A necessary condition, in my view, is for faultlines to exist within the financial system itself – and the deeper they run, the greater will be the threat to stability. The identification and mitigation of such faultlines requires engagement with the details of the system. Those who argue that it is all down to global imbalances and that we did not need to know about leverage via CDOs and the shadow banking system and so on are equally wrong. But the scale of the macroeconomic imbalances that were allowed to accumulate surely raised the bar for resilience of the financial system, and probably beyond what was reasonable. We need to quit pointing the finger, alternatively, at global macroeconomic and financial system causes, and accept that it was both. The Turner Report does that. A few points on micro regulation The Report and accompanying FSA Discussion Paper’s principal focus is, of course, micro regulation. I have just three points to add or emphasise on that this morning. Effective prudential supervision of individual firms relies on the line supervisors being prepared to substitute their views for those of management when they have good reason to believe that the viability or stability of a bank otherwise may be in peril. They need the confidence, when necessary, to face down management, and even boards; and also to be prepared to take the risk of being overruled on appeal.
First, there were too many large financial businesses for which an AAA rating was, fatally, more than a description of their credit standing; it constituted their business model. Examples include Fannie and Freddie; the Landesbanks; the US monoline insurers; the SIVs; and, if they can be thought to have a business model, the ABCPs. These institutions distorted the supply of credit across the global economy. (In the case of the monoline insurers, for structured finance they were effectively in the business of providing “end-of-the-world insurance with a settlement period of T+1”.) An even wider group of private-sector AAA institutions were not required to collateralise derivatives-related counterparty-credit exposures. The effect for the system as a whole was to introduce an extraordinary vulnerability to a ratings downgrade of any of these institutions or structures. There was, in effect, a potentially systemic cliff. A second serious faultline in global capital markets – arguably the greatest – was the firm expectation of “no break the buck” in the massive global Money Market Mutual Fund industry; c. $ in the US, more or less the same size as commercial bank deposits. The failure to pay par at a major US money fund when Lehman collapsed helped trigger the unravelling of confidence across global markets.