UNCORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 767-i

House of COMMONS

MINUTES OF EVIDENCE

TAKEN BEFORE

TREASURY COMMITTEE

 

 

BANKING CRISIS: REGULATION AND SUPERVISION

 

 

Tuesday 23 June 2009

PROFESSOR ALAN MORRISON, DR ANDREW LILICO and DR KERN ALEXANDER

LORD TURNER OF ECCHINSWELL

Evidence heard in Public Questions 1 - 105

 

 

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Oral Evidence

Taken before the Treasury Committee

on Tuesday 23 June 2009

Members present

John McFall, in the Chair

Nick Ainger

Mr Michael Fallon

Ms Sally Keeble

Mr Andrew Love

John Thurso

Mr Andrew Tyrie

Sir Peter Viggers

________________

Witnesses: Professor Alan Morrison, Professor of Finance, Said Business School, Oxford University; Dr Andrew Lilico, Director, Europe Economics; and Dr Kern Alexander, Senior Research Fellow at the Centre for Financial Analysis and Policy (CFAP), Cambridge University, gave evidence.

Q1 Chairman: Good morning and welcome to our inquiry into banking and supervisory regulation. If I can start with yourself, Dr Alexander, could you introduce yourself for the shorthandwriter please and say where you come from.

Dr Alexander: I am Kern Alexander from the Centre for Financial Analysis and Policy at the University of Cambridge.

Professor Morrison: I am Alan Morrison from the Said Business School at the University of Oxford.

Dr Lilico: I am Andrew Lilico from Europe Economics and Policy Exchange.

Q2 Chairman: Now, there are quite a number of things we want to get through this morning, capital and liquidity regulation, cross-border supervision, macro-prudential tools and narrow banking, so these are the issues that we would like to focus on before Lord Turner comes in at 10.30. Talking about Lord Turner, how culpable is the FSA in the development of the financial crisis, and what has been its biggest failing? What can it take forward as a lesson?

Professor Morrison: It is hard to say precisely who is responsible for the financial crisis, but there were clearly some failings in some supervisory institutions and one of those was the FSA. I should say that, to the extent that it experienced problems, those problems came from two sources. The first was the fact that it has culpability both for conduct of business and for financial supervision and, to some extent, and the FSA has acknowledged this in recent years, it over-emphasised the conduct of business at the expense of financial supervision. The second problem the FSA had, which it has also acknowledged, is that, possibly by virtue of the way that it is constituted, it was concerned largely with understanding the risks at the level of the individual firm and, whilst the risks at the level of an individual firm could each look perfectly acceptable, combining those things and thinking about them in the aggregate could sometimes generate a picture that was much less attractive, and I think the FSA and other supervisors in this country sometimes failed to focus on the aggregate picture or the macro-picture, what we now call the 'macro-prudential'.

Q3 Chairman: Dr Alexander, what should be the priorities for financial regulation in the future?

Dr Alexander: Well, I think financial regulation needs to focus more on the broader financial system, as we have seen it set forth in the Turner Report, focusing on systemic risk. One of the major failures in regulation over the last ten years certainly in the US and in the UK has been that the regulation was too market-sensitive, it focused on the individual institution and did not take into account the level of risk or leverage building up in the total financial system. The regulator thought that, if individual firms were okay and seemed to be managing the risk appropriately, then everything was fine. We now need to link that, and micro-prudential regulation is fine, but it needs to be linked with a robust macro-prudential framework.

Q4 Chairman: Dr Lilico, the next financial crisis is likely to arise from the same source as this one. Lord Turner, on 18 March, set out his stall for the future, but are the FSA just closing the stable door after the horse has bolted, or is it ahead of the curve here?

Dr Lilico: I think it is always very difficult to anticipate what the next financial crisis is going to look like. My view is that the Turner Review has drawn some of the wrong sorts of lessons in ways which mean that it is unable to see the right kinds of lessons, so, in particular, I think that it is a mistake. We have a set of financial regulations which grew out of certain assumptions which were then interpreted through economic theory so as to produce some recommendations, so he decided that those recommendations did not produce the results he liked, and what the Turner Review then did was to ditch the economics. I would rather have kept the economics and challenged the assumptions. In particular, I think there are two kinds of assumptions worth challenging. One is the idea that it is a net gain to replace individual diversified analysis by shareholders, depositors, purchasers of retail financial products with regulatory badging, and the other is that you reduce systemic risk by co-ordinating internationally.

Q5 Mr Fallon: One of the other aspects of Turner, which now seems incredibly fashionable, is that capital should be held on a counter-cyclical basis. How should that be done? Should that be done in a discretionary way, or should it be more formulaic, as is done in Spain?

Dr Alexander: I think that you have to have a combination of rules and discretion, and the rules need to provide reference points or guidelines for regulators. The reason I say that is that in other jurisdictions in Europe the regulators, by law, are required to have more rules-based regulatory regimes and the regulators are not allowed so much discretion as, say, the FSA has, and this is because of principles of due process and constitutional law, so, when we get into the rules for this discretion debate, I think we have to have a balance between both. I would simply say that Europe needs to be working from the same playbook and you need to have a rules-based framework in place, but yet it needs to be flexible enough to change as market conditions change, but regulators need to learn as markets evolve and take advantage of innovations that occur in the market.

Q6 Mr Fallon: Yes, but the rules did not change in Spain or in Canada; they were simple and fairly straightforward and people kept to them.

Dr Alexander: Well, the regulators did change them, I think, in 2004 because of pressure from the banking industry, but you are right, that generally Spain had counter-cyclical rules which basically led to their banks having more capital than other banks in Europe and, therefore, they were able to withstand the crisis much better, they were not getting bail-outs from the Central Bank. I would suggest that the FSA in the UK and other Member States in the EU ought to have counter-cyclical rules as well, and they need to be formulaic somewhat, but there needs to be discretion built into it to adjust to market conditions as they change.

Professor Morrison: I agree that there is a need for a focus on rules-based systems, and ideally they should be as simple as possible and as hard to bend as possible, but one very good reason for rules-based regulation is the one that has been pointed to by people like Charles Goodhart, that in times of boom it is incredibly difficult to put the brakes on when a rule gives you something to refer to and, to the extent that discretion is built into the system, it is incredibly important that the people have the right to exercise discretion, have the right incentives and are accountable, otherwise, I suspect, counter-cyclical regulation will simply have little effect.

Q7 Mr Fallon: How do we reflect counter-cyclical requirements in the banks' accounts?

Dr Alexander: In the accounting standards for reporting?

Q8 Mr Fallon: Yes.

Dr Alexander: I am not an accounting expert, but I believe that one of the things the banks are going to raise is that, if they have to set extra capital aside, they do not have to report it as profit and pay tax on it if they are just having to hold it, so, if we could allow them some flexibility to set capital aside, reserve capital, and not to have to report it and pay tax on it, then they may be more willing to do that. If they, therefore, put this in the profit and loss statement and pay tax, then they are going to want to pay dividends, so I think we need to be flexible on how we allow the banks to set aside reserve capital.

Q9 Mr Fallon: So the accounting treatment for banks is going to have to change? Is that right?

Dr Alexander: Possibly, yes, for banks that are subject to prudential regulation, we need to change it in this situation.

Q10 Mr Fallon: Overall, Dr Lilico, are we going to be, or should we be, seeing banks holding much more capital than in the past?

Dr Lilico: I think the likelihood is that we will see banks holding more capital than in the past, but, as much as anything, I think that that would be a reaction by the market to the circumstances that other people have learnt some lessons, and one should be wary of over-reacting at the regulatory level until you have some idea of how the market itself is going to react to circumstances.

Q11 Sir Peter Viggers: You have, quite interestingly, danced away from the question, saying the market should lead, but I just wonder what you can bring to the table in terms of assessing how much capital banks should have. Can you contribute by suggesting what is the optimal level of capital for a bank?

Dr Lilico: My view is that it is useful to have rules, but what I think it is more useful to have is guidance numbers, so I think that prudential regulation is the proper pair to the lender of last resort function. What is happening in prudential regulation is that the Central Bank is deciding whether the institution that it is supervising is a worthy recipient of lender of last resort at a pinch, so I think that means that in normal times it is useful to have some guidance as to what you think is about right for people to hold, and that is a judgment, but that, once you come to difficult periods, such as that from 2007 onwards, I do not believe that formulaic capital adequacy requirements have any role at all and I think that they should be abandoned, so I do not think you could hope to devise a rule that would apply in good times and bad.

Q12 Sir Peter Viggers: But Basel I and of course the Turner Review are looking at ratios for core tier one and tier one capital and so on, but you would not place a great deal of reliance on those?

Dr Lilico: I think that those are useful indicators. I think that it is a mistake to try to have exactly the same rule apply everywhere in the world. The Basel I framework arose at a time when there was some scepticism about the way that the Japanese were treating their capital and I am not convinced that it turned out that the Basel I framework improved the situation for Japan. I think that there is an issue of discretion which is around how the Central Bank interacts with its own system of banks that it is overseeing.

Q13 Sir Peter Viggers: Dr Alexander and Professor Morrison, would you agree with that?

Professor Morrison: I agree with much of it. The capital regulation, I think, should be as simple as possible. There is a case for some simple rules on things like tier one and core tier one ratios and, at the same time, one should be prepared to relax those requirements in an extreme crisis. However, in an extreme crisis those ratios never bite; the market demands far higher capital requirements before it is comfortable with a bank in a time of crisis than the regulators do. Actually, this is one of the problems with counter-cyclical regulation, that, when you attempt to relax capital requirements, the regulator relaxes capital requirements and it may have very little effect because the market is requiring such massive levels of core capital. One of the problems we have had, however, with capital regulation has been an excessive reliance on highly technical models that feel like the national science's, but in fact are not, so we rely on parameter estimations and things like correlations and so on and this is according a level of scientific validity to these theories which they do not have. They are very useful tools for managers, but whether they should be hard-wired into regulation is a very moot point, in my opinion.

Q14 Sir Peter Viggers: Just moving on a bit, what types of capital should feature in the calculations?

Dr Alexander: I think core tier one capital should be expanded, and of course the definition of 'core tier one capital' should be the ability of the capital to absorb losses fully, and that is mainly common equity shares. If you get into preferred shares or subordinated debt, those types of capital have a more limited ability to absorb losses. What we want banks to have is not necessarily such high capital charges, but that they have good-quality tier one capital that composes most of the regulatory capital that they are holding, and that is one of the problems in Europe, that you get different definitions of the type of capital that banks hold across Member States in the EU and the capital requirements structure does not adequately address that. The point is that the definition of 'capital' should be linked to its ability to absorb losses.

Q15 Sir Peter Viggers: What I am hearing is a message that an abstract approach to this issue should be treated with extreme caution, but the Turner Review suggests that trading book capital requirements might increase by a factor of three. Would you like to comment on that rather specific and concrete suggestion?

Professor Morrison: There is not doubt that trading book capital requirements, I think, are too low. The rationale for having lower levels of capital for trading book instruments is that a troubled bank can sell those instruments rapidly and, hence, does not retail as much capital, but actually we have discovered recently that, at the time you most need to sell those assets, they may be extremely illiquid because no other bank is prepared to purchase them, so that is one reason why more capital against those instruments might be held. Another is that the liquidity of these instruments is not a fixed and permanent number, it is something that depends on the expectations and the behaviour of market participants and those expectations and behaviour change in response to things like capital regulation, so it is quite conceivable that more capital will actually up the liquidity. Whether the right number is three, two or four, I do not know, but I believe that capital requirements should be much higher for the trading book.

Q16 Sir Peter Viggers: From your earlier remarks, would you agree that the financial sector has relied too heavily on abstract models developed by mathematical experts at the expense of old-fashioned commonsense?

Dr Lilico: I think that mathematical models can be very valuable and that they can provide important insights to those who are making regulatory judgments and are useful guidance, so I think it is a mistake to think that the crisis tells us that the mathematical theories and the mathematics of economics should all be abandoned and are proven to be invalid, but, on the other hand, I think that it is always useful in regulation to be humble and to understand that there are limits to your understanding as a regulator, so you must not think that you can produce some model which enables you to decide on exactly what the right kind of thing to happen is.

Q17 Sir Peter Viggers: As to the division between the banking book, old-fashioned banking, if you like, and the trading book, which has been called the 'casino' element of banking, when one puts to bankers that there might be some kind of division more clearly drawn between these two aspects, the banks tend to say, "Well, it's actually much more complicated than that. It's all shades of grey rather than black and white". How would you comment on that?

Dr Lilico: I do not think that it is necessary or desirable to divide up the casino banking from the utility banking. I also think that it is a mistake to imagine that the utility banking is likely to remain unchanged by these events. I offer, for example, the point that, even if you go back to before the madness of the bonds market to 2004, 30% of income to the European banking sector from the non-wholesale customers was mortgages, and I do not think that that is going to continue in the future.

Q18 Mr Fallon: If we could return to European regulation, whilst the fiscal responsibility for bail-outs and depositor protection remains national, why should we accept some supra-national power to override national regulators and their responsibilities?

