In the long-awaited Turner Review of global banking regulation, published today, the regulator recommended that banks should build up capital buffers as a move towards countercyclicality. The size of the buffer would be calculated either on a discretionary basis by regulators or through a formula-driven system in which the required level of capital would vary according to a pre-defined metric.
"The FSA believes that there is merit in making the regime at least to a significant extent formula driven," Turner wrote. While leaving the decision up to the regulator would allow them to include system-wide risks in the calculation, using a pre-determined formula based on the bank's own accounts "would provide a preset discipline not dependent on judgement and not subject to the influence of lobbying". Regulators should still be able to apply surcharges to represent systemic risk, he added. The result of the reform would be either a varying capital charge from between 4% to 7% core Tier 1 capital, or a capital buffer built up in good times and drawn on during downturns.
Turner continued that fundamental changes were needed to bank capital and liquidity regulations and banks should hold at least three times more capital against risk in the trading book.
"The banking system of the future should operate with more and higher quality capital, reducing its vulnerability to shocks," said Turner today. "We need to make the banking system a shock absorber in the economy, not a shock amplifier. That requires actions to ensure that the introduction of the Basel II capital adequacy regime does not introduce unnecessary procyclicality."
The risk-based capital rules of Basel II have been criticised for encouraging banks to increase lending and run down capital in good times, meaning they then hoard capital in a downturn, potentially aggravating the economic cycle.
Value-at-risk calculations can have the same effect, Turner wrote: "Systemic risk may be highest when measured risk is lowest, since low measured risk encourages behaviour which creates increased systemic risks...According to VAR measures, risk was low in spring 2007: in fact the system was fraught with huge systemic risk."
Market observers have welcomed the focus on introducing countercyclical measures into the capital adequacy framework. "The focus on reducing procyclicality in the system and enhancing macro-prudential analysis going forward is to be strongly welcomed," said Patricia Jackson, head of prudential advisory at Ernst & Young.
The Turner Review also put its weight behind European Union (EU) moves towards central clearing of credit-default swaps (CDS) and suggested tighter regulation of credit rating agencies.
"Poor credit ratings and poor use of credit ratings played an important role in the crisis," said Turner. "We must regulate credit rating agencies to ensure rigorous analytical independence, and ensure that they only rate instruments simple enough and with enough historic record to make consistent rating possible."
The FSA said it supports legislation being formulated by the EU to enforce better governance and conduct of rating agencies. If it passes through the EU institutions at first reading, that legislation could enter into force later this year.