Turner Review

Running Head:Turner Review

 

 

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Introduction

The Turner Review was compiled and published in 2009 by Lord Turner. He is the chair person of the Financial Service Authority (FSA) in UK. The review outlines well reasoned and viable regulatory reforms for financial institutions as well as banks. The review aims at addressing the inadequacies of financial supervision and regulation which could not survive the global financial crisis. In an effort to develop a novel regulation system, the review has taken into account all the factors that led to the global financial crisis such as securitized credit market complexity, excessive leverage, the shadow banks role in the process of maturity formation, lack of sufficient capital buffers, and commercial bank involvement in trading activities that were extensively risky (Acharya & Yorulmazer 2007). The review proposes that in a bid to ensure regulation consistency, the UK should adopt a single regulator approach across business lines. The review further acknowledges that importance of having the central bank as a systemic regulator. The principle based and light touch regulations are discouraged by the review and instead, focus is directed on rule bases regulations which are more intensive that are geared toward an extensive systemic risk as well as macroeconomic policy. The review therefore provides financial institution and banks a prudential regulation for future operations.

Discussion

            According to the review, the major factors that have drove the world in the current financial crisis include among others the increasing financial innovation, growth in the market size, as well as microeconomic imbalances thus, causing overall systemic risk increase. In light of the foregoing crisis there was a great need to revaluate the existing regulatory regime, for instance the assumption that markets function in an efficient and rational way. To this end, Turner proposes a regulatory policy change in his review to a regulation approach that is more systematic (Turner 2009).

In designing capital adequacy set of laws, the review postulate a couple of variant approaches which include: forming rules that are geared towards influencing the activities undertaken by different banks through sinking excessive risk taking incentives for the good of the economy at large. Alternatively, the rules can be formed to shield the creditors in case of failure by a single bank. Turner in his review postulate that in order to direct more attention on Tier 1 capital and Core Tier 1, it would be prudent to boost the value of capital held by banks. The review further proposes that the current optimum level of capital should be substituted with a novel formation. The review however, acknowledges that the increase in the capital requirement should wait until the economy is more stable (Cooper 2009).

The insufficiency of the existing regulations used for purposed of defining the level of risk involved in the trading book of particular assets is also highlighted by the review. Following the inadequacy of rules governing risks the banks were free to hold a small proportion of their overall capital visa vie the market risk in existence.

Turner review points out that the existence of institutions which have been undertaking functions similar to those of banks contributed to the global financial crisis. This is because, these bank like institutions were not subject to regulatory rules that applied to banks. Consequently, shadow banks as well as the off balance sheet SIVs posed actual systemic risk as the carry out extensive maturity formation and they were leveraged highly despite the fact that their liabilities were far much less than the assets maturity. That notwithstanding, these institutions were not within the regulatory regime thus contribution to the crisis. It is therefore the proposition of the review that much emphasis should be directed economic substance while designing future regulation rather than focusing on the legal form of such regime (Dowd 2010).

The review further note that the regulators must be authorized to single out those institution are bank like and were need be, the regulators should  restrict the impact of these shadow banks on entities that are regulated or subject such shadow banks to prudential regulations. In the event that there is a significant risk posed by off balance sheet banks to the economy, the regulators should design measures for purposes of bringing such banks on balance sheet. This can only be achieved where the domestic regulators are well coordinated and integrated thus, reducing arbitrage risks between rules.

The inadequacies of the light touch approach used by the Financial Services Authority are also highlighted by the review.  These light touch approach were designed on the basis that markets are able to correct themselves and as such,  the management of individual organizations bears the responsibility of managing risk. Consequently, more focus was directed towards individual firms and as such there was no attempt to challenge the strategies and models of business. The remunerations policies employed by the majority of financial institution should be re-evaluated to ensure that the remuneration does not act as an incentive to encourage short-termism or even excessive risk taking.