Dr Alexander: I would say because the externality is cross-border. Banks have exposure to each other throughout Europe in the money markets through a variety of risk exposures, and European policy-making needs to begin to have better surveillance of the systemic risk posed by certain banking groups and financial institutions that operate in Europe. It does not mean that we displace national regulators, it simply means that we involve regulators at the national level having more accountability to a committee of supervisors consisting of the Member State regulators themselves so that there is more co-ordination at the European level.

Q19 Mr Fallon: But that is not the proposal. The proposal is not just for surveillance, the proposal is that, under certain circumstances, the national regulator should be overridden and there should be binding mediation on the Latvian regulator or whoever it is. It is not just surveillance, what is being proposed, it is override.

Dr Alexander: Well, it is override regarding the application of EU law. If there is a dispute regarding how the Capital Requirements Directive is being applied, there certainly needs to be a European policy input regarding how the CRD is being implemented by, say, the UK or Spain or Poland. In the past, it has just been up to the Member State to do whatever they wanted to do for the most part and it has been impractical to call a Member State to account.

Q20 Mr Fallon: But do the other two of you agree that it should be done through Brussels or through the Basel framework?

Professor Morrison: I am not sure that it is feasible to do everything through Brussels, even if it were desirable. I presume when you say "what is being proposed', you are referring to the de Larosière Report and one of the things that de Larosière suggests is this European systemic risk council which would have the power in disputes to apply binding decisions to the parties involved, and de Larosière himself has acknowledged that that is going to involve sometimes overriding macro-policy at the national level. This seems to me to be a hard thing to accomplish for an institution that has not got tax-raising powers and so on.

Q21 Mr Fallon: It may be hard, but is it right, Dr Lilico?

Dr Lilico: I think that always and everywhere the proper prudential regulator is the Central Bank, so I would have a eurozone both micro- and macro-prudential regulator which was the ECB and the European system of central banks. At the UK level, it would be the Bank of England and, in other Member States with their own currencies, it should be theirs, so that is the way, I think, it should be done and the logic of the current system is connected. The reason why that is not the route being pursued is connected with the idea that the long-term destination of the EU is that there should be a single currency throughout the EU and that, because there remains that commitment by all the EU Member States, it, therefore, seems logical that you should have one European regulator.

Q22 Ms Keeble: I want to ask you a bit more about the macro-prudential tool and the working of it, and perhaps particularly Professor Morrison because I think you advised the House of Lords Economic Affairs Committee on this. What, do you think, would be the most effective tool?

Professor Morrison: It is hard to say and I think we should not rush to judgment because we do not have to get this right in the next fortnight, but I suspect that the two most useful tools are likely to be one or a combination of either capital requirements that flex with the economic cycle or lending ratio limits, so loan to value ratios in the housing market or loan to deposit ratios in the banking sector. If you look at loan to deposit ratios in the banking sector over the last seven or eight years, they expanded very rapidly, particularly in institutions which have subsequently got into trouble, and these are the big macro-indicators that one could predicate rules upon.

Q23 Ms Keeble: The big debate, apart from what the tool is, is who wields it. In the Economic Affairs Committee's Report, the power would shift to the Central Bank, which is what Dr Lilico also says. Is that your view and can you justify it?

Professor Morrison: The decision to use a macroeconomic tool, a macro-prudential tool, is something that requires a knowledge of the macroeconomy and that is a knowledge that resides in central banks, so it seems like a rational place to put this power. However, this would require the right sort of institutional framework and it is not clear that it could simply be handed over to a Bank committee. The Bank is going to need market intelligence, quite a lot of detailed market intelligence, and that will require representation from the FSA because any macro ----

Q24 Ms Keeble: Which is not on the committee currently.

Professor Morrison: Well, at the moment there is no committee with a macro-prudential tool, but the committee, as it is currently envisaged, is a sub-committee of the Court of Bank Directors, which is really an advisory body. My feeling is that, if one is going to actually have a policy tool, it is going to be necessary to give the banks sufficient close information about the markets and that information at the moment resides partly in the Bank, but to a large extent in the FSA because it is doing close, day-to-day prudential supervision, so having some senior representation from the FSA on this committee would be a good thing. The second observation is that any committee like this which has the power to use some sort of macro-prudential tool is going to run up against broader questions of economic policy, and the Treasury has to have a representation too.

Q25 Ms Keeble: If you were to give that power to the Bank of England, particularly given you have identified those two particular issues, would you not actually curtail or limit the way in which the FSA currently works in working with banks around the way in which they operate, and would that not actually impede the sort of proper management, supervision and regulation of banks?

Professor Morrison: I am not sure that it has to. The FSA has institution-specific information and uses that institution-specific information to make decisions about individual institutions: are they running their risk systems correctly, do they have the right governance systems and so on and so forth? Those questions can feed into broader questions of macro-policy, but they are distinct. The macro-policy is about aggregate variables, and what the FSA is doing is institution-specific. To the extent that there is a danger that you would wind up double-dipping, there is a cost associated with that. Having two institutions attempting to do similar things and crawling over banks, there is a cost and one should do everything one can to reduce that cost, but, if that cost is what you have to incur to avoid systemic crises, then it is probably a cost worth spending.

Q26 Ms Keeble: What do you say to the issues that David Blanchflower raised in his speech in Cardiff where he argued that you could end up with the Central Bank having to look sort of one way in what it did with interest rates and the other way in what it did with the macro-prudential tool? As he put it rather finely, "Central bankers might have one foot on the accelerator while applying the handbrake", do you think that is a risk if both tools rest with the Central Bank?

Professor Morrison: It is a risk. One proposition might be that what the Bank needs to do in the money markets could have an adverse effect on the soundness of some banks, and that is one reason why another tool in addition to interest rates is probably a good idea because, if you are trying to use interest rates for both of those things, inevitably you will be conflicted. One needs to be careful that the Bank does not use one tool to cover up mistakes in another tool. At the same time, there are trade-offs to be made here. If one foot needs to be on the accelerator and one foot needs to be on the brake, somebody needs to internalise these trade-offs and it seems reasonable that there needs to be a body to do that, and the Bank has the expertise probably to accomplish that.

Q27 Ms Keeble: What do you think of the way in which things were handled recently with the quantitative easing and could this not apply again, given, as you have said, that we do not need to decide in the next fortnight, where the Bank has the oversight of financial stability through the Banking Act and the legislation is quite broadly drawn with quite a lot left to secondary legislation and, therefore, it is well possible for the Bank to refine its thinking about its tools more and then come back when it needs the powers, as it did, for example, for quantitative easing where it got the powers very quickly and was able to take the actions that were needed, or do you think that that is just leaving it too late?

Professor Morrison: I think we should not leave it until the next crisis before the Bank asks for the tools that it needs because we can design the tools at greater leisure and get them in place before then, but the idea that these tools should evolve rather than appear in a big-bang way seems to me entirely rational. They are complicated things, we have not been here before and it will require quite a lot of thought and discussion.

Q28 Ms Keeble: It is quite unseemly to see a sort of turf war, in a sense, between the Bank of England and the FSA. How do you see it being resolved?

Professor Morrison: I do not know how it will be resolved. If there is a turf war going on, then of course that is an undesirable thing, but perhaps it is just a debate. Hopefully, the turf war will resolve itself in a rational fashion.

Q29 Ms Keeble: What do the other two of you think about the issue about the macro-prudential tool and who should wield it?

Dr Alexander: Of course the Bank of England has got broad powers over macro-prudential policy, interest rates and managing the currency, but we should not lose sight of the fact that in the recent crisis we saw that systemic risk arise not just from individual financial institutions, that it can arise in the broader capital markets and in the over-the-counter derivatives markets, for instance, in the AIG case, so the structure of the financial markets is very important and that is where the FSA comes in. The FSA has got the data and it is not just supervising individual institutions, though it certainly does that, but it also has oversight of the clearing and settlement exchanges and this is where a lot of the systemic problems that we had arose, and that is why, I think, the FSA is well-positioned; they have got the data, they have got the oversight of those capital markets now and we should use that, and there needs to be a better linkage and a better balance with the Bank of England regarding the macro-prudential policy.

Q30 Ms Keeble: So would you agree with the shared membership of the committee then?

Dr Alexander: Certainly. I think it is surprising that they are not on the Financial Stability Committee now, as set forth in the Banking Act, and I think it is anomalous to think that you can oversee systemic risk in the financial sector and not have your financial supervisor at the table, providing data on the capital markets on clearing and settlement.

Q31 Ms Keeble: But you seem to be quite comfortable with the FSA wielding the tool, or you think it is a possibility?

Dr Alexander: I am comfortable with the FSA doing that exactly. Well, they have got that responsibility already. I think it depends on the jurisdiction. We have become a bit path-dependent in our institutional structure right now, so we have got the FSA and they are already regulating the capital markets, so now the challenge for policy-makers is to have better co-ordination between the Bank and the FSA and to have the FSA on this Financial Stability Committee.

Dr Lilico: I think that the Bank of England should manage the tool insofar as it is a part of macro-management, but the thing I would add here is that there may be a case for having a fully international component, so, for example, you could imagine having an element of your counter-cyclical caps or requirements or a capital buffer of some sort that was dependent upon a rating which the IMF would give of the international economy, so I would call it a 'Defcon rating for the world', something coarse-grained, like light red, dark amber, light amber, green, and then, dependent on that, you would then have a component of the capital requirement which would link it fully internationally.

Q32 John Thurso: The Committee recently visited the US. There were three specific areas that were raised with us: size; interconnectedness; and the business model that the banks were pursuing. Do you think that the FSA has got each of these areas properly covered?

Dr Alexander: Well, on size, we were discussing capital adequacy earlier and what types of rules we might adopt to apply capital standards, and I think that one of the rules should be linked to the size of the bank. Larger banks pose a larger systemic risk to the financial system and, therefore, they should pay a tax for how big they are, and smaller banks perhaps do not need such high capital charges as they pose less systemic risk. Interconnectedness brings us to the capital markets and how they have certainly become complex, they are interconnected, and we have seen how liquidity risk can now arise in the broader capital markets, not necessarily with individual banks, and I think that is why securities regulation has always focused traditionally on conduct of business rules and only focusing on segregating money for client accounts and that sort of thing, but now we see that securities regulators need to focus more on the systemic aspect of their oversight of capital markets. The third aspect, I am sorry?

Q33 John Thurso: Business models.

Dr Alexander: We have seen a major failure of corporate governance in financial institutions. In part, some of it is regulatory arbitrage responding to regulation, but a lot of it too is an over-focus on shareholder wealth maximisation at the expense of the broader social costs that financial institutions take.

Q34 John Thurso: But do you think the FSA are sufficiently alive to these issues and working on them?

Dr Alexander: I believe that in their recent discussion papers they seem to be aware of the problem and seem to be aware of their past mistakes in having a too market-sensitive framework of regulation, so now we see of course the Turner Report, so I think they are on the right track in addressing these issues, but now follow-through and political support are going to be necessary.

Q35 John Thurso: Professor Morrison, please add to that if you want to, but specifically on the question of size, in his recent Mansion House speech, the Governor said that any bank that was too big to fail was, I think he said in the words of a famous economist, broadly too big to exist, they are too big. Do you concur with that view and should we be taking action to regulate the overall size of banks?

Professor Morrison: Quite a lot of banks seem to be too big to fail either because they are too big systemically or too politically sensitive to fail, and the expression 'too big to fail' dates back to the mid-1980s when Continental Illinois was identified as too big to fail by the US regulatory authorities, and they said at the time that another ten banks - I cannot remember the exact number - were too big to fail. It is probably just a fact of life that banking is such a systemically important activity that some institutions are going to be too big to fail, so the question is how one should respond to the fact that institutions are too big to fail. The critical effect of being too big to fail is that the people who finance you anticipate bail-out and your cost of capital reduces, so there may be an argument for becoming very big because that makes you very effective, you are able to give better support to customers and you have more information about the economy and you can do things efficiently and all of those good things, but there is also an argument about becoming too big because, when you become too big, your funding becomes cheaper. For that reason, I agree with Kern, that something needs to be done to make it costly to become too big and in that way you are making the right trade-off. When you become so big that you anticipate bail-out, some of your costs of funding are transferred to the taxpayer and the Deposit Insurance Fund and you fail to internalise that and, to that extent, there is a failure of markets, so reimposing those costs on institutions via, I do not know, bigger capital requirements, which is one way of doing it, but it is not the only way of doing it, is not a bad idea. That would probably mean that many banks cease to be as big as they are anyway and, if we get this right, the ones that remain big will be making the right trade-off; they will be generating sufficient efficiencies to make it worthwhile imposing those costs.

Q36 John Thurso: We have really got two separate situations, one where the system is working perfectly adequately generally, the markets are working well, and one where an institution, through a set of poor judgments, finds itself in trouble, so you have got a strong basic system and one bank failing, and probably in that situation quite big banks could be managed through a failure and allowed to fail in a managed fashion. However, what we have gone through is something where the entire system has broadly been in considerable distress and, therefore, institutions failing within that compound the problem into the entire system. Should we, therefore, be regulating on the basis that it is the systemic failure that is the most important thing to guard against rather than necessarily the individual institution?

