The British banking system must undergo “profound” changes if a repeat of the current collapse is to be avoided in future, the head of the City watchdog warned.
Financial Services Authority (FSA) chairman Lord Turner said aspects of the current regulatory system for banks and other institutions were “seriously deficient”.
Delivering The Economist’s inaugural City lecture last night, he said that in future the banks should be required to build up their capital holdings during the good times so that they were protected against losses when there was an economic downturn.
He said regulators needed to find a way to intervene before the risks in the financial system ran out of control.
“The changes which we need to make to create a sounder system for the future will be profound,” Turner said.
“Central banks and regulators between them need to... identify the combination of measures which can take away the punchbowl before the party gets out of hand.”
Turner – who took over as FSA chairman last September – said there had been a widespread failure to identify the risks which had been building in the financial system for a number of years and led to the current crisis.
While he accepted that there had been failures by the FSA in the run-up to the collapse of Northern Rock, he said the problems in the system were much wider.
“The far bigger failure – shared by bankers, regulators, central banks, finance ministers and academics across the world – was the failure to identify that the whole system was fraught with market-wide, systemic risk,” he said.
“The key problem was not that the supervision of Northern Rock was insufficient, but that we failed to piece together the jigsaw puzzle of a large UK current account deficit, rapid credit extension and house price rises, the purchase of UK mortgage-backed securities by institutions in the US performing a new form of maturity transformation, and the potential for irrational exuberance in the market price of credit.
“We failed to realise that there was an increase in total system risk to which financial regulators overall – authorities, and central banks and in fiscal authorities – needed to respond.”
Turner added that banks should now be required to build up “substantial capital buffers in good economic times... so that they can run them down in bad”.
“The present system of capital regulation of trading books is from a prudential point of view seriously deficient,” he said.
“Overall, the level of capital required against trading books has been simply too low relative to the risks being taken.”