The FSA Chairman said the recent crisis had shown that expansion in the scale and sophistication of financial activity is not always beneficial to the global economy. Policymakers need to indentify the fundamental drivers of past financial crises.
Speaking at the Reserve Bank of India in Mumbai, Lord Turner, Chairman of the Financial Services Authority (FSA), said that both the Asian crisis of 1997 and the recent crisis had made clear that expansion in the scale and sophistication of financial activity is not always beneficial to the global economy. While a consensus has developed over the last two decades in support of ever greater growth and liberalization of financial markets, this has been based on ideology more than on firm evidence.
Instead, the evidence of both the financial crises of the last 13 years is that there are inherent risks in this ideology. The Asian crisis was rooted in short-term capital flows which proved highly susceptible to irrationally exuberant momentum effects and to sudden contagious losses of confidence. The latest crisis was “rooted in over- exuberant credit extension in developed markets, and in the development of complex and opaque forms of securitised credit and of new and risky forms of maturity transformation”. Although speculators can play a useful role in providing liquidity and market information, it is also possible for speculators to produce “destabilising and harmful herd and momentum effects”.
There is now growing agreement about the regulatory change needed to create a more stable system, such as higher bank capital and liquidity and more capital against trading books. But these responses do not address more fundamental questions such as the macroeconomic impact of volatility in the supply and demand for credit.
Lord Turner said that policymakers need to indentify the fundamental drivers of past, as well as the latest, financial crises and should be open to policy options that have been excluded by the free market consensus of the last two decades:
· Developed countries should consider macro-prudential tools to control credit expansion – particularly in an upswing. This could be done by counter-cyclical variations in bank capital or liquidity requirements, which may need to be applied at a sectorally specific level (for instance to constrain commercial real estate lending).
· Policy instruments such as taxes which place constraints on short-term speculative inflows may be particularly relevant for some emerging economies.
· A variety of levers focused on ‘putting sand in the wheels’ of short-term speculative trading should be considered. Increasing capital against bank trading activities is the key priority but transaction taxes should not be excluded, despite the practical difficulties of implementing them.
Lord Turner concluded:
“The sensible conclusion on the overall benefits of increased financial activity, liquidity and innovation is that it is valuable in some markets, but not in all markets and not limitlessly. The problem for regulators and central bankers is that this conclusion does not provide us with nice easy answers on which to base policy. It is much easier to proceed in life on the basis of a clearly defined and simple credo which provides the answer to all specific issues. But it is more likely produce good results if we live in the real world of complex trade-offs and of relationships which are true up to a point.”
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