Professor Morrison: I think we should and, even at the level of the individual institution, we should worry about things like capital charges becoming so big and that, realistically, if one of the major clearing banks in this country were to fail at any time, it could expect support, so that needs to be dealt with, but you are right to say that the key concern is multiple failure or many banks ceasing to have confidence in one another and being unprepared to lend to one another because the knock-on effect on the real economy is profound, and that is the place where things like macro-prudential regulation come in and this sort of thing could happen with many small banks. Many small banks making the same mistakes adds up to one huge systemic problem and that is why we need an overall perspective of the financial system.

Q37 John Thurso: In that case, Dr Lilico, I think you answered earlier that you were not in favour of separating the utility bank from the casino bank, but is not one of the key problems that we have that each has imported into the other the worst aspects of their cultures and that one of the primary functions of the utility bank, which is to take, hold and safeguard deposits, is at odds with the risk-taking culture of the merchant bank? Should we not explore a return to something closer to Glass-Steagall?

Dr Lilico: First of all, I do not think that any bank should be too big to fail, though unfortunately politicians seem not to agree with me, and the markets can anticipate that, so I do not think that you have as clean a scenario as the one you described before in which you are going to have a kind of ordinary time and the rest of the time because what will happen is that, if people anticipate that, if they get large enough, they will be bailed out, then the market will react to that, so you will get mergers that are driven by the desire to become too big to fail. I actually think that that is something which should be now considered as an issue in merger law, so the possibility that a merger is motivated by the aim to gain the taxpayer. I think another kind of consequence connected with that is that you will tend to use higher levels of leverage because in bail-outs the experience we have seen is that bond-holders are spared, so you are better to have a capital structure in which you have a larger proportion of debt and less equity, so you will have increased pressure for leverage in the capital structure and, insofar as prudential requirements try to act against that, you will try to find lots of 'get-arounds' for that. I think another thing is that in terms of the investment banks and the others, it is valuable to consumers if they can participate in the gains from the use of their money so as to maximise returns because then they are going to get higher deposit rates. The one kind of thing that I would think is worth considering is the following: that, in order to make it easier to allow institutions to fail, it would be useful if you really did have somewhere where you could just store your money because that is not what a bank is. Banking is an intrinsically risky activity, so bank deposits should not be regarded as risk-free because those monies are being used in intrinsically risky activities and, if you insure them, that creates an instability at the very heart of the capitalist system. On the other hand, if you wanted to have the possibility of allowing people to lose their deposits, I think it would be useful if they always had the option of a form of account where they could not use their deposits, so I would recommend that every bank licensed to take retail deposits should be forced to hold, what I call, a 'gilt aggregator account', so this is a fully gilt-backed account which you are not able to employ in fractional reserve banking and with this one the only kind of insurance needed of course is against fraud, and then, if anybody wants to take their money out of that, then the bank has some notional charge for storing the money, so it is basically like a sort of safekeeping kind of banking. If you take your money out of that into high-yielding timed deposits, you should be read the Riot Act by the bank and told, "You're no longer insured" and that kind of thing, so that is the extent, so I think the way to deal with this issue is entirely internal to banks, to have a very limited opportunity for people in any retail institution to have a pure safekeeping kind of account.

Q38 John Thurso: I think there was actually a Private Member's Bill in the Lords that proposed very much that type of account for banks. Can I ask you, Professor Morrison, one last question. If it is not thought desirable to actually just separate the parts as a kind of brutal way of achieving an end, is there any merit in looking at the licensing system, such that each bank brand must have a licence and each brand licence has capital requirements, so that a big bank company that had many brands would actually have all of the components? One of the things that I observed with the RBS failure is that Coutts, which is wholly owned by it, actually was very well capitalised and could have been hived off at any moment separately, so, if you had the component parts of a super-group each licensed, as in fact RBS did, but HBOS did not, you would perhaps be able to have more stability. Is that something that has any particular attraction?

Professor Morrison: It is hard to know, without crunching the numbers, exactly what the effect of that would be. I am sure it would generate a greater degree of stability and it would also generate some costs simply because capital cannot be employed quite as efficiently, you have idle capital sitting in some institutions, and that is the argument, to the extent that there is one, against ----

Q39 John Thurso: You talk about capital efficiency, but are not capital efficiency and high risk synonymous?

Professor Morrison: Not necessarily. If you are taking a high risk, then you need to get a high return and, if you are getting a high return in return for your high risk, then, purely economically, you are being efficient. The trouble in banking is that much of the risk and much of the return is beneath the surface. Some of the risk is being borne by deposit insurance funds and being borne by taxpayers and is not correctly accounted for by the people taking the risks, so, to that extent, people, particularly when they are highly indebted, as Dr Lilico said, when institutions are very geared, they have an incentive to take excessive risks, but having capital that could be employed productively not being employed productively is inefficient and there is an opportunity cost to doing that. The question is: how do you measure that cost because there is a gain as well, which is the reduction of systemic risk, and that is something that is terribly hard to measure?

Q40 Chairman: In terms of liquidity, how do you define 'liquidity', Professor Morrison?

Professor Morrison: It is a very hard thing to define, which is why we do not have formal regulations over it at the moment, so many people define a bank's liquidity in terms of the asset base that it has, so, if it has lots and lots of gilts on its book, then it is a very liquid institution. The problem with liquidity, as I remarked earlier, is that it is not a constant, but it is something that evolves in line with market expectations and the beliefs of market participants. When market participants stop believing in one another, liquidity dries up, so I think perhaps a better way to think about liquidity would be to think about the exposure a bank has to the drying up of liquidity, and that is particularly to be measured in terms of mismatches of maturities, so banks have always engaged in maturity transformation and that is something that we would like banks to do. When the maturity transformation is not between deposits and long-term investment, but between short-term wholesale funding and long-term investment, it seems that the liquidity risk is much higher, so my inclination would be to measure liquidity in terms of maturity mismatches on a bank's portfolio.

Q41 Chairman: Why, in Adair Turner's words, did both economics and policy-makers "take their eye off the ball" regarding liquidity?

Dr Alexander: I think that there was an under-appreciation of the risk that liquidity risk poses to the broader financial system. So much of the policy debate and so many of the academic models looked at market risk and credit risk, and then liquidity risk was under-appreciated. In fact, Alan Greenspan praised the fact that we had a smoothing of risk in the financial system and that securitisation helped facilitate this, so the types of financial instruments that were being used in the economy, credit risk transfer instruments like securitisation, were seen as spreading risk throughout to those who were willing to absorb the risk and, therefore, there was not an appreciation that that liquidity risk could arise in such circumstances, so the academic models, the policy, the regulatory frameworks were built upon the fact that credit risk transfer was promoting liquidity, but what we did not count on was the fact that suddenly all the institutional investors could just simply not want to roll over their short-term investments and then the liquidity would dry up. That was something that was not foreseen and it is a major failing, I think, on the part of both academics, policy-makers and of course the risk managers in the banks who should have seen this.

Q42 Chairman: Dr Lilico, the FSA has suggested a 'core funding ratio' tailored to each bank. Now, that might expose the FSA to the accusation of inconsistent regulation across banks. How can it ensure adequate liquidity at each firm whilst ensuring that each firm is treated fairly?

Dr Lilico: It seems to me that the liquidity problem is a mistake, it is just a symptom of the wider mis-pricing of risk, so, if you got your risk analysis of how much risk there was and if you got your risk assessments right, then the likely fluctuations of the requirements of liquidity would have been less and the liquidity might have proved adequate, so I think that the liquidity point is to be overstated. I think it is important to distinguish between different kinds of crises, so any kind of institution can have a crisis associated with just not having enough cash, sometimes you can have insolvency associated with past losses and sometimes you can have insolvency associated with a lack of future profitability. I do not think that this was just a liquidity crisis and I think that some of the liquidity discussion is just a carryover from the early phases of the crisis when we thought liquidity was a bigger issue, so, although I think liquidity is worth looking at again, I am not convinced that we need to change things all that much.

Q43 Nick Ainger: Following on from that, the Turner Review sets out the figures in relation to structured investment vehicles which show that in four years from 2003 to 2007 the growth of SIVs and their total assets tripled, and Turner says that this was a major contributor to the highly leveraged situation that certain institutions found themselves in. Dr Alexander, you talked earlier about one of the banks' functions is maturity transformation. How important are SIVs to maturity transformation? Do we still actually need these SIVs?

Dr Alexander: I think securitisation is an important component of our financial system and that we should not throw it out, but it is how it is regulated and we have to understand the risk that securitisation presents. Again, many experts did not foresee the liquidity risk that an over-reliance on securitisation funding could pose to the broader financial system. I think that, if we properly regulate securitisation, SIVs and the various conduit funding that banks have been using, then they are appropriate ways to raise capital. They are a part of financial innovation and we should not curtail financial innovation, but we have to understand that the funding through SIVs is short-term and that it can dry up quickly, just like in the old days there was a bank run with depositors running for the exit, but now we have got institutional investors that can turn off the funding pretty quickly, and we have to think about how to regulate that and what types of costs to impose on that.

Q44 Nick Ainger: Coming on to this point about how to regulate, we have been told by academics and practitioners in the financial services sector that part of the problem is the complexity of these various vehicles, these CDOs and CDOs squared, and we even had the Chairman of the Deutschebank who did not even know what a CDO squared was. It is all very well saying, "Yes, we should regulate and regulate them better", but with the very fact that they are incredibly complex and that the risk element is in their complexity, how do we expect regulators to understand the risk involved and, therefore, point out to the institutions, "You are at risk because of this" if the institutions themselves do not even understand the risks involved?

Dr Alexander: Well, if they do not understand it, they should not do it and the regulators should not permit it. Right now under Basel II, regulators have to approve the risk models that banks submit to them for review, for credit risk, for market risk and now liquidity is included in that in Basel II, so regulators should not be approving these models as submitted if the bank cannot explain the model and cannot demonstrate an understanding of the model. This is part of the dialogue, the interaction, that the regulator has to engage in with the banks, but it is not the regulator's problem to figure it out. The bank has to explain it and the regulator needs to have maybe advisory experts there to test the models that the bank is submitting for approval. If they have a model that is testable and it makes sense, then they can approve it.

Q45 Nick Ainger: So what we need is actually far more informed regulators who are able to make an objective judgment of what they are being told by a particular institution?

Dr Alexander: They need to be able to make an objective judgment, but the burden is on the bank to make that model work, to prove that under certain conditions of stress-testing and the various ways, and the regulator has to be there to be vigilant and it is not the regulator's job to figure it out, but it is the bank's job to explain it and then the regulator, I think, will rely on expertise to make sure before deciding whether to approve it.

Q46 Nick Ainger: Do the others agree with that?

Professor Morrison: Well, no one could argue against a well-informed regulator, it is like arguing against commonsense, but I think we need to be aware of our own systemic limitations. Some of the models which were generated were very elegant and very clever and had very little economic content; they were essentially physics rather than economics. We made the mistake of thinking that, as a physical model can tell us what happens when water boils, these models would tell us what happens when a default starts to occur in financial markets, and sometimes the problem here was excessive reliance in the regulatory arena upon models which were really intended as devices to help managers to understand what was going on, so, to the extent that there were regulatory failings, I think perhaps the regulatory failings were in taking some of these models too seriously. When you do that, the incentives to the people who create the models are bifurcated. To some extent, they are concerned with creating accurate models and, to some extent, they are just concerned with reducing their capital charges, so one problem here was not appreciating the limitations of some of the tools that were being used in regulation and that, by using the regulation, it may have changed their nature, and that is a big problem. Another problem was failing to recognise, and this is a simple problem that can easily be fixed, but failing to recognise that banks that provide backed-up lines of credit to SIVs, even if those lines of credit are not legally binding, actually find it very hard to walk away from them and, hence, had a liquidity exposure that was not recognised.

Q47 Nick Ainger: You used the phrase "physics, not economics", but what do you actually mean by that?

Professor Morrison: What I mean is that, if you take a simple model of a securitisation, say, I have a securitisation where I take two loans that I have made to a corporation, bundle them and then sell another piece of paper that defaults when both of these loans default together, then, in order to put a price on the securitised asset in the absence of a liquid market, I have to make assumptions about how often each of these loans will default individually and how often they will default at the same time. People do this using elegant methods that come from the mathematics of fluid mechanics originally, so I have a model which shows the price of one of these things moving up and down and another one and, when they both move down far enough, we see a default, so those are models that have this feeling of precision. You can calibrate them by going out and gathering data and you get a figure for simultaneous defaults and you get a figure for individual defaults and you treat those things like physical constants in the same way that you have a number that tells you when water freezes and when it boils, but those things are not physical constants, they are economic numbers that depend upon the behaviour and the expectations of market participants. When market participants suddenly realise that everyone is doing the same thing and they suddenly realise that, because of the immense opaqueness of these markets, they do not know what one another is doing and exactly what the exposure of different people is, those parameters can change rapidly, so assumptions built and hard-wired into models about correlation parameters just turned out to be completely incorrect in 2007. It is not that they had been estimated in the wrong way, the estimation procedures were good, but there was a structural change in the way that people saw the world. I think failure to understand these feedback mechanisms as being integral to the way that financial markets operate has got a lot to do with the misuse of these mathematical models, so, when I say "physics, not economics", I mean that in physics we have some things which are constants and we can make predictions that are going to be correct over time, and in economics we can make statements about how people react to incentives, but straightforward correlation parameters are not physical constants, they are summaries of how people respond to incentives and what those incentives are.

