Speaking at Cass Business School in London Lord Turner said in future it will be essential for regulators to monitor overall developments in leverage and maturity transformation at financial institutions and if necessary intervene using these “policy levers”.
He said: “We may need to consider macro-prudential limits on borrowers as well as on lenders.
“Loan to value or loan to income limits on residential mortgages may be controversial: such limits on commercial real estate may be difficult to impose without provoking complex avoidance.
“But their imposition in the boom years would directly address the core problem we face – the interconnected instability of credit and asset price circles. And if such measures could successfully reduce the probability or severity of credit cycle induced recessions, they would be in most borrowers’ interest.”
And he added: “It may be many years before any of these policy tools need to be used: the economy today is certainly not suffering from an irrationally exuberant upswing. And the first task of the interim FPC will be to consider in detail the pros and cons.”
Both leverage levels and aggregate maturity transformation increased significantly in the pre-crisis years but regulators did not adequately track and respond to that development, Turner said.
He said the FSA wrongly believed it could assume that rational investors in free financial markets would ensure that risk was dispersed in an efficient and stable fashion, making intervention necessary in future.
He also said the capital ratio rules in Basel III did not go far enough and in an ideal world equity capital requirements would be set much higher.
Rather than current ratios of around 11-13% recommended, Turner said banks should hold something more like the 15-20% of risk weighted assets illustrated by Professor David Miles in a recent paper.
He acknowledged that forcing banks to hold this much capital would put too much pressure on lending to implement immediately however.
“We need to recognise that as a result the system remains more vulnerable than is ideal,” he said.
“Today’s regulators are the inheritors of a half century long policy error, in which we have allowed private sector banks to pursue their private interest in maximising leverage levels, at times influenced by a deep intellectual confusion between private costs and social optimality.”
Lord Turner also said regulators must recognise that financial instability is caused not only by poor incentives such as too big to fail status or unfair bonuses but by investors’ myopia and irrationality, and by the sheer complexity and interconnectedness of the financial system.
He said: “The pre-crisis delusion was that the financial system, subject to the then defined set of rules, had an inherent tendency towards efficient and stable risk dispersion. The temptation post-crisis is to imagine that if only we can discover and correct specific imperfections – such as bad incentives or industry structure – that a permanently more stable financial system can be achieved.”
As well as making banks resolvable Lord Turner argued that for systemically important banks regulators must agree equity surcharges high enough to reduce the probability of failure to “minutely low levels”.
He also suggested shadow banking markets and institutions such as money market mutual funds and hedge funds may be regulated in the future to protect the wider financial system.
He said the Financial Stability Board is developing recommendations on how to monitor and, if necessary, regulate developments in shadow banking. Among the policy options to be assessed are the regulation of minimum margin requirements in repo and other secured financing markets.
