of his observations.

1) The task of making the financial system safe is seriously unfinished business.

2) More intense regulation must apply to all financial firms - to hedge funds, money market funds and shadow banks, along with banks - or dangerous risks will migrate from the banks to somewhere else.

3) Effective regulation must look for the interconnections between financial institutions, the risks that reside in markets and in the linkages between firms, rather than just concentrating on the elimination of dangers posed by individual banks and institutions.

4) Regulation must be dynamic. The notion that a new set of rules can be established that will permanently make the system safe is naïve and dangerous (though it was the prevailing orthodoxy prior to the crisis of 2007-8) - because any new set of rules creates incentives for financial players to find ways round those rules. Regulators therefore have to be permanently on the look out for the innovations that create new risks, they have to be the leaders of a permanent Trotskyite regulatory revolution.

Which means, as I have argued in posts before, that the Financial Policy Committee that is being created at the Bank of England - and whose fledgling version includes Lord Turner as a member - will be a hugely powerful new financial and economic institution.

Its very mission will be to significantly limit banks' and other financial firms' cherished freedoms to lend, invest and sell what they like, to whom they like, when they like - and not because of any identified harm to individual consumers or any one bank's depositors, but in response to perceived threats to economic stability.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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