Q48 Nick Ainger: Dr Lilico, alongside the SIVs and so on, we also had the mutual funds and so on taking part in maturity transformation as well, so this shadow banking system developed. Turner says that this again added further risk into the whole system and much of it appeared to be almost beyond the regulator. Is that a fair analysis?

Dr Lilico: I do not think that that is really right, no. It seems to me that a key discipline for innovation in any sector is that you put a lot into some new, fancy thing where you do not know what is going to happen about it, you get it wrong and you go bust, but, if you do not have that discipline that you go bust if you get it wrong, then you should not expect innovation to be efficient, so that is one key factor here. Also, I think that people have been a little bit harsh on some of the SIVs in that, if the companies had actually gone so far as going into liquidation, I do not believe that as much would have come back on to the balance sheet as it actually did because, when you have some legal separation, the creditors of various bits would have objected to being lumped together with creditors on other parts, so I think that that thought that it is an entirely artificial separation is a mistake. I also think that there is little evidence that actually hedge funds and the wider sector contributed anything negative to the financial crisis. I think that, in some cases, they were the canary in the mine and, in other cases, they were the messenger, the bringer of bad news and I think that, if you did not want to hear the bad message, then you objected to the hedge fund and its practices, and I think that is just a mistake.

Q49 Nick Ainger: Anyone else on shadow banking?

Dr Alexander: I am less suspicious of the structure of finance as it evolves. It evolves in response to government concerns and the financial system has evolved because of the regulation as well. What we have to do is try to ensure that the regulators try to impose a proper cost on risk-taking, and what we had not understood was the type of social cost that this so-called 'shadow' banking sector posed to the financial system. It is not that that shadow banking sector is bad to have, that we should prohibit it, but it is that we want to put a price on it so that the risk-taking is internalising the costs that it is creating, and that, the regulator had failed to do.

Professor Morrison: The shadow banking sector, like most innovations, there are good things and bad things about it. One needs to be careful in financial markets to distinguish, although it is very hard to do so precisely, between innovation which is there to encourage the efficient use of capital and the efficient deployment of resources, which is what we would like financial markets to accomplish, and innovation that is there to get round regulation, and there is no doubt that a good proportion of the shadow banking was about getting round regulation. This may reflect the fact that regulation became excessively complex and there were massive whole regulations and we are now aware that this is a problem, and I suspect that it is being addressed, but a good part of financial innovation is the response to poorly designed regulation.

Chairman: Can I thank you for your evidence this morning; it was very helpful to us in advance of Lord Turner's appearance before us this morning, so thank you.


Witness: Lord Turner of Ecchinswell, a Member of the House of Lords, Chairman, Financial Services Authority, gave evidence.

Q50 Chairman: Lord Turner, welcome to the Committee. We are grateful to you for coming along. In your view, are the biggest challenges now faced by the FSA about drawing up new rules and regulations or about improving the supervision of financial firms, as opposed to regulation?

Lord Turner of Ecchinswell: They clearly have to be both, but I think it is important to realise that if we simply significantly improved our supervision in its intensity, but without very significantly changing the regulations that exist - by which I mean the capital requirements, the liquidity requirements, the accounting requirements, et cetera - the former would be absolutely a necessary but not sufficient condition. When the Northern Rock report on the failures of UK supervision came out, one of the non-executive directors of the board told me when I joined last year that he had felt that, when they put out the report, they ought to have said, "On Northern Rock we made a complete hash of it. If we had done it perfectly within the same structure of regulation, it would have made almost no difference to the development of the financial crisis". I think that is an important thing to understand: that the ability to fix the problem by more intense supervision, by having the correct meetings, by having the correct procedures, but without a different overall approach to regulation and an overall philosophy of what the regulator is trying to do nationally and internationally, is very limited indeed.

Q51 Chairman: In our response to this crisis, how can we avoid the Sarbanes-Oxley equivalent here?

Lord Turner of Ecchinswell: I think that is an important point. Sarbanes-Oxley is a very detailed set of reporting requirements but, if you tried to identify what are the two or three fundamental things it is trying to achieve, it is actually quite difficult to do that. I think that is why it is highly likely that in our regulatory response we need to be able to identify a relatively small number of high-impact levers which will really make a major difference. I think those will be more capital across the whole of the banking system and higher capital - and there are some new ideas emerging even since the Turner Review of how we could do that, which need to be thought about; more capital in particular against the trading books of banks, the proprietary trading activities of banks; new approaches to liquidity; and a philosophy of a macro-prudential approach to analysis and the pulling of the levers of capital and liquidity. The latter being something which everybody now agrees with in general but where we need to put the flesh on the bones of what the tools are and how it operates. I think that those will make the real difference. It may be that, within that, higher-quality capital, counter‑cyclical capital, is the single most important thing. However much we try to get better at foreseeing future problems, we will never get perfect at it and we therefore need to create within the financial system worldwide, and in particular with the banking system, more shock absorbers. The shock absorbers in the banking system are ultimately the capital requirements.

Q52 Chairman: The FSA Supervisory Enhancement Programme - what impact has that had?

Lord Turner of Ecchinswell: It is having a huge impact. In response to your first question, Chairman, I said that it cannot in itself be sufficient but I think that it is important and, alive with everything else, it can make a large difference. It was something which was well under way before I joined the FSA as Chairman. It had been put in place in response to the problems revealed by the internal audit report of Northern Rock, and it is a very major change. First of all, there are significant extra resources devoted to the supervision of high‑impact firms. Having said that, the total resources are still significantly less than some other countries devote to the supervision of ---

Q53 Chairman: In November last year you said to us that only 38% of the vacancies had been filled but you had a date, spring 2009, for all of them to be filled.

Lord Turner of Ecchinswell: I think that we are now 90% or so there. We are fundamentally through the process of hiring - it is about 280 new people - but it is also crucial to realise that they are doing fundamentally different things from what we did before. For instance, we are much more involved in a very detailed analysis of the assets of banks; the accounting approaches of banks. In the past, we have not really challenged the way that accounting is done; the accounting judgments being made on the market in trading books. We are involved in detailed discussions now with auditors in a way that we were not before, and we are also using stress testing in a far more intense fashion than we were previously doing. We are also gathering far more detail on the liquidity and we have a new liquidity regime. I think that it is a very major change in the intensity of supervision, with an increase in the scale of resources but also a change in the nature of the questions that we are asking and a greater willingness to challenge business models. There are some bits that we still have to get in place and which the Board was discussing recently. We said that we would get better at doing sectoral analysis; at understanding peer reviews across sectors; at identifying where banks and insurance companies were making their money and what that means for the risks. I still think that we have to reinforce and improve that. We also have to add a capability to do this sort of analysis of the overall picture, the macro prudential picture; and I have been talking with the Chief Executive about further steps we have to make in organisational structure and resourcing to add to and intensify what we have already achieved on the Supervisory Enhancement Programme.

Q54 Chairman: If we had the senior executives from, say, HSBC, Lloyds, Barclays or whoever here, and asked them what the impact on them has been of your Supervisory Enhancement Programme, what do you think they would say?

Lord Turner of Ecchinswell: That is an interesting question. I think they would say that the nature of our engagement with them is much more intense than it was in the past. That, for instance if you look at the stress test that we have run on banks, they are documents of a size and level of detail, of going through what their assets are, what their risks are, to a greater extent than before. However, that is a very good challenge. What it suggests to me is that one of the things I should probably do to test it is to go round them and get a point of view of what difference they have seen. I think that, if you are talking to them, it would be a very interesting question. I think they would say that there has been a very major increase in the intensity of our supervisory oversight.

Q55 Chairman: There is this new philosophy of intense supervision that you have mentioned, and most people would agree that that change is now required. However, there are signs even at the moment that it is maybe a bit "business as usual". How will you ensure that you resist the pressure from the banking sector and others to relax your intensity?

Lord Turner of Ecchinswell: You did not ask me, Chairman, whether I wanted to make an original comment but, if I had been, I would have said the following - which relates specifically to this point. I think it is incredibly important for us to realise the enormous intensity of the financial crisis that we have just been through; the huge harm that it is doing in the developed world and indeed the developing world, as the World Bank report revealed this week; and the burden of fiscal debt which the UK and other countries will have. I think we have to realise that this was not a minor event; it was in some ways the biggest financial crisis in the history of market capitalism. It was based upon fundamental intellectual errors about the way that markets work, and the self-equilibrating, or in fact non self-equilibrating, character of financial markets. I think there is a danger that, because we are now seeing some signs of positive things - and I think that there are truly some green shoots out there - because of those positive signs and because of the exhaustion level of driving through the changes required, there could be some drawing back from the degree of radicalism that we require, particularly given the fact that some of it requires international agreement and getting international agreement is an immensely tiring process of driving it through a complicated set of fora. I think there is a real danger therefore that we do not seize the opportunity of this crisis - and it seems a bit odd to say that a crisis is an opportunity, but that can be the case - to make sure that we make changes radical enough to ensure that we are not sitting here again in ten or 15 years' time. I do have that concern, and I think that one of the things we need to do on the FSA, having launched the Turner Review and our discussion paper in March, having had a process of a consultation that has resulted in several hundred responses which came in over the last few weeks, is to draw breath and to think about it; and we will be heading towards some new sort of statement in the autumn and another conference to discuss it, where we make sure that we are being radical enough and that we do not become satisfied with what we have done so far. I do have that worry internationally, that we could fail to be radical enough in response to what occurred.

Q56 Chairman: In the domestic sense it is obvious that incentives matter, and that is agreed. The focus yesterday was on the pay-out to Stephen Hester at the Royal Bank of Scotland. We had an independent remuneration consultant, Carol Arrowsmith, before our Committee a number of months ago and we asked her what the typical remuneration package would be at the height of the credit crisis. She told us it would be the basic salary; share options five or six times what the basic salary would be; and a bonus, two or two and a half times. That is almost exactly mirrored by the incentives that Stephen Hester had yesterday. They are incentives based on share price, which some would say is a crude measure. Looking at that incentive package, you would be forgiven if you had the impression that it is really "business as usual".

Lord Turner of Ecchinswell: Yes, and I do have some concerns that that may be the case; not in particular in relation to a specific individual, but we have certainly noticed that there is now very aggressive hiring going on in the trading activities of investment banks. The specific issues of that particular contract are a matter for the Government and UKFI, not for the FSA; but I think that the issue of how we, as best possible, use regulation to make sure that remuneration structures are consistent with appropriate approaches to risk is one where we need to intensify our focus. Though let me say one thing, because I know that in a previous report you commented that you had some concerns that the FSA have been "complacent" on the issue of remuneration. I think that reflected the fact that in the Turner Review I said that although it was important it was less important than other things. I continue to believe that, and the way I would express it is this. If you roll back ten or 15 years and imagine two states of the world, one in which we had the tightest possible definition of what were appropriate remuneration policies but we had not changed capital and liquidity standards overall and in trading books, how much difference would that have made? I do not think all that much. The other is one where we had fixed capital requirements in trading books and something in the accounting but had left remuneration to an entirely free market decision. I think that would have made quite a lot of difference, and I suspect that you would not find a serious economist across the world who would disagree with that. We do need to try to make significant changes to the remuneration approaches of banks and investment banks, therefore, and in particular in investment bank activities of banks, but we have to realise that there is a limit to what you can achieve through that route alone. Let me sum up what I mean by that. You yourself said in your previous report that you did not think that the FSA or any regulator could be involved in regulating the total amount of remuneration. Therefore, our focus is what is the structure of remuneration? What is the balance between immediate payment, deferred payment, payment in cash and payment in shares? If we got that as good as we wanted it, the fact is that people may still take excessive risks. If you look at the remuneration of Dick Fuld, the head of Lehman Brothers, he was to a very significant extent paid not in cash but in shares, and those shares were significantly deferred. Actually he lost a very large amount of money when Lehman's went bankrupt. That did not stop him sitting on top of an organisation which was taking excessive risks. The fact is that, when there is irrational exuberance in markets, people are themselves carried away with irrational exuberance. They believe that those deferred equities that they have will pay out. One therefore needs to realise the limits of what we can achieve on that. The final thing I would say is this. We have to realise that there were parts of the wholesale financial services industry - in particular, bits to do with structured credit, credit derivatives and fixed income trading - which I think simply grew beyond their socially useful size. They were, as one of the economists here was just saying, indulging in innovation which was not socially useful innovation but either regulatory arbitrage innovation or a tax arbitrage innovation or forms of rent extraction. As long as that is occurring on a more‑than-useful scale, some people will end up, in some way or other, being paid very large amounts of money for things which are not terribly useful. To address that, we have to get the capital requirements right; we have to get the things that determine the scale of that activity right. To try and regulate that by remuneration policies is like trying to control inflation by prices and incomes policies, even while having nominal demand growth faster than is compatible with stable inflation. It is the same category of mistake.

