Monday, February 09, 2009

Larry Elliott, economics editor guardian.co.uk,
Monday 9 February 2009 13.33 GMT
The greatest financial crisis in the post-war era has left the banking system in a weakened state despite last autumn's efforts to prevent a systemic collapse, the City's watchdog said today.

In its annual risk assessment, the Financial Services Authority said major reform of regulation and supervision was required to reduce the "probability and severity" of severe disruptions.

The FSA wants banks to set aside more capital during upswings to put a brