The Turner ReviewA regulatory response to the global banking crisis

Lord Turner

Chairman

Financial Services Authority

Exhibit 1.1: Global current account balances

-1,400

-1,000

-600

-200

200

600

1,000

1,400

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

US

$bn

US Oil exporters China Japan Other advanced economies Other EME

Source: IMF, FSA calculations

Exhibit 1.3: UK real interest rates(20 year bonds, yield at May 25th or nearest week day)

Source: Bank of England Real Yield curve calculations

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1985 1990 1995 2000 2005

Note: For the years 1985, 86, 89, 90 & 91 no 20 year yield is precisely available; the longest available yield (in range 16-19 years) is shown

Exhibit 1.4: Household debt asproportion of the GDP

0%

20%

40%

60%

80%

100%

120%19

87

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

perc

ent

US UK EU

Source: ONS, Federal Reserve, Eurodata, Bureau of Economic Analysis, FSA calculations

Exhibit 1.5: The growth of securitised credit

0

20

40

60

80

100

120

140

160

180

200

2000

2001

2002

2003

2004

2005

2006

2007

£bn

RMBS CMBSABS CDOCLO Covered bonds

Source: SIFMA Source: Oliver Wyman

ABS – volumes outstanding, US

Securitisation issuance trends in the UK

0

500

1,000

1,500

2,000

2,500

3,000

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

$ bi

llion

loans receivables leases loans loans Other

Key Drivers of the Crisis

§ Mutation of the securitised credit model

§ Massive growth and increased complexity

§ Risk retained on banking balance sheets

§ Increased leverage in multiple forms

§ Increased maturity transformation, by banks and shadow banks, in new forms: reliance on “liquidity through marketability”

§ Misplaced reliance on apparently sophisticated maths

§ Hard-wired pro-cyclicality, ratings triggers, margin calls

§ Lack of adequate/ counter-cyclical capital buffers

Exhibit 1.8: Estimates of mark to market losses on US credit securities: at April 2008

55

280

55

470

Other (e.g. Hedge Funds)

Insurance companies, pension funds & direct

individual savings

GSEs & Government

Banks 530

425

80

125

Source: IMF Global Financial Stability Report, October 2008

Key Drivers of the Crisis

§ Mutation of the securitised credit model

§ Massive growth and increased complexity

§ Risk retained on banking balance sheets

§ Increased leverage in multiple forms

§ Increased maturity transformation, by banks and shadow banks, in new forms: reliance on “liquidity through marketability”

§ Misplaced reliance on apparently sophisticated maths

§ Hard-wired pro-cyclicality, ratings triggers, margin calls

§ Lack of adequate/ counter-cyclical capital buffers

UK special factors

§ Home country of leading banks involved in trading activity

§ Rapid growth of mortgage debt; rising property prices

§ Credit growth financed from overseas through securities sales and bank lending

§ Rapid and risky growth of mortgage banks

The customer funding gap is customer lending less customer funding, where customer refers to all non-bank borrowers and depositors.

Exhibit 1.25: Major UK banks' customer funding gap andforeign interbank deposits

0

100

200

300

400

500

600

700

800

2000

2001

2001

2002

2002

2003

2003

2004

2004

2005

2005

2006

2006

2007

2007

2008

£bn

Interbank deposits from abroad Customer funding gap

Source: Bank of England, Dealogic, ONS, published accounts and Bank of England calculations

Five fundamental theoretical issues

1. Are financial markets rational or subject to herd/momentum effects?

2. Is the securitised credit model inherently unstable?

3. Misplaced reliance on sophisticated maths: fixable deficiencies or inherent limitations?

4. Has financial innovation been socially useful?

5. Does market discipline work?

Source: Moody’s KMV, FSA calculations

Firms included: Ambac, Aviva, Banco Santander, Barclays, Berkshire Hathaway, Bradford & Bingley, Citigroup, Deutsche Bank, Fortis, HBOS, Lehman Brothers, Merrill Lynch, Morgan Stanley, National Australia Bank, Royal Bank of Scotland and UBS

CDS series peaks at 6.54% in September 2008.