Q57 Chairman: In your evidence you told us that the FSA was scrutinising the accounting judgments made by bankers. What are auditors for?

Lord Turner of Ecchinswell: What has been interesting to us in exercises we did last autumn was to compare the values attached to particular assets and derivative exposures and the value, for instance, of mono-line insurance cover, for what appeared to be very similar categories of asset or contract in the books of several of our major banks. You can actually compare what is the percentage approach to a value markdown or the credit taken for an insurance cover, et cetera. What we discovered at that time - and this was not something we had done before - was significant variation in those approaches. I think what that illustrates is that there is a role for somebody to be doing that on a compare and contrast basis, then convening the auditors and saying, "On the basis of what on paper are the same accounting standards, you are ending up agreeing to what are significantly different judgments as to what is the application of that standard, in what appear to be somewhat similar conditions". I think there is a role, therefore, for the FSA - and we are working out the details of this - to be the occasional convenor of auditors, to discuss these issues with the actual figures in front of us, and to try and create a greater commonality in the judgments that are being made. However, I have to say that it was surprising to me how significantly different some of those judgments which had resulted from the auditor application of the same standards were.

Q58 Mr Tyrie: You have given us some very interesting and full replies to these questions. Thank you for that, Lord Turner. This touches on exactly what you have just been alluding to. How much of this detailed information that you are collecting in the enhancement programme can we get into the public domain through accounts and through annual reports, in order that the risk associated with the information can be correctly priced by the markets?

Lord Turner of Ecchinswell: This is an important issue that we need to work on further. Of course, given that it is accounting information, that also needs to be agreed with the International Accounting Standards boards and we do need a commonality of approach on it, across the world ideally. It is something which is being addressed by the Basel Committee because, within the Basel II approach to capital adequacy, there was always what was described as the three-pillar approach: a new way of working out the figures, Pillar 1; Pillar 2, a set of supervisory judgments as to add-ons required; and Pillar 3 was described as a greater degree of disclosure of some of these judgments and how the approach had been used. There was not great progress on that before Basel II was launched and we need to make more progress. That is very much work in progress, therefore, to try to define that. The challenge on disclosure, to which there is no easy answer, is that the disclosures at the back of bank financial reports are getting bigger and bigger, and there is more and more data there already; and it is not clear that we have market analysts who are effectively analysing even what data is there already. We therefore have to be a little careful of simply believing that further data will magically produce a more effective form of market analysis and market discipline than have existed in the past. In general, however, I do believe that we should probably go down the track of greater disclosure of some of these accounting judgments - if we can describe them in a fashion that is susceptible to a standardised disclosure. We are generally sympathetic to that, therefore, but this is a real devil-in-the-detail issue, on which international work is now going on.

Q59 Mr Tyrie: But is it not the crucial one? Because if you do not get very far with disclosure, we are entirely dependent on the internal judgments you are making.

Lord Turner of Ecchinswell: That is an important philosophical issue as to how much the greater stability of the financial system in future will depend on greater transparency, disclosure and more effective market discipline, and how much it will dependent on a greater willingness of the regulator, the supervisor, to make discretionary judgments, or of the macro‑prudential authorities to pull macro-prudential levers. I may differ a bit with you on this. I am a little less certain that the discipline will come through market discipline. The evidence for that, I would suggest, is that, even though there was not perfect information in terms of individual bank accounts back in spring 2007, I think it was a reasonable thing to believe that the level of risk within the financial system was increasing - given the scale of the increase of a credit extension, given what we already knew about sub-prime mortgages in the US, et cetera; and yet aggregate, on average, bank CDS spreads, rather than going up, continued to fall, to reach pretty much an all-time low in about June 2007. Therefore, the thing which is meant to give us a forward indicator of risk failed almost entirely. I do think that we have a problem of the fundamental nature of financial markets. The concept of market discipline in response to transparent information depends crucially on the idea that market prices will reflect all of the available information rather than reflect herd and momentum effects. I think that to a significant extent they reflect herd and momentum effects. They serve as available information.

Q60 Mr Tyrie: They certainly cannot reflect it unless they have the information. If I may say so, when I asked you some questions the last time you came before the Committee, I asked you about the mistakes your predecessors had made. You said yes, they had made some serious misjudgements. Then I asked you whether you would have made the same misjudgements, given the information before them, and you said yes, you would have done. What I am concerned about is creating a vast regulatory regime which ultimately depends on yourself or people like yourself making further mistakes in the future. Notwithstanding the fact that you may be better at it than anybody else available, it still may not be good enough. Therefore, transparency might be a better route.

Lord Turner of Ecchinswell: We fundamentally have three ways to progress and I think that we have to progress through each of them, one of which is transparency - in the hope that that improves the effectiveness of market discipline. Given the failure of markets to use the data which was already available to them, I have some doubts about whether further information radically improves that effectiveness. The other is a greater willingness of regulator or central bank or macro-prudential authorities to make judgments, either at an individual institution level or at a macro level, which lean against the wind of irrational exuberance. Again, I do not imagine that we can ever do that perfectly, but I think we have to be willing to attempt to do that. In a sense, it means that I do not agree with the Greenspan doctrine that that is completely impossible. The third, though - and it is the point I made earlier - is if you believe that market discipline will always be ineffective and subject to herd and momentum effects, if you believe that regulators are also imperfect human beings - which I undoubtedly agree with - and will get things wrong, then what we have to do is put more buffers into the system. We just have to accept that both of those other corners of the triangle are uncertain and we have to have a system which, in the face of inevitable volatility, simply has more shock absorbers to absorb that inevitable volatility and irrational exuberance, followed by irrational despair.

Q61 Mr Tyrie: I would just like to ask a couple more questions about the enhancement programme. To take a specific case, do you think if this programme had been in place, the information that was clearly already available about HBOS's increasing risk would have been acted upon and, in particular, the head of compliance's concerns? Do you think this structure is better capable of reacting vigorously to that?

Lord Turner of Ecchinswell: Yes, I do. I said earlier that in itself it would not make a difference without other tools as well, but it would undoubtedly have made a difference. Indeed, there are also important things that have to be debated, which will come up in the Walker review, where Sir David Walker is looking at governance issues. I believe, and I think that Sir David is heading in this direction, that the nature of the relationship between the professional executives involved in risk and the non-executives and the risk committee - but also the regulator - the ability to feel that they have a direct line to the regulator and to non‑executive risk committees, and are defended against any pressure from the other executives, is one of the most important issues for us to think about within the governance relationships. I think that changes are required there. I think that combining those possible changes which may come out of Sir David Walker's review with our enhanced supervisory approach could make a difference. Where one has to be a little careful is this. If we had had this greater supervisory approach, would we have said in relation to the Dunfermline Building Society that they should stop doing commercial real estate lending on quite the scale they did? The answer is that you would have to combine the more intense supervisory approach with a greater willingness to accept that it is the role of the regulator and the macro-prudential authorities to have a point of view on the overall trend in the marketplace. That was not there at the time. You have to remember that the Dunfermline Building Society was able to do that commercial real estate lending because Parliament had decided in 1997 that that was a useful freedom for it to have, and was doing so in an environment where we did not have macro‑prudential guardians telling us that, on aggregate, commercial real estate was growing too rapidly. With those two as background, actually there was not anything about the specific commercial real estate lending that Dunfermline was doing which would be a red flag. Again, it is why I say that the Supervisory Enhancement Programme, combined with what may come out of the David Walker review, can make a significant difference to many of these issues - the issues which were relevant, for instance, in HBOS - but they need to be combined with new approaches to capital and liquidity and a greater willingness to make macro‑prudential judgments about where we are in the cycle.

Q62 Mr Tyrie: One last question on this. Given that the enhancement programme will be very dependent on the quality of staff running it and given that, when the City recovers, their reputational risk will be considered by them to be so high that they will want the very best people on the other side of the table dealing with the people coming in from the FSA, how confident are you that you will be able to keep your staff?

Lord Turner of Ecchinswell: You are quite right to ask the question how we are going to keep our staff. Clearly the last six months has been a favourable period for us to be recruiting, because there have been some quite good people out there. Having said that, the particular people we might recruit, who are competing with the people who are the risk and compliance officers, even before this latest increase in trading remuneration which is going on, even last autumn, that was the bit of the City recruiting which was fairly dynamic. That is why we need an adequate budget to be able to compete. That has not been an easy thing to say over the last six months, and we have had people criticising us for the fact that we have still paid end-year bonuses; but we need that adequate budget. We feel that we have a remuneration structure approach at the moment which, in the conditions of today, is adequately but not excessively competitive. We will obviously need to make sure that we keep that in future, to have the right quality of people.

Q63 Sir Peter Viggers: The Turner Review made six key proposals on capital regulation. Of course, the world has rather moved on since then. I wonder what your present view is of the extent to which you can prescribe the optimal level of bank capital.

Lord Turner of Ecchinswell: The issue of prescribing the optimal level of bank capital is of course a very interesting theoretical one. It is noteworthy that, in the 12 years of the discussion of the Basel II regime, there was intense discussion of the relative weight of capital that should be put against different activities in the banking book. Then, when it got to the aggregate level of capital, the committee essentially said, "The aggregate level of capital should be the same as it previously is". Not only was that implicit: it was an explicit decision. The whole thing was calibrated to produce roughly the same result as before. It is slightly odd, in retrospect, to think that there was this huge intellectual effort into a capital regime, with very little questioning about what the optimal level is. It is very difficult to derive a complete theory of the optimal level of capital, but I think there is a reasonable argument that it is higher than we have had in the past. There are some very interesting theoretical issues about it. If we overdo it and have too much capital, are we increasing the cost of credit intermediation? This gets to the intriguing debate about what is called the Modigliani‑Miller theory of capital. Whereas, at least if you accept that theory, it really does not matter if we double or triple the capital requirements; it does not make a macro-economic difference. That is an issue about which the world has to think. It has also been pointed out, for instance in Bank of England papers, in previous versions of the Financial Stability Report and in American reports, that 40 or 50 years ago banks used to operate not with just a bit more capital but with a great deal more capital than they have at the moment. It is something that we will try to stimulate as a debate - between ourselves and the Bank of England, with the Basel Committee, with the Bank for International Settlements, with academics - as to what the overall level is. However, at the moment we are proceeding on a global consensus that we do want more capital and higher-quality capital, which means more of a common equity or close‑to‑common‑equity form. I think the new idea that has emerged over the last three or four months, which was not in the Turner Review but which we are also very interested in, is the idea of contingent capital: things which are not necessarily common equity but would definitively become common equity under some circumstances, i.e. things which are mandatory convertible, for instance not just at the option of the bank but at the option of the regulator. You could imagine something where there is a required Core Tier 1 ratio of X% and where, if a bank fell below that, subordinated debt instruments would have to convert into Core Tier 1. I think that some of those issues about insurance policies or mandatory convertible are very attractive ideas, which we need to add to it. They get us round this debate a little of "Should our Core Tier 1 ratio be 4% or 6% or 8%?" by giving us something which would become Core Tier 1 when that shock absorber or buffer was required.

Q64 Sir Peter Viggers: Your review argues that only Core Tier 1 and Tier 1 capital should feature in regulatory ratios. There is notably less emphasis on Tier 2 capital. Why is this?

Lord Turner of Ecchinswell: Tier 2 capital is subordinated debt. The difficulty about subordinated debt is that, in a sense, it is loss-absorbing in a condition of a failure - what some people have called a "gone concern" situation - but, on the basis of a going concern, losses go through to common equity and that can then produce very strong pro-cyclical behaviour. For instance, banks which face a hit to common equity may start constraining the growth of their balance sheet very quickly, to try and get their ratios back. There is therefore a feeling, and I think it is reasonable, that in an ongoing basis we need capital as much as possible to be equity or contingent equity, something that becomes equity, because that is really the only thing which absorbs the losses as they occur rather than absorbs losses in condition of default. The other trouble with subordinated debt is that there developed practices in the market whereby they often had call options in them, and although it was available to a company not to take the call option, and for instance to pay it back after five years, you ended up with a set of market practices where it was perceived as very bad for market confidence if you did not call the subordinated debt at the end of, say, a five-year call period. What that meant was that some things which were nominally very long-term, permanent capital, 20 or 30-year bonds, de facto ended up being forms of medium-term funding rather than long-term capital. There are lessons for us in that. One of the lessons is about regulatory creep. What you continually have when you define a set of standards in capital is a set of clever investment bankers saying, "Yes, but couldn't this particular version with this particular feature still just meet your definitions of what is capital?" That happened in relation to quite a lot of what are called the hybrid Tier 1 and innovative Tier 1 and Tier 2 capitals. I think we have to be much more rigorous about that in future. Capital should fundamentally be loss-absorbing; it should either be equity or it should be things which are capable under certain circumstances of becoming equity.