Regulatory coverage

The causes of the current crisis according the review are founded primarily on the regulated community as it stands. For this reason, more thorough regulations must be put in place to capture different sectors which have not been captured by proper regulation in the past (Turner 2009). Such institutions may include among others offshore firms and off balance sheet SIVs. Turner is of the view that these institutions should therefore be regulated in a more enhanced approach by the fund managers of the respective institutions. The powers of the Financial Services Authority in this respect would be gather information regarding the operations of these institutions through the fund managers. The powers of the regulator should also extent to regulating the liquidity and capital levels held by these firms. In addition, the regulator should be empowered to demand for a local offshore regime as well as impose more restrictions where there is a systematically important fund.

Capital adequacy

The capital requirements by the regulation have over the years been pro- cyclical, and this contributed to the current crisis. In light of this capital requirements, Turner suggest that rather than employing a point in time approach, financial institutions should focus on a through the cycle approach of default prospects. The current capital rules should be subjected to a number of technical rules for purposes of addressing particular inadequacies highlighted by the crisis at hand (Shiller 2009). Such changes may include introduction of novel ratio of gross leverage for purposes of providing a fixed perimeter on the ratio of Tier 1 equity to gross assets.  Dependence on credit ratings by the Basel II also needs to be re-evaluated. Further, there is a need for more preventive and comprehensive requirement in relation to liquidity. The review however, acknowledges that fact that such changes need to be effected bit by bit and cautiously particularly in the current financial crisis that has affected these institution.

 

Credit rating agencies

The review postulates that the existing proposals of the EU regulations regarding credit rating agencies should be adopted for purposes of regulating agencies in their efforts manage and disclose conflicts. Ratings should however be restricted to products in light of the adequate transparency and historical record.

Turner is of the view that splitting the regulation guiding investment and commercial banking is a mission in futility. Such a move to split the regulation according to the review is untenable considering the existing structure of international financial institutions, and also in light of the advantages that accrue to banks through their credit securitization (Turner 2009). After all the current standing of most investment banks are firm enough in their systemic importance to necessitate lender of last resort, amenities for purposes of boosting their status. Rather than engaging in splitting regulation therefore, Turner is of the opinion that more emphasis should be put on designing rigorous limitations to check deposit taking firms operations, which should also involve developing novel limitations on any activity regarding trading book. This can be done through increased monitoring risks related to liquidity, in an effort to mitigate the possibility of the current crisis recurring at a future date (Ashby et al 2010).

There is not enough coordination in cross border supervision on a global level, and the result is the current global financial crisis. Depending on the place of incorporation financial institution in Europe are subjected to different regulation, a situation that could be disastrous. The later situation in Europe can be well illustrated by the incident that took place in Iceland which brought to light the fact that banks operating on a cross border level are subjected to very limit regulatory directives emanating from the local regulators, and therefore, it becomes very difficult for the regulators to protect local consumers from such banks.

It is in the backdrop of such situation that the review by Turner suggests that a regime should be designed to set out all the conditions required for any cross border institution to commence its operations in another country. Important of all, should be the requirement that such cross border banks must have a local subsidiary established in the designated country, and as such subject to the regulation at the local level (Stern & Feldman 2009). It goes without saying that such a step would go a long way in harmonizing the supervisory responsibility of the regulator and also enhance the ability of the regulator to protect local customers. The review suggest that the European community should form a single regulatory administrative body charged with the responsibility of  overseeing supervision, taking an active role in micro prudential assessment, as well as setting standards.

Mortgage regulation

The use of product based regulation is cited as an approach that is imprudent since it give way to harmful regulatory arbitrage in the financial institutions. Trading of CDSs by AIG is a perfect example of in this respect (Bank of England 2009). In the past years, product regulation was viewed as an act that would suppress innovation and for this reason avoided at all costs. In every general rule however, there is always an exception. Product regulation can be prudentially applied to particular products such mortgages.

One of the outright failing of the UK financial regime is perhaps the fact that the country does not have a single body charged with the responsibility or vested with the influence to identify trends that are likely to destabilize the system, powers to supervise the whole system, or even the authority to take a concerted action in the event of a threatening trend. This problem has been termed as an under lap in the Turner review (Finlow-Bates 2011).  A part from macro-prudential ‘under lap’, Turner point out that before the financial crisis, the Financial Services Authority employed a defective approach in respect to micro prudential rule. It follows that more emphasis were directed towards adherence to the directives and rule by the financial supervision rather than undertaking a strategic and in-depth assessment of risk. The ability of firms to take decisions regarding the risk involved in their operation and the understanding of firms’ nature of business forms the basis of successful prudential regulation.

