Licenciado

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LEVERAGE, MATURITY TRANSFORMATION AND FINANCIAL STABILITY: CHALLENGES BEYOND BASEL III

Adair Turner

Cass Business School 16 March 2011

Between 2007 and 2009 the global financial system suffered a huge crisis, with major harmful macroeconomic effects. In response, a major programme of regulatory reform has been launched and is part complete. • •Last year we agreed a major reform of bank capital and liquidity standards – Basel III. This year the Financial Stability Board will decide measures to address problems created by systemically important financial institutions (SIFIs) – by banks seen in the past as ‘too big to fail’.

These changes will make a major difference. But the world’s regulatory authorities – central banks and banksupervisors – thought that they had it right when they agreed Basel II, and that was clearly wrong. So have we now got it right? Are we being radical enough? And do we understand the root causes of this financial crisis? This lecture asks those questions. It is organised in five sections (Slide 1). • In the first three, I will argue that neither Basel III nor fixing ‘too big to fail’ through improvedresolvability are sufficient to ensure financial stability, proposing that: in an ideal world, we would set equity ratios significantly above Basel III standards; the ability to resolve large systemically important banks is highly desirable, but not sufficient to address risks of systemic instability; and that we need to address potential risks in shadow banking, avoiding too exclusive focus onindividual banks or even on the whole banking system.

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In the fourth section I will suggest that underlying these findings are two fundamental issues, two key drivers of financial risk.
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EMBARGOED UNTIL 1830 HRS, 16th MARCH

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The balance between debt and equity contracts across the economy and within the financial system. And the aggregate extent of maturity transformation which thefinancial system performs.

In the fifth and final section, I will then suggest four policy implications. The need for an equity capital surcharge for systemically important banks. The vital importance of macro-prudential oversight focused on the aggregate levels and dynamics of leverage and maturity transformation. The need for policy responses which are discretionary and varied through thecycle, rather than believing that there is any fixed set of rules sufficient in itself to ensure stability. And the need to ask questions about the economic functions which finance performs, recognising that decisions on the appropriate robustness of stability oriented policies cannot be divorced from judgements about the social value of increased financial intensity, market liquidity and financialinnovation, judgments largely avoided before the crisis.

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Underlying these specific implications is, however, a more general one; that we are deluding ourselves if we think that there is any one policy – one silver bullet – which will permanently ensure a more stable system. The pre-crisis delusion was that the financial system, subject to the then defined rules, had an inherent tendencytowards efficient and stable risk dispersion. The temptation post-crisis is to imagine that if we can only discover and correct the crucial imperfections – the bad incentives and structures – that a permanent, more stable financial system can then be achieved. It cannot, because financial instability is driven by human myopia and imperfect rationality as well as by poor incentives, and becauseany financial system will mutate to create new risks in the face of any finite and permanent set of rules. We can make the financial system more stable, but it will require a multi-faceted and continually evolving regulatory response.

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Ideal capital ratios above Basel III levels

To think clearly about required policy we must be clear about the essential problem. The bank solvency and...