Q65 Sir Peter Viggers: In your review you said, "The future world of banking probably will and should be one of lower average return on equity but significantly lower risk to shareholders as well as to depositors", and you call for a public debate. Do you actually want a public debate or do you want a public education programme?

Lord Turner of Ecchinswell: I think both. I do think that is right. If you look at the expectations of return on equity which existed in the marketplace and in market analysts back in 2004-05, they were things which were only compatible either with a very high level of gross margin, i.e. some category of rent extraction going on vis-à-vis the real economy, or a high level of leverage, a minimisation of capital, or risky activity. They were not compatible with a banking system simply performing its core functions at the sort of level of profitability that you would have thought was compatible with that. I think that the general principle - I do strongly assert, and would be surprised if somebody could argue against it, is generally accepted and it has been said by some private bankers. Some private bankers have said to their analysts and shareholders, "In future we will be somewhat lower return on equity but we will be lower risk". I cannot remember whether I spoke of a public debate in relation to that issue, but it is not one where I am in much doubt. I think that is the direction of change which is required.

Q66 Sir Peter Viggers: You have argued that capital requirements should be counter‑cyclical and you said they should be hard-wired and formally driven. All of which is fine, but who is going to call the cycle? In 2007 we all thought that we were in a certain position; we all now recognise that we were not.

Lord Turner of Ecchinswell: This is one of the areas where the concept is broadly agreed but I really do think that we now have to put flesh on the bones of that concept, and it is not straightforward. This is where there is very significant work being done by the Basel Committee, where the FSA is deeply involved. It is something we also need to debate with the Bank of England. They have a major input to this. The two choices as to how to go forward are a hard-wired formula and things which are to a degree discretionary. With the hard‑wired formula - and the version of this is the Spanish dynamic provisioning - you have set out a formula in advance, which says that if credit grows at a certain pace you will automatically have some extra capital put aside against it. This is on the grounds that we do not know things perfectly but, in general, the more rapidly credit is growing in the economy the more likely it is that some of that credit is fairly risky. However imperfect, therefore, you simply hardwire that into a formula in advance. The other way is to give to some macro-prudential body the right to look at the situation and to reach a judgment back in 2005-06 that the economy is overheating on the credit side and that we need, in the famous phrase, to "take away the punchbowl before the party gets out of hand"; but to do it not through the sole instrument of the interest rate, i.e. not using interest rates to prick asset bubbles, but through the use of counter-cyclical prudential requirements. What we suggested in the Turner Review was that we probably need a bit of both. We probably need some hard-wiring but we certainly do not exclude the possibility that in addition there is some counter-cyclical judgment going on. Of course, the more that it is judgment about the position in the cycle, the more that it does have an overlap with the conduct of monetary policy; because you end up with counter-cyclical capital requirements becoming alternatives to the use of the interest rate, to achieve the same effect. This is an area where we are confident that the content is right; it is broadly agreed throughout the world; but there is a lot of work still to be done to decide the precise range of instruments and the balance between formula-driven and discretionary judgment.

Q67 Mr Fallon: Can we turn to the European issue, Lord Turner? If fiscal responsibility for the bail-outs or for depositor protection remains national, why should we accept any degree of supranational authority from Brussels?

Lord Turner of Ecchinswell: I do not think we have perfect solutions, but let me describe the problem. Last year, we had the Icelandic banks growing in the UK, accepting retail deposits and advertising for retail deposits. They had a right to do that as passported branches under the European Single Market, as members of the European Economic Area.

Q68 Mr Fallon: I think that we understand the problem. We have been studying it for a couple of years.

Lord Turner of Ecchinswell: I am sure you do.

Q69 Mr Fallon: What is the answer to my question?

Lord Turner of Ecchinswell: For the record, which is sometimes useful to do - because you may understand it but not everybody does - that is a problem which arises from the Single Market rights to operate. Suppose in ten years' time we have similar concerns about the growth of banks from a relatively small country within the European Union, where we have some doubts about the capability of the fiscal resources or the deposit insurance to bail it out if it went down, and we also have, as we had with Iceland, doubts about the approach that the local supervisory authority is applying to the constraint of that growth and the capital adequacy and the liquidity. We would like some capability for there to be a European supervisor of supervisors, which is placing pressure on the supervisory authorities of that potential future small country to make sure, as best possible, that tight standards are being applied. Unless you go to the other extreme and say, "We don't want the Single European Act. We are going to undo that. We are going to have a treaty change so that there are no longer branch passporting rights in relation to gathering retail deposits" - that is why you have to go in that direction. That is why in the Turner Review we flagged up this concept of more Europe or less Europe; i.e. unless you are willing to go in the direction of less Europe, which is limiting retail branch passporting rights significantly, to assure us that in ten years' time we are less likely to be sitting there with an Icelandic situation, we need some ability at European level to be assuring the quality of the supervision of all supervisory authorities across Europe. I think that is the logic of it.

Q70 Mr Fallon: I did not ask you about surveillance or quality assurance; I asked you about supranational authority. The issue of course is what happens when there are disagreements. Should there be binding mediation at the European level or not? If there is binding mediation at the European level, then the FSA in effect becomes an agency of Brussels.

Lord Turner of Ecchinswell: No, I think it is over-simplistic to describe it as that, frankly. There are some circumstances in which binding mediation may be something which would be attractive to us. If we are worried about the future equivalent of an Icelandic financial authority, unless we have some teeth, not only to observe through surveillance that there are concerns about that capability but actually in some way to make sure that there is improvement, what is our defence against another Icelandic situation, for which you would quite rightly criticise us, in ten years' time? What is our defence? It is not clear to me what it is.

Q71 Mr Fallon: It is a very British point of view, is it not, to see this as one-way. What would happen if the Icelandic authorities or the Latvian authorities queried a decision that you had taken here?

Lord Turner of Ecchinswell: Yes, and one would have to make sure that one was adequately involved in the process and that the thing was set up sufficiently professionally that one would be sure that that was only occurring if that challenge was reasonable. Of course the challenge has to be both ways; but we will be extensively involved, in detail, in helping create the professional standards and the technical competence of this regulatory authority. You are absolutely right, but you are not giving an answer to me about what you are going to do about the future Iceland in ten years' time.

Q72 Mr Fallon: Happily you are here to answer our questions.

Lord Turner of Ecchinswell: Yes, but sometimes it is actually quite useful to ask you a question, and you do not have an answer to that.

Q73 Mr Fallon: You are here to answer the questions. Let us be clear about this. You concede that there is a case for binding mediation, supranationally over the FSA, from Brussels.

Lord Turner of Ecchinswell: Under some circumstances it can be acceptable. The crucial thing is that we do not want it to be in relation to the supervision of individual institutions; it is about overall supervisory approaches. We are absolutely confident that the supervisory capabilities of the FSA would be extremely unlikely to be challenged, because we think that we would be setting the standard of what that professionalism is. However, I do think - and this is why in the Turner Review we shifted our policy to accept a greater degree of co‑ordination - that, after what happened in Iceland last year, it is irresponsible for us not to give the people of Britain an answer as to how we would stop it happening again.

Q74 Mr Fallon: It is not just co-ordination, is it? It would be binding.

Lord Turner of Ecchinswell: Yes, but how would co-ordination without some teeth have stopped Iceland?

Q75 Ms Keeble: I want to ask you about the macro-prudential regulation and tools, which you have referred to previously quite a bit. You referred to three high-impact levers and in your review there was reference to six factors that needed to be taken into account. The previous witnesses talked about the possible tools being controls on capital requirements and also lending rate limits. Out of all of those, which do you think would be the most effective tool?

Lord Turner of Ecchinswell: I am sorry? Capital requirements or lending?

Q76 Ms Keeble: Capital requirements and further restrictions around those, without being too specific, and also lending rate limits.

Lord Turner of Ecchinswell: Lending rate limits?

Q77 Ms Keeble: That is right.

Lord Turner of Ecchinswell: Were they referring there to loan-to-value ratios?

Q78 Ms Keeble: That type of thing, yes, and they referred specifically to the property market. Within all of those, I wondered which you think would be the most effective tools to respond to macro-prudential warnings.

Lord Turner of Ecchinswell: The answer is that I do not have a definitive answer here. This is where I would agree with the comments made by the Governor of the Bank of England at the Mansion House last week: that these are very complicated issues where we need to try and tease out an appropriate answer. We will certainly be thinking over the summer about what our point of view on this is. The available instruments are clearly in capital requirements - the variation of those. As I said earlier, we are strongly favourable to some element of hard‑wired counter-cyclicality in those, through something like the Spanish dynamic provisioning approach. I think that most people would agree that that is a key element of it, even if you have other things. Some countries also use loan-to-value ratios. Some countries use it simply as a prudential limit which is stable over time, and some vary it over time. For instance, I spent last week in China and Japan, and China has been varying its loan-to-value ratio limits on residential mortgages as part of its stimulus package. It has therefore been increasing the allowed level of a loan-to-value ratio as a form of stimulus package. What I flagged in a speech I gave to a mortgage conference a month and a half ago was that I really do think that is one where we need to think very deeply before deciding to go down that route. We will produce a paper in the autumn on that particular issue, as to whether loan-to-value or loan-to-income ratios should be used either as a mechanism of consumer protection against over-high lending or as a macro-prudential tool. I guess I would say that, within the possible tools - capital ratios, loan-to-value ratios - the capital ratios is an almost definite; the other issues are whether you want other ones as well. There are also, by the way, quite crucial issues about loan-to-value ratios, or what are effectively loan-to-value ratios, in the wholesale space and, for instance, in the derivative trading space, where it is an issue of collateral requirements within margin lending. I think that those also are worth thinking about.

Q79 Ms Keeble: If you agreed with the Governor about the refining of tools, do you agree with him as to who should wield them?

Lord Turner of Ecchinswell: I have expressed a point of view on how these tools should be applied. Indeed, I did so in front of the House of Lords' Economic Affairs Committee, and I was pleased to see that they largely reflected what I said in their recommendations. However, my attitude is the following. There clearly needs to be very close co-ordination between the prudential regulation and supervision of banks in particular and central banking functions. The more that we go down the path of macro-prudential levers, the more that integration has to occur. Paul Tucker has used the phrase, the "underlap" between a Bank focused on the inflation target and us focused on supervision, and that that was a mistake. We therefore need to integrate it. I have expressed myself in the past, and I express myself again, as an agnostic on the overall institutional structures by which we ought to organise the different functions. I can see some arguments for the whole of banking supervision being with the Bank of England. It would solve some problems, but it would create others. I am not someone who says, "I will defend to the limit the existing organisational structures"; I am an agnostic on it. Indeed, my biggest argument against change is that any change would produce six months of people looking for new jobs rather than focusing on the job that they had to do. What I will say is this, however. Suppose you had banking supervision in the Bank of England. How would the Bank of England then organise its macro-prudential decision-making process? It would undoubtedly set up a financial stability committee/board, which would combine people from the macro side of the house and people from the individual supervisory side of the house, in order to bring together the insights that come from top-down macro analysis and the insights that come from bottom-up analysis of the situation in specific institutions and sectors. It would have some sort of financial stability committee/board, which would have the head of the supervisory department on it as well as the Governor or the Deputy Governor. My answer is therefore quite straightforward. If that is how you would logically organise it if supervision were within the Bank of England, if we suppose that supervision stays within the FSA, we should organise it in the equivalent process. We should have a joint financial stability committee, which I think should be chaired by the Governor but should include people from both the Bank of England and the FSA. I would be very worried that, if we do not do that, we will simply create unnecessary competitive behaviour and a lack of co-operation between the two entities.

Q80 Ms Keeble: I want to come back to you on that a little more. The need for greater co‑ordination is a fairly clear argument. However, you run a slight risk of reinventing some of the problems that we have seen in the Tripartite, of having everybody involved and the question is who takes the decision; who actually has the lead. You may be agnostic, but you are a key partner in all this and your perceptions and your views are obviously important, for us as for others. Even if you have a co-ordinating structure which, for the sake of argument, might theoretically fall inside the Bank, do you think that the decisions about wielding these instruments, so to speak, should be taken in the interests of financial stability by the Bank or do you think they should be taken by the regulator qua regulator? Ultimately, where should the decision rest?

Lord Turner of Ecchinswell: My point of view is that they should be taken by a joint committee; that there should be an equivalent of a Monetary Policy Committee for financial stability decisions.

Q81 Ms Keeble: Chaired by ---?