One of the major causes of the global financial crisis according to the review was the unabated rise in the overall leverage system (Turner 2009). This state was perpetuated by the unfettered system of shadow banks, as well as the complexity and opacity of the scrutinized credit approach. The review suggest that the existence of rigid liquidity set of laws particularly the liquidity buffer may hinder banks in future to leverage their balance sheet as the stringent system may shrink the balance sheets of such banks (Llewellyn 2009).

Conclusion

The review aims at addressing the inadequacies of financial supervision and regulation which could not survive the global financial crisis. The review further identifies several factors that lead to the global financial crisis which include among others securitized credit market complexity, excessive leverage, the shadow banks role in the process of maturity formation, lack of sufficient capital buffers, and commercial bank involvement in trading activities that were extensively risky. The causes of the current crisis according the review are founded primarily on the regulated community as it stands. To this end, more thorough regulations must be put in place to capture different sectors which have not been captured by proper regulation in the past. The review proposes that in a bid to ensure regulation consistency, the UK should adopt a single regulator approach across business lines (Turner 2009).

The remunerations policies employed by the majority of financial institution should  also be re-evaluated to ensure that the remuneration does not act as an incentive to encourage short-termism or even excessive risk taking. Turner suggests that a regime should be designed to set out all the conditions required for any cross border institution to commence its operations in another country. Important of all, should be the requirement that such cross border banks must have a local subsidiary established in the designated country, and as such subject to the regulation at the local level (Alexander 2009).

The current capital rules should be subjected to a number of technical rules for purposes of addressing particular inadequacies highlighted by the crisis at hand. Such changes may include introduction of novel ratio of gross leverage for purposes of providing a fixed perimeter on the ratio of Tier 1 equity to gross assets.  It is suggested that bank like institutions such as shadow banks as well as the off balance sheet SIVs should be regulated in a more enhanced approach by the fund managers of the respective institutions (Crouhy 2008). The powers of the Financial Services Authority in this respect would be gather information regarding the operations of these institutions through the fund managers. Further, the powers of the regulator should also extent to regulating the liquidity and capital levels held by these firms.

 

 

 

References

Acharya, V., & Yorulmazer, T (2010), “Too Many to Fail – An Analysis of Time-

Inconsistency in Bank Closure Policies”, Journal of Financial Intermediation, Vol 16,pp1-31.

Alexander, J (2009), “Regulatory Arbitrage and Over-Regulation”, in P Booth Ed.,

            Verdict on the Crash: Causes and Policy Implications, Institute of Economic          Affairs, London.

Ashby, S et al (2010), ‘Lessons about Risk: Analyzing the Causal Chain of Insurance        Company Failure’, Insurance Research and Practice,      Vol18, No 2, p4-15.

Bank of England (2009), Report of the Board of Banking Supervision Enquiry into the

Circumstances of the Collapse of Barings, HMSO.

Cooper, G (2009), The Origin of Financial Crises, Harriman House Ltd, Hampshire,

Crouhy, M (2008), “The Subprime Credit Crisis of 2007”, Journal of Derivatives, Vol.

16 Issue 1, p81-110.

Dowd, K (2010), “The Case for Financial Laissez-Faire”, Economic Journal, Vol. 106,

436, pp679-87.

Finlow-Bates, T (2011), “The root cause myth”, The TQM journal, Vol. 10, No. 1,

pp10–15.

Llewellyn, D (2009), “The Economic Rationale for Financial Regulation”, FSA

Occasional Paper, No. 1, April.

Shiller, R (2009), The Subprime Solution, Princeton University Press, Princeton.

Stern, G., & Feldman, R (2009), Too Big to Fail: The Hazards of Bank Bailouts,

Brookings Institution Press, Washington DC.

Turner, A (2009) “The Turner Review: A Regulatory Response to the Global Banking

Crisis”, Financial Services Authority, March, accessed on 13/4/ 2012, from:             http://www.fsa.gov.uk/pubs/other/turner_review.pdf.

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