The recent report by Financial Services Authority chairman Lord Turner on the economic crisis is a welcome addition to our understanding of the incredible events in the financial sector in the past couple of years.
It provides an excellent overview of how events unfolded and highlights many of the mistakes made by banks and regulators. But my concern is with the practicalities – i.e. how we put in place a regulatory regime to reduce the risk of history repeating itself.
The FSA has admitted that principles-based regulation failed in several areas, as was demonstrated by the collapses of Northern Rock, Bradford & Bingley and of course HBOS.
The need to balance the business plans of organisations with the requirements of proper risk management became out of kilter with the underlying Figure 1: Regulation pre-banking crisisSource: Hometrackrisks being run by several big banks.
But there are several important gaps in the Turner analysis.
Let’s start with the critical issue of people. In the past 10 years or so the migration of retail selling techniques into retail banking has been significant.
The arrival of salespeople with little or no experience resulted in growth strategies with limited emphasis on longer term customer management or risk. Consumers have been sold to rather than buying.
The availability of credit to marginal consumers has been driven by an appetite for higher market share. The process of checking of the most senior professionals in banks and other financial institutions must be overhauled.
Second, Lord Turner highlighted the importance of good corporate governance and this was enhanced by well publicised input from whistle-blower Paul Moore regarding his experiences at HBOS.
But processes outlined on paper do not necessarily tell you what happens on an everyday basis. Meetings with no minutes, limited access to decision-makers and an auditor so dependent on the bank for its revenue that it merely became a rubber stamp were revealed. Consumers, investors and indeed regulators deserve better.
Third, in the interests of transparency and consumer protection, the casino (investment and trading) and utility (retail) functions in banks need to be separated.
The financial statements of banks are difficult to understand, mainly due to the integration of trading activities with more conventional retail banking. Traditional retail banking institutions such as building societies produce accounts that are more accessible to consumers.
Fourth, there must be clarity on the respective roles and accountabilities of the FSA, the Treasury and the Bank of England. This must not just be an agreement on a piece of paper – known as a Memorandum of Understanding – but be seen working on the ground.
Figures 1 and 2 show how much things have changed since the FSA was set up in 1997. The overlaps between institutions have become significant and confusing.
Fifth, the FSA talks about how it wishes to address the issue of pro-cyclicality – i.e. the tendency for capital requirements to be reduced in an upturn and increased in a downturn. This is desirable but delivering a practical solution is a huge challenge.
Economists are struggling to explain the economic impact of recent events on existing economic models and forecasts. Anticipating the cycle and adjusting capital and liquidity requirements in the light of these projections could destabilise the market. Asking the regulator to be at the forefront of this seems rather ambitious.
Finally, the integrated nature of the market and the downturn makes the role of a single regulator too complicated. How can it decouple global issues from those within its control?