TURNER IS ASKING THE RIGHT QUESTIONS ON FINANCE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

Turner is asking the right questions on finance

By Martin Wolf

Published: September 10 2009 22:03

I like and admire Lord Turner, chairman of the UK’s Financial Services Authority. He is more than an acute analyst. He is also brave. He showed that in his struggle with Gordon Brown, then chancellor of the exchequer, over plans for pension reform published in 2005. He is showing that again today in the lively debate he has initiated on the future of financial regulation.
This financial crisis was no minor blip, to be forgotten as quickly as possible. On the contrary, the UK (and other significant countries, not least the US) have just received a monstrously expensive warning. That is why Lord Turner’s willingness to raise unpalatable questions is both welcome and refreshing. His report for the FSA is among the best analyses of the crisis. Now, in a discussion for the British journal Prospect, he has taken the debate into even more controversial territory.

I will address five of the issues raised there: the case for moving the responsibilities of the FSA over banking into the Bank of England; the supposedly excessive size of the financial sector, particularly in the UK; the levels of capital required of banks, particularly on their trading activities; the possible role of taxes on financial transactions – the so-called “Tobin tax”; and, finally, the vexed question of bankers’ pay.

On the first, Lord Turner is right to argue that “the institutional architecture is the least important issue here”. The fundamental issue is not structure, but philosophy. The UK authorities adopted the same view as the US: market forces guaranteed both efficiency and stability. They were wrong. Now that the view has changed, the upheaval caused by transforming the regulatory structure is unnecessary. Worse, it might make things worse: giving any institution a monopolistic position would surely be a mistake.

Now turn to whether the financial sector is “too large”. John Gieve, former deputy governor of the Bank of England, argues that it is not “very helpful to try to define the right size for the financial sector”. I agree. But the sector enjoys subsidies from the state, via access to the lender-of-last-resort function of the central bank and explicit and implicit guarantees against insolvency. These need to be offset.

This leads us to the third point, the case for higher capital requirements. Here Lord Turner is a part of the choir: the Group of 20 finance ministers and central bank governors meeting in London last weekend also agreed to require banks “to hold more and better quality capital”.

Yet higher capital requirements are far from a panacea. One danger is that banks may take on even more risk, to sustain high returns on equity. Another is that banks would again find a way around higher capital requirements via off-balance sheet vehicles and exploitation of risky derivatives strategies. A third is that higher capital requirements would again trigger an explosive expansion of an unregulated shadow banking system. In short, higher capital requirements will only work if they come with a huge increase in regulatory will and effectiveness. I am not holding my breath.

That leads naturally to the “Tobin tax”. Obviously, it would have to operate in all significant financial centres. So the chance of its happening is zero. As a way of shrinking the financial sector it also seems ill-designed. The argument for it would have to be, instead, that it would be desirable to reduce the liquidity of markets in this way.

Until recently, I would have viewed that as unacceptable. But I might now entertain the argument that willingness to invest in costly “due diligence” on what investors are buying may be undermined by the perceived ease of selling. For these reasons, market liquidity no longer seems an unambiguous good. Maybe shifting the structure of incentives towards “buying and holding” might be better.

Finally, how far are changes in the structure and levels of pay the answer? I agree with Lord Turner that “the honest truth is that bad remuneration policies, though relevant, were far less important in the unravelling of the crisis than hopelessly inadequate capital requirements against risky trading strategies”. The issue cannot be the level of bonuses, unless we want to decide the “just rewards” of everybody. Nor should it be the principle of bonuses, since a link between performance and reward is desirable. The issue should be the nature of incentives. Employees must not be rewarded for breaking the bank, particularly if it is then rescued by the taxpayers.

Lord Turner is making important contributions to a debate we must have. It is horrifying that this industry inflicted such damage. It is horrifying, too, that it is guaranteed by the taxpayer, even as it returns to business as usual.

But the more one analyses both the debate and what is happening, the more difficult it is to believe that a safer and more responsible industry is emerging. I love Lord Turner’s willingness to raise difficult questions. But I am not persuaded that he, or anybody else, offers convincing answers.

Copyright The Financial Times Limited 2009