FSA shoulders some of the blame

Lord Adair Turner, head of the Financial Services Authority (FSA) has admitted that the regulatory supervisor did not focus enough on excessive risks by banks. By this he is referring to the speed at which banks grew their assets (loans) many times faster than customer deposits. This causes a burgeoning 'funding gap' and mis-matches between loans and funding (all part of 'liquidity risk'). He also means 'concentration risk' where banks may be over-exposed to certain borrowers or particular assets. Banks should seek diversity across all kinds of business. "We didn't focus enough on that," Lord Turner said on the BBC's Andrew Marr Show, referring to the fact that by 2004 "the whole system was risky". He stressed that other regulators around the world had also failed to notice the problem.
Public anger and dismay at the FSA being half-asleep on the job is immense, almost as virulent as the anger at the banks. What Turner is talking about however is Basel II Pillar II where banks have to carry out economic scenario stress tests, with forecasts and assessment of worst case shocks, and also combine all risks into a comprehensive analysis of 'economic capital models'. See, even tried and tested, risk-aware, bankers glaze over at this point! The Daily Mail, used this picture to illustrate the typical mortgage seeker baffled by the problem of a £30 billions funding gap between the £90 billions borrowers want and the £60 billions banks can afford? A year ago it seemed plausible to discuss liquidity risk and bank funding in terms of frustrations for mortgage borrowers and the housing market.
What is the 'credit crunch'? By another name it is 'liquidity risk' or 'funding risk', as the name suggests a drying up of lending to banks by other banks. How banks fund what they lend out is basic boot-camp training for bankers, but that does not make it easy to compute.This was discussed before the Treasury Committee in January, Here is an excerpt:
Dr Danielsson: There is a tendency in all modelling to model what you see and not model what you should be modelling,.. focus on the observable. Liquidity is one ...that everybody seems to know ...but nobody has been able to properly define it... trying to model liquidity in a statistical decision-making model has been until now impossible, and therefore, as a consequence... because you could not model it and you could not put it into a decision-making process... it sort of got brushed under the table and now all of these proposals on liquidity do not focus on modeling, they focus on management. This is the biggest criticism of the FSA.It had so parcelled out the issues and details of risk supervision that sight was becoming lost of the overall reality. But, arguably the systemic dimension was the responsibility of the Bank of England and not the FSA? Professor Goodhart: ... lack of concern with liquidity that had been shown previously, particularly by regulators, was out of a belief that the wholesale markets, where most banks went to get their marginal funding, were very efficient and would work and would be open under all circumstances as long as the banks had sufficient capital, and it was that belief that wholesale markets will always work efficiently, subject to the banks abiding by the capital requirements, which was shown not to succeed from August 2007 onwards, and those wholesale markets are still not working properly. The banks' search for liquidity has consistently shifted from holding liquid assets to the belief that they could obtain additional funding by going to these wholesale markets. It was the failure of these wholesale markets that brought concern about liquidity back to the centre of the stage.
Q14 Mr Todd: So what should a regulatory system for liquidity look like?
Professor Goodhart: Well, there very nearly was such a system introduced in fact in the 1980s. At the same time as the Basle Committee was introducing an accord on capital they were searching for an accord on liquidity, but that search ran into difficulties, and effectively got dropped in the 1980s, it became too difficult for them to proceed, and the process went on then continuously whereby the banks turned for their additional funding, their liquidity, to the wholesale markets and more and more got rid of their lower yielding but highly liquid public sector debt, to the point where the British banks entered the crisis in 2007 holding a really minimal amount of highly liquid British government debt... We would need to go back to look at an appropriate regime for liquidity.
Q16 Mr Todd: And Basel II - back to the drawing board?
Professor Goodhart: Basel II has got a lot of good features. I think it is the best system that I know for trying to ensure the adequacy and the constraint on risk-taking of the individual system. Where it fell down completely was in looking at the systemic risk, the macro-credentials, compared to the micro-credential risk. It is not that Basel II is wrong or bad; it is just totally and completely insufficient in that it did not look appropriately at the systemic issues. To the systems wonks Liquidity risk just looked like another one to be looked at later. And banks' finance and risk accountants were fully focused on just trying to calculate the present and the past, not the future. The detailed requirements of accurately accounting for credit risk and market risk were alone all-absorbing.
Lord Turner only became FSA chairman in September 2008. His deputy, Sir James Crosby, his deputy, resigned last week, following criticism of decisions he had taken when he was chief executive of HBOS. There was also criticism of the decision to appoint Sir James at the FSA, when the watchdog had previously warned about the risk regime he set up at HBOS. Lord Turner stressed that the appointment had been the Treasury's decision. He also said warnings about risk at HBOS had been routine and related more to processes and reporting structures not major warnings about the risks being taken. But he conceded that the FSA's focus had been a failing. "The FSA at that time was more focused on the processes, the structures, the reporting lines, rather than simply saying 'when I look at this whole business model... it's all too risky'." Referring to the news on Friday that HBOS expected an annual loss of £10bn, he said: "The losses that have been revealed this week, I would point out, are not huge surprises to the FSA" He said the authority had predicted such losses when carrying out stress-testing in October.
Just as there was a review after the Northern Rock debacle, so will there be another one now. Lord Turner is reviewing financial sector regulation and will publish his findings on 18 March. His review will make "very major changes" to how banks are regulated, such as how much cash they have to hold in reserve, and changes to rules on credit rating agencies and how bankers are paid.
Lord Turner defended the decision to pay bonuses to the FSA's staff, adding that the FSA's chief executive Hector Sants would not be taking a bonus. The rest of staff, by not getting bonuses means average pay cuts of 15%. This is at a time when many are saying the FSA needs more and much better staff and therefore needs to pay much higher salaries.