The Financial Services Authority (FSA) published its Turner Review, a report on recommendations for reforming the U.K. banking system and the rest of the global financial markets. 

The review identifies three underlying causes of the crisis: macro-economic imbalances, financial innovation of little social value and important deficiencies in key bank capital and liquidity regulations. These were underpinned by an exaggerated faith in rational and self-correcting markets, says the report.

The report stresses the importance of regulation and supervision being based on a system-wide “macro-prudential” approach rather than focusing solely on specific firms. Additionally, it also suggests that fundamental changes must be made to bank capital and liquidity regulations and to bank published accounts, as well as more and higher quality bank capital, with several times as much capital required to support “risky trading activity.”

The report also examines concerns regarding pro-cyclicality under the Basel II regime. It recommends the build up of counter-cyclical capital buffers in good economic times so that they can be drawn on in downturns, and reflected in published account estimates of future potential losses.

FSA also recommended that regulators take immediate action to ensure that the implementation of the current Basel II capital regime does not create unnecessary pro-cyclicality. This, said the U.K. government agency, can be achieved by using ‘through the cycle’ rather than ‘point in time’ measures of probabilities of default.

It also proposes a central role for much tighter regulation of liquidity and increased reporting requirements for unregulated financial institutions such as hedge funds, and regulator powers to extend capital regulation. The report also calls for the regulation of credit rating agencies to limit conflicts of interest and inappropriate application of rating techniques.

There is also a recommendation for major changes in the FSA’s supervisory approach, building on the existing Supervisory Enhancement Program (SEP), with a focus on business strategies and system wide risks, rather than internal processes and structures. 

For the securitization market, the report stated that the initial thought was that securitized credit intermediation would reduce risks for the whole banking system and credit losses would be less likely to create a banking system failure. However, this did not happen.

“When the crisis broke it became apparent that this diversification of risk holding had not actually been achieved — instead, most of the holdings of securitized credit and the vast majority of the losses which arose were not in the books of end investors intending to hold the assets to maturity but on the books of highly leveraged banks and bank-like institutions,” the report said. “Some banks were truly doing ‘originate and distribute’ but the trading operations of other banks (and sometimes of the same bank) were doing ‘acquire and arbitrage’. The new model left most of the risk still somewhere on the balance sheets of banks and bank-like institutions but in a much more complex and less transparent fashion.”

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