13 October 2012

FSA/Lord Turner: Regulatory reform and deleveraging risks

In his speech, Turner talked about developing a reformed regulatory framework – what has already been achieved, what is left, and what risks and realities need to be considered in future.

The challenge of transition: deleveraging and deflationary risks

The challenge is not simply to build a better system for the medium- or long-term future, but to transition to it while not harming the recovery from the great recession, which the crisis of 2008 induced. And managing the transition may prove more difficult than defining the end point. In all the economies of the developed world – in the US, Japan, the eurozone and the UK – recovery from recession has been far slower than most commentators and all official forecasts anticipated in 2009. That reflects our failure to understand just how powerful are the deflationary effects created by deleveraging in the aftermath of financial crises.

When credit booms turn to bust, as we know from Japan throughout the 1990s – private sector deleveraging can have powerful deflationary effects, and conventional policy levers lose power. 

• interest rates move to the zero bound;
• quantitative easing is appropriate but may face diminishing returns in a liquidity trap;
• macro-prudential levers are stymied by a ‘don’t start from here’ problem – we didn’t demand the build up of countercyclical capital buffers in the upswing so they are not available to be released. 

Faced with recession, public sector finances deteriorate, and total economy leverage doesn’t actually decline – it simply shifts from private to public balance sheets. Fiscal policy is then constrained by fears about long-term debt sustainability. Together this creates an extremely challenging environment in which, as the latest World Economic Outlook puts it ‘the risks of recession in advanced economies are alarmingly high’.  The tail risks are clearly on the slow growth/deflationary side.

In this context there is a danger that progress towards where we need to be in the long term could further depress nominal demand and activity in the short. If we increase capital ratio requirements and leave it entirely to private banks to decide when and how to achieve those higher ratios, we may simply provoke further deleveraging and deficient lending supply.

How can we overcome those dangers?

I suggest there are two possibilities: they are not mutually exclusive.

• The first is to combine progress towards a sounder financial system with innovative unconventional policies which seek to cut through the challenges of our impaired financial system – either, as Olivier Blanchard’s WEO foreword puts it: ‘helping particular categories of borrowers or helping financial intermediation in general’. The package of measures which the UK authorities announced this summer fall into this category. The measures include: (i) additional central bank liquidity insurance and an adjustment to FSA liquidity requirements to allow some credit for that insurance; (ii) direct central bank funding support at an attractive rate for bank lending to the real economy; and (iii) adjustments to the FSA’s capital regime to eliminate capital requirements on that new lending, while maintaining overall progress to greater balance sheet resilience.
• The second is to cut through the balance sheet resilience/lending supply trade off by engineering rapid increases in bank capital resources. Effectively this would mean a repeat of the 2009 US approach. That required banks to conduct robust stress tests: it defined quantities of capital which each of the banks were then required to raise; and it provided a public back stop if banks were unable to raise new capital from private sources within a proscribed time period. In principle, such an approach has attractions. In the eurozone, however, it could only be credible if the public backstop were available at ‘federal’ eurozone level; applied at a national level within the more vulnerable periphery economies, it would simply strengthen yet further the potentially fatal sovereign solvency/bank solvency embrace which is at the core of current stress.

Clearly there are no easy answers here. The challenges created by deleveraging in the wake of an excess credit and leverage boom are very severe. But we need to find ways both to build a stronger sounder system for the future – avoiding a future repeat of a 2008 style crisis – and to navigate through the realities of today’s troubling times.

Full speech

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