Lord Turner of Ecchinswell: It should be chaired by the Governor. It should probably have a majority of people who come from the Bank staff. Maybe if it had nine people, there would be five from the Bank and four from the FSA. I think that it should be debating and looking in the same way that the MPC does at papers developed both by Bank and FSA staff, drawing on the insights which come from both top-down macro analysis and bottom-up analysis; and it should be reaching decisions about where we are in the cycle and whether there are then tools, such as capital or liquidity or margins, which need to be tightened or loosened in a counter‑cyclical fashion. Unless you do that there is a real danger that, if you simply have that in the Bank and then those instructions are, as it were, handed to the FSA, first of all you will produce wasteful competitive behaviour; but I think that wasteful competitive behaviour would be quite justified. I suspect that whenever an individual institution goes down, the FSA will be blamed. That is almost inherent. It is to do with the majesty that the Bank has and its slight mystery. It is part of Bagehot's phrase, "the decorative elements of the constitution as well as the functional". It has a mystique. The blame will attach to the FSA. The FSA therefore cannot simply sit there and say, "We'll rely on the judgment of the Bank". Suppose the Bank gets it wrong. Suppose the Bank does not adequately pull counter-cyclical levers. It ends up with power without responsibility and the FSA ends up with responsibility without power. If you are going to do that, then maybe you should think about moving bank supervision back to the Bank.

Q82 Ms Keeble: What is your reflection on the observations made by David Blanchflower in his speech in Cardiff, where he said that if the central bank is responsible both for interest rates and the macro-prudential instruments, they might "have one foot on the accelerator while simultaneously applying the handbrake"? Do you think there is a problem of conflict of interest in the situation you have described?

Lord Turner of Ecchinswell: I agree that needs to be thought out very carefully, but I think the counter-analogy would be to say that we have realised that simply having the interest rate available as a brake, rather than some other brakes as well, is also highly imperfect. I do not know whether Professor Blanchflower disagrees with this. He may be one of those people, for instance like John Taylor of the Taylor Rule, who has written a book on it, who believes that appropriate use of the interest rate by central banks could itself have achieved a better result and that there were failures of classic monetary policy, interest rate policy. I do not know whether Professor Blanchflower believes that, but my own conclusion has been that there are difficulties in simply using the interest rate as a brake and accelerator; that it is very difficult to lean against the wind of asset bubbles or credit cycles using just the interest rate - particularly in a medium-sized country which has a floating exchange rate, where you can get complicated impacts through the exchange rate - and that therefore we need more than one brake available. The argument for is that we need more than one brake available. Obviously he is quite right that, once you have said that there should be more than one brake available, you could be inconsistent in taking the pressure off one while putting it on the other, as it were. I did not know that he had said that but, in order for him to be willing to go with the full consequences of that, he has to be arguing that interest rates alone could have been an adequate tool to guard against the cyclical effects which we saw. Some people do believe that, but I think there is a large body of opinion which no longer believes that.

Q83 Ms Keeble: I want to press you once more on where the decision-making rests, just to be absolutely clear, because it has obviously been a matter of some dispute and there are also all the blanks that have to be filled in on the Banking Act. You would argue with the Governor about having a structure inside the Bank to look at the financial stability issues, to look at how to use the macro-prudential tools, and then joint decision-making as to how they should be used; but then the responsibility for implementing them rests clearly with the FSA. Crudely, that seems to be the situation you are describing.

Lord Turner of Ecchinswell: The analytical input to such a committee would come from both houses. They would be receiving papers, analytical inputs, which would be coming from both the Bank and the FSA.

Q84 Ms Keeble: But that would rest in the central bank.

Lord Turner of Ecchinswell: No. The committee would receive papers developed both by the Bank of England and by the analytical bits of the FSA. I do not think you could have the FSA not doing any of the analysis.

Q85 Ms Keeble: The committee would be in the Bank; it would be part of the Bank structure.

Lord Turner of Ecchinswell: Once you have a joint committee, it gets a bit notional whether it is in the Bank or not. It is in whatever its composition is. Where it would meet, I do not know.

Q86 Ms Keeble: No, but it would be part of the central bank. It would be chaired by the Governor.

Lord Turner of Ecchinswell: Yes, it would be chaired by the Governor, but it would be receiving inputs and papers from analytical resources both within the sectoral and prudential analysis bit of the FSA and the financial stability bit of the Bank. It would be debating those issues and it would be arriving at a consensus point of view on what had to happen, obviously voting at the limit if required; but I think this would better be consensus. I do not think that it is equivalent to the MPC, because you do not have a nice, simple lever to pull, ie up a quarter, down a quarter. It is therefore more likely to work on a consensus result basis than a voting basis. I think that the execution does have to be done by the supervisors, because they are the people who are actually looking at, "Are these people hitting the capital ratios which are required?". However, the crucial thing here is to so construct the close working relationship between the FSA prudential supervision of banks and the Bank of England's financial stability responsibility that you have, as it were, mirrored across the divide the devices that you would have if they were both within the Bank. There is an inexorable logic that that must be the sensible thing to do.

Q87 John Thurso: The Committee was recently in America and three points were put to us as things of concern relating to banks. They were, first, size; second, the interconnectedness; thirdly, the business model. Are there any of those that the FSA does not have covered?

Lord Turner of Ecchinswell: Does not have covered?

Q88 John Thurso: Are there any of those three that you are particularly concerned about?

Lord Turner of Ecchinswell: Absolutely. All of those three. I think that they get to some of the most tricky issues about which, even since the Turner Review, I have spent time thinking, and will be thinking about over the summer, where the FSA really needs to think through what is required. Let us take the size issue ---

Q89 John Thurso: I was going to come on to the size one first. I want to ask you in particular if you accept what the Governor said in his Mansion House speech, which was basically "If a bank is too big to fail, it's too big", and the concept of an institution which cannot fail sits ill in a market situation. Do you agree with him on that?

Lord Turner of Ecchinswell: I think that this is a crucial issue and we need to break it down into several bits. First, you have to decide what your tools are. Are you saying that a bank cannot be beyond a certain size or do you impose extra capital requirements if they get beyond a certain size? My own suspicion is that if you said, as a sort of rule, "I'm going to stop banks getting beyond a particular size, and no bank can be more than £x billion in assets", in order to make that figure small enough that you could be really sure that, when it went down, it was not systemically important, you would probably have to make it very small - much smaller than the present level, not just a little bit smaller.

Q90 John Thurso: To save time, could I ask you, at the same time as you address that, to address the other end of the scale? If you take HSBC, Barclays and RBS, their liabilities are four times the size of our GDP. Are they going to be a bank that is too big to save?

Lord Turner of Ecchinswell: Exactly the point I was going to get to because, in that, I think there is a crucial need to distinguish issues. On the "too big to fail", I have some doubts as to whether we would really be able to get them small enough that we could then say, "They can just fail, without systemic concerns" - unless they were very small. Actually, if they were very small we could have a different systemic problem. Lots of small banks have lots of interconnectedness and lots of potential domino effects. Remember that the 1929-33 banking collapse in the US was a banking collapse of lots of small banks; so we have to be careful of not iconising the small bank model. I do not think that there is an easy definition of what is the most stable banking structure between small and large banks. There is this absolutely fascinating stuff on network interconnectedness, drawing inferences from disease pathologies, which I think is very valuable but it is also very difficult to tease out what precisely follows from it. What I take out of that is that we probably will have banks in the future sufficiently large that, if they did get into trouble, there will be few alternatives other than rescuing them. Therefore, we need to do two things. First, we need to make the likelihood of failure very small. Second, we need to increase the pain which will be felt by those people who in all circumstances suffer in a bank rescue, and those are the equity providers. The crucial issue about "too big to fail" is essentially an issue about where in the capital structure people suffer loss. Is it only the equity holders? Is it also the subordinated debt holders? Is it, under certain circumstances, senior creditors? Who suffers loss? That is the real issue about "too big to fail". The more that we go down the road of having higher equity capital buffers, first of all we reduce the likelihood of failure; second, we create a large buffer which gets round the moral hazard problem. Because the thing which is clear in all bank rescue operations is that you can wipe out the equity holders - even if you choose, for systemic purposes, not to impose a haircut on creditors. I am therefore significantly attracted by the ideas which are in the Geithner proposals last week and were not in the Turner Review: that we should think not about absolute limits on size - because I think they will be very difficult to achieve agreement on at a global level, or to enforce - but sliding scales of capital requirements which simply require higher capital requirements from larger banks, or higher capital requirements from banks which are involved to a greater extent in risky trading activities alongside retail banking activities.

Q91 John Thurso: It is effectively a kind of tax on size.

Lord Turner of Ecchinswell: It is a tax on size. The idea of a tax on size, although it was not in the Turner Review, is one that we need to think about and we need to think about it at a global level. The cross-border point is very important. We really need to break down this cross‑border point about "too big to save" into three different categories. First, things like the Icelandic banks, retail banking operations in other countries where the home base was not a large enough country to rescue it, operating in a branch fashion. What you have to realise about Icesave in the UK is that it was not a bank in the UK; it was fundamentally raising deposits which were then used to fund assets anywhere in the rest of Landsbanki's balance sheet. There was no bank that you could look at, with its own liabilities and assets, in the UK.

Q92 John Thurso: Could I ask a quick question on that? Could we not insist that any bank or brand that operates in the UK must be licensed in the UK?

Lord Turner of Ecchinswell: Not under the Single European Act, no. That is what branch passporting rights are. Category two is the complex, interconnected trading activities of a Lehman's‑like equivalent or the remaining investment banks, which typically operate with multiple legal entities, often for tax and regulatory arbitrage purposes - and I think there is a major issue about whether we have been too lenient about accepting proliferation of legal structures for tax and regulatory arbitrage reasons - which are essentially running interconnected, global trading business. Category three is the sort of HSBC or Banco Santander model. Banco Santander's banks in Latin America are essentially stand-alone banks, regulated as subsidiaries, with their own liabilities and their own assets. Sometimes when we see these things, "The liabilities of HSBC are X% of UK GDP", we fail to realise that that includes HSBC Hong Kong, regulated by the HKMA, who are absolutely determined that that will be adequately capitalised, such that, if HSBC went down globally, HSBC Hong Kong would survive. What is a possibility with those categories of banks, therefore, is that we essentially accept that they have to be, in each of their countries of operation, adequately capitalised as stand-alone banks which could survive the failure. In which case, you get round the "too big to fail", because essentially you accept that no one fiscal authority is responsible; that they are holding companies of separate banks. That is a different situation and I think that we need to introduce that into the debate, to understand it.

Q93 John Thurso: Can I take you on from there to the fact that what you have just signalled is that, if you break the interconnectivity, you can save parts of a big bank when it is going down. Indeed, with the experts who were here earlier I pointed out that Coutts had remained wholly solvent and with lots of capital, notwithstanding the troubles at RBS. Equally, in your speech to the Global Financial Forum, you pointed out that many of the measures you advocate will have the effect of what Glass-Steagall would do, which is to suppress the size of banks to some extent. However, in your review you pretty categorically reject Glass‑Steagall. Why? Why do we not just go for what we all really want, which is to chop the thing up, have it separately capitalised and licensed, so that we take an awful lot of this risk of interconnectivity out? Perhaps you could do that without taking too much time.

Lord Turner of Ecchinswell: The trouble is that it is very complicated, but let me try. What I said in the Turner Review that I did not think was a reasonable way forward - and the words were very precise - was achieving a hard and fast legal divide between that which was narrow banking and that which was investment banking. The reason why I said that is this. If you look at the things which caused trouble in this crisis, they were not things far away from the fundamental activities of a commercial bank. They were not, for instance, equity trading activities. They were things to do with the provision of credit; they were to do with securitised credit. Indeed, I think that the vast majority of the things which got us into trouble - the things that UBS were up to in their big fixed income trading in the US - are things which would have ended up on the commercial bank side of the old Glass-Steagall debate. That never said to a commercial bank that you could not own a corporate bond in your treasury portfolio. It did not say that you could not do tradable syndicated loans. It did not say that you could not do credit derivatives. Indeed, the final step in the dismantling of Glass‑Steagall was the Gramm-Leach-Bliley Act 1999. Think about it. Before then, JP Morgan had developed credit derivatives and was doing large amounts of credit derivatives - that sitting on the commercial bank side of the fence. You could say, "We can draw the divide somewhere else"; but the difficulty is that, if you try to write this out as a law and ask, "What are you going to say that a commercial bank cannot do, in order to prevent the problems that arose?" are you going to say that they can never use a credit derivative? Credit derivatives, correctly used, can be a form of achieving insurance. Are you going to say that they cannot do a bond underwriting? Some of the people who are reported as being in favour of a new Glass-Steagall - for instance, Paul Volcker with whom I discussed this recently - say, "No, bond underwriting would clearly be a function which would sit on the commercial bank side of the fence". Are you going to say that they cannot do tradable securities which they originate - turn into a security, hold for a period of time and then originate? Most of the activities that got us into trouble, when you look at it, are therefore reasonable activities of a commercial bank - which is why I believe that the problem is the scale on which they did it, not that they did it. Therefore, somewhat with the tax on size, I think that what we need is price-based instruments rather than legal division instruments to limit what they are doing; but that we should limit what they are doing, I absolutely agree with.