Exhibit 1.27: Composite Time Series of Select Financial Firms' CDS and share prices

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

Dec

02

Apr

03

Aug

03

Dec

03

Apr

04

Aug

04

Dec

04

Apr

05

Aug

05

Dec

05

Apr

06

Aug

06

Dec

06

Apr

07

Aug

07

Dec

07

Apr

08

Aug

08

Dec

08

Ave

rage

CD

S Sp

read

in P

erce

nt

-

0.50

1.00

1.50

2.00

2.50

Mar

ketC

ap In

dex

CDS SHARE-PRICE-ADJUSTED

Recommendations

1. Fundamental changes in capital, liquidity and published accounts2. Institutional and geographic coverage: economic substance not

legal form3. Other important changes: credit ratings, remuneration and

counterparty risks4. Macro-prudential analysis and the need for intellectual challenge5. A new FSA approach to supervision: more intrusive and more

systemic6. Governance and risk management: firm responsibilities and

structures7. “Narrow banking” versus “investment banking”: major constraints

but not complete separation?8. Cross-border banks: more international cooperation and more

national powers

Recommendations

1. Fundamental changes in capital, liquidity and published accounts

2. Institutional and geographic coverage: economic substance not legal form

3. Other important changes: credit ratings, remuneration and counterparty risks

4. Macro-prudential analysis and the need for intellectual challenge

5. A new FSA approach to supervision: more intrusive and more systemic

6. Governance and risk management: firm responsibilities and structures

7. “Narrow banking” versus “investment banking”: major constraints but not complete separation?

8. Cross-border banks: more international cooperation and more national powers

Capital, accounting and liquidity

§ Increase the quantity and quality of overall bank capital

§ Major changes to trading book capital

§ Made the banking system a shock absorber not a shock amplifier

§Avoid procyclicality in Basel 2 implementation

§Create countercyclical capital buffers

§ Anticipate future likely losses in published accounts

§ Introduce a gross leverage ratio backstop

§ Major intensification of liquidity regulation and supervision

Recommendations

1. Fundamental changes in capital, liquidity and published accounts

2. Institutional and geographic coverage: economic substance not legal form

3. Other important changes: credit ratings, remuneration and counterparty risks

4. Macro-prudential analysis and the need for intellectual challenge

5. A new FSA approach to supervision: more intrusive and more systemic

6. Governance and risk management: firm responsibilities and structures

7. “Narrow banking” versus “investment banking”: major constraints but not complete separation?

8. Cross-border banks: more international cooperation and more national powers

“There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient.

The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently the commercial banks may be less vulnerable today to credit or economic shocks”

IMF Global Financial Stability Report, April 2006

Exhibit 2.9: The conventional wisdom – 2006

Recommendations

1. Fundamental changes in capital, liquidity and published accounts

2. Institutional and geographic coverage: economic substance not legal form

3. Other important changes: credit ratings, remuneration and counterparty risks

4. Macro-prudential analysis and the need for intellectual challenge

5. A new FSA approach to supervision: more intrusive and more systemic

6. Governance and risk management: firm responsibilities and structures

7. “Narrow banking” versus “investment banking”: major constraints but not complete separation?

8. Cross-border banks: more international cooperation and more national powers

“Narrow Banking” vs “Investment Banking”

§ Pure investment banking firms still systemically important (Bear Sterns)

§ Undiversified narrow banks can be risky: Northern Rock, Indy Mac, WAMU

§ Global economy needs complex global finance capabilities

§ Narrow banking – classic retail and commercial banking: regulated, insured§ Investment banking – risky trading activities: unregulated, unsupported in

crisis

§ Not complete separation

§ But capital and liquidity policy constraints on risky activity

§ Commercial banks focused on serving customer needs

Proposition: Distinguish

Complication

Way forward

Recommendations

1. Fundamental changes in capital, liquidity and published accounts

2. Institutional and geographic coverage: economic substance not legal form

3. Other important changes: credit ratings, remuneration and counterparty risks

4. Macro-prudential analysis and the need for intellectual challenge

5. A new FSA approach to supervision: more intrusive and more systemic

6. Governance and risk management: firm responsibilities and structures

7. “Narrow banking” versus “investment banking”: major constraints but not complete separation?

8. Cross-border banks: more international cooperation and more national powers

European Union level regulatory body

EU institution replacing existing level 3 Committees

Regulation: technical rule-makingØ Drafting of detailed technical rulesØ Advice to Commission on Directive textsØ Non-binding guidance to Member States and industry on best practice

implementation

Supervision: Oversight of national supervisorsØ Oversight of European colleges of supervisorsØ Peer reviews of supervisory approaches: best practice guidance on “comply or

explain” basis

International and macro-prudentialØ European representation alongside Member States on international bodiesØ Role in European macro-prudential analysis, alongside ECSB

Wider issues – open questions

Product regulation?§ Retail e.g. mortgages§ Wholesale e.g. CDS

Other countercyclical tools?

Balancing liquidity versus financial stability concerns