Thursday, April 02, 2009

Turner Review

A number of committees in several countries are working on proposals for financial sector reform. In the UK, a committee headed by the chairman of the FSA, Adair Turner, has submitted a report, the Turner Review, backed by a Discussion Paper. It has 28 recommendations for regulatory reform along and another four issues thrown open for discussion.

What is striking about the Review is the pronounced swing of the pendulum in favour of tighter regulation and away from reliance on market discipline. The Review does not mince words:

“The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built, and in particular the theory of rational and self-correcting markets. Much financial innovation has proved of little value, and market discipline of individual bank strategies has often proved ineffective.”

I have a critique of the Review in my ET column, One hell of a page turner. I seriously doubt that any future government can proceed with the substance of the recommendations of the Percy Mistry and Raghuram Rajan reports.

Let me highlight one important point made in the Review. It does not believe that separating commercial banking from investment banking will make the banking system any safer and it also believes that not having complex banks catering to multiple needs across the globe would entail forgoing significant benefits. Some of the arguments it makes in favour of not distinguishing between 'utility banking' and 'investment banking' are:<>
  • while it is clear that the securitised credit model evolved in a fashion whichundermined the initial proposition that it would prove lower cost and lower risk, it is important to recognise that, if more effectively regulated and supervised, it could have thosenarrow banking, whose severity might have been reduced if an appropriate form of securitised credit trading and credit insurance had been in place.
  • Furthermore, any idea that risky trading activities in institutions outside the utility banks, can be allowed to grow in an unregulated fashion, subject only to the market discipline that they will not receive LOLR or fiscal support in crisis, is not credible in a world of interconnected markets. Bear Stearns was not involved in any significant way in utility banking activities; but when it was on the verge of failure, the US authorities rightly identified it as systemically important.
  • Finally, it is important to recognize that ‘narrow banks’ focusing almost entirely on classic commercial and retail banking activities can be extremely risky. NorthernRock,WashingtonMutual and IndyMac were all ‘narrow banks’.


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