Q94 John Thurso: There is one question which I do not think you have answered in that, which is that it is a matter of culture. The merchant investment bank comes from a partnership culture; it is all their own money and they take all the reward. They take risk and they take reward and they bet with their own money. The retail bank comes from the joint stock tradition, with a completely different set of values. What we have actually done is to import the worst of each culture into the other culture. The separation gets back to a greater purity of the risk-taker in one section operating on a risk-taking basis and the more cautious banker on the other side, operating in a more cautious way. It is the cultural element that is a factor.

Lord Turner of Ecchinswell: I partly agree with you but I do not think that we can write a law that says, "Commercial banks cannot do X, Y, Z", in a way which would make sense, given what large commercial banks for large corporates in the world need to do and which would be effective. Once you tried to draw up that law, you would either be excluding commercial banks from things which their corporate customers would think were perfectly sensible, things required to provide service to corporate customers, or you would be pointing at a line where you make yourself feel good by keeping the commercial banks out of equity underwriting and trading, but actually equity underwriting and trading did not cause any problems in this. You really have to concentrate on where the problems are and where you draw the line. I think that when you get down to that level of detail you end up being in favour of things which are, as it were, economic instruments, such as the capital you require against it, or maybe constraints on the size. We could end up saying, "We are simply going to limit the size of proprietary trading activities that can be done within the same legal entity as the retail side of it". I would not exclude that. I guess what I am saying is that I do not think - and I would be willing to predict - that we will end up being able to define a law which achieves what we want and says, "Put this on that side of the fence and that on the other". I think that we are going to do it by a set of economic instruments. However, the fundamental point - that there were banks taking the benefits of retail deposit insurance, of a "too big to fail" status, involving proprietary trading which made lots of money for individuals, and that that is not okay - I completely agree with that, and we have to stop it.

Q95 Chairman: Lord Turner, I think our Committee felt that your report dismissed the implications of Glass-Steagall too readily and there needs to be quite a debate on this, not least the "safe bank" concept and the need to rebuild trust and confidence with consumers. I think that there is more explanation needed there. That is where we were coming from.

Lord Turner of Ecchinswell: That reaction quite surprised me, because I thought I had carefully set out a set of rules that said, "It seems unlikely that we can have a hard and fast legal distinction which excludes commercial banks from all categories of market-making". I think that was over-interpreted as being against any action in this area - which has quite surprised me as a reaction.

Chairman: Maybe more clarity in the future.

Q96 Nick Ainger: Lord Turner, in the review you say that "The increasing complexity of securitised credit, increased scale of banking and investment banking activities, and increases in total system leverage were accompanied by changes in the pattern of maturity transformation, which created huge and inadequately appreciated risks". You argue for international agreement to try to address the issue of this system, which was supposedly there to distribute risk but in fact ended up concentrating it in certain institutions. In relation to Mr Fallon's questions about a European supervisory system and so on, what are the impediments? What is to stop us trying to sort out what you have already described today in relation to SIVs growing beyond their usefulness?

Lord Turner of Ecchinswell: Do you mean what is to stop us doing it domestically?

Q97 Nick Ainger: You argue for international agreement, because obviously these things are internationally traded. What is stopping us setting this up?

Lord Turner of Ecchinswell: Internationally?

Q98 Nick Ainger: Yes.

Lord Turner of Ecchinswell: The answer is that I think we need to keep clear as to what we can do alone, what we can do at European level, and what we can do internationally. The ideal is to get as much agreement internationally as possible. It is not a straightforward process and it requires a lot of energy and activity to try and get agreement. This is not an area which I have been at all involved in in my life before I became Chairman of the FSA, but one of the things that struck me since becoming involved is the complexity and the lack of definition of the decision-making processes at the global level to arrive at agreement. The thing one has to realise is that, unlike for instance in the area of trade where we have the WTO, we do not have a global treaty-based organisation to govern international financial regulation, with defined processes of getting to agreement which then become part of international law with sanctions on them. We simply do not have such an institution. What we have created over the years is a set of institutions - the Basel Committee on Banking Supervision and now the Financial Stability Board - which have either evolved or been created as instruments of the G20 on, as it were, a naturally evolving or declarative basis to say, "You go away and get as much agreement as possible". The Financial Stability Board, which meets with its new membership for the first time in Basel this week on Friday and Saturday, has been charged by the G20 - and there in the G20 statements is a set of statements that "The Financial Stability Board will do X, Y and Z" - but the Financial Stability Board actually has no legal authority to do X, Y and Z. All it can try to do is corral everybody round some agreements and then try to get everybody to agree that they will enforce it. This is an imperfect process but it is the only process that we have, and we have to drive it forward as much as possible. For instance, at the back of the Turner Review, where we talk about the implementation, there are a whole series of responsibilities and dates for the Basel Committee, for the FSB, of liquidity standards, trading books, which we now need to get on with. They are imperfect processes, however. They are not straightforward to get to agreement and, in the past, they have operated at timescales which, compared with what we want to do now, are glacial. The development of the Basel II capital adequacy regime took about ten years or so between the mid-1990s and 2005, and we are now talking about trying to get agreements on counter‑cyclical capital, the trading book capital, within a year. We basically have to drive that and make it work as best as possible, but we are starting with a machinery which a benevolent dictator of the world would not define as the machinery through which to do it. That is what we are doing, therefore, and I am confident that we will drive as much agreement as possible. It also does say that, in some, one may fail to get international agreement. Then, within Europe, you collapse back either to the UK level or the European level, recognising that, where it takes a legal form it is usually European level; because our capital adequacy directives, our capital requirement directives, our legislation in relation to credit rating agencies, are fundamentally European legislation and not national legislation.

Q99 Nick Ainger: If, as your review said, this was a significant reason why we ended up with the crisis that we did - and the Chairman in his introductory questions was expressing concern as to whether we are moving back to "business as usual" - who is actually taking action to try to limit? What is happening now? Particularly as you indicated earlier that the investment banks are recruiting substantially in their trading field, which presumably would cover this sort of area.

Lord Turner of Ecchinswell: What is happening now is that, ahead of global agreements on what Sir Peter Viggers asked me about - what is the optimal level of capital for the long term? - all of us have imposed in our particular national environment pro tem capital regimes which are higher than in the past. We have higher capitalised banks. What is happening in trading books is that, over the next year, we have a major exercise to go on at the Basel Committee to do a complete drains-up on how we approach the definition of risk in trading books. Even ahead of that, however, there are proposals which will result in significant increases in trading book capital but not until the end of next year, because of the normal process. That is happening. There is therefore a set of things happening already.

Q100 Nick Ainger: The point is this. Your review also says that the SIVs, the structured investment vehicles, developed as regulatory arbitrage. There was a way of getting round the regulation. How are you plugging that gap?

Lord Turner of Ecchinswell: We are effectively plugging that gap. Those are being looked at far more effectively than in the past. Many of these grew up in the US, where you had the distinction between the regulation of investment banks and commercial banks. The SIVs - first of all, most of them are being wound down. It is important to realise that, although we talk about the investment banks hiring aggressively at the moment, what they are making large amounts of money out of at the moment is probably - and it is a thing we need to keep a very close eye on - significantly riskier than it was two years ago. They use the phrase "flow trade". Essentially what has happened in the investment banking business is, because capacity has gone out of the market, they are making much more profit than before in some relatively plain‑vanilla and not all that risky activities to do with trading government bonds, distributing government bonds, et cetera. It is not the case that they are, as best we can tell, recreating these SIVs and conduits. If they are, we will watch that very carefully and we will make sure that they are integrated into our point of view of the capital adequacy that they require.

Q101 Nick Ainger: Obviously SIVs do perform a function, and I have heard you defend their process - what they achieve. However, as you indicated earlier, they went beyond their usefulness and in effect made a major contribution to the crisis. What is to stop, in a year, 18 months or two years, investment banks and commercial banks starting again down this route, and do you have the staff with the capability properly to regulate these instruments?

Lord Turner of Ecchinswell: First of all, I am not sure that I have ever said that SIVs were necessary or useful things.

Q102 Nick Ainger: Are they?

Lord Turner of Ecchinswell: It is not clear to me that they are. I think that we have been over-tolerant of off-balance-sheet vehicles. There are some circumstances in which they usefully separate away risk, and that can be legitimate; but often they are forms of regulatory arbitrage and tax arbitrage, and I think that we need to be much more aggressive in the future at spotting them. That is point one.

Q103 Nick Ainger: Would you say that, because of the risk they pose, not just to the institution but because they pose a systemic risk, we should actually stop them?

Lord Turner of Ecchinswell: You do not necessarily need to stop them; you just need to say, "You can set them up but I'm still going to treat it as if it was on balance sheet". It is the principle that I set out in the review: that we have to regulate things according to economic substance, not legal form. If somebody sets up a structure for the purpose of tax arbitrage or regulatory arbitrage, which moves something off balance sheet but when you look at it you realise that the risks are the same as if it was on the balance sheet, you have to say, "That's going to have the same capital treatment as if it was on balance sheet". Am I totally confident that we have all of this under control? The point I made earlier was that the system has gone through a terrible shock and we are trying to put in place new regulatory controls, many of which we can do under our existing legal power and regulations, some of which require regulations. However, I have to say that the questions you are asking me I have been asking over the last month or so. Until a couple of months ago, I had said - and indeed I know that the Governor had said - the good news is that we have a bit of time to get this right. The Governor used the phrase, "Exuberance of either a rational or irrational sort was not in great supply at the moment", so we could take our time to get it right. I do have some concerns that we may see a more rapid return to risky trading activities than we had anticipated was likely in the face of the shock that has occurred, and I therefore think that we have to take away your challenge - which is one I have been challenging internally already - to say that, even before we get some of these fundamental changes in, for instance, the capital against the trading book, are we watching carefully enough what is happening already in the marketplace? I will take that challenge and take it further still.

Q104 Chairman: Lord Turner, one likely impact of the FSA taking a greater involvement in firms' decisions on business models is that market participants may become lazy and rely more and more on the FSA. Is it not incredibly dangerous for market stability to rely increasingly on institutions like yourselves for your judgment? If you get it wrong, the consequences will not be mitigated by others, if others have been doing less due diligence.

Lord Turner of Ecchinswell: I recognise that that could theoretically be a danger. I do not think that it will be the case. I think this is where what we will do as a regulator and supervisor, and what will come out of the Walker review in terms of the internal governance of firms, have an important overlap. We need to achieve, with the internal governance of firms, a much stronger role for key non-executives to look at the risks that companies are running and to feel responsibility for them and for those business models. In the past, I think that it would have been reasonable to criticise the FSA's previous approach as asking a set of questions about the existence of internal processes and structures for reviewing risk, but without either challenging the business models if we were worried about them or asking enough questions to understand whether those processes and structures were somewhat formulistic or were really producing internal challenge. I think that in future we need to be close enough to understand whether non-executives and executives are really challenging whether the business models are too risky. That is therefore an intensification of our previous focus on internal management responsibility, alongside being willing to say, "Even though you have reached this judgment, we think you are growing too fast and going into risky areas". I think that what there will always be in a future better supervisory regime is a sort of fluid interplay between that. It is probably unlikely, if we get it right, that there is a management which is just doing things and we say, "You're completely wrong". Hopefully it takes the form of us challenging the business model and that in itself being something where the non-executives say, "Yes, that's absolutely right. The FSA is right to challenge it" - but with the ability still, if they do not do it, for us to say, "If you want to do that, we're going to charge more capital against it, because we think it is too risky". I understand the danger, but given in particular that our attitude - and it goes back to an earlier reply - is that we have a responsibility to defend systemic risk and to defend creditors. The people we do not have a responsibility to are equity holders. Essentially, equity holders are there to absorb risk. That is why we want more of it there to absorb risk, and that is why I also talked about this idea of contingent capital - things that can become equity. I think the fact that we could perform our job in a way which keeps things systemically sound but is still pretty bad for shareholders will still concentrate the minds of management and boards that shareholders will get upset if they take risks which lead to dilution. For instance, suppose we have mandatory convertible forms of equity which under certain circumstances become equity if ratios fall below a certain level, that may make us perfectly happy about the systemic situation; shareholders will still be very annoyed with management and boards if that occurs, because it will be a dilution of existing shareholders. I think that it will still work, therefore.

Q105 Chairman: You expressed a firm conviction in an earlier answer that a European body with binding powers would not find any problems with FSA supervision. Should we be renaming you the "Flawless Supervisory Authority"?

Lord Turner of Ecchinswell: We will never be a flawless supervisor, but it should certainly be our aim that we are a model of good supervision. I think that it would be odd if the supervisor of Europe's biggest and most important financial centre was not a beacon of high‑quality supervisory standards and was more likely to be the institution pushing to make sure that there were excellent supervisory standards in all other countries of the European Union, rather than being one which was criticised. That would certainly be our aim but, no, we will not be flawless.

Chairman: On that profound point, can I thank you very much for your evidence. You have been very open with us. It has been detailed and is very helpful to us with our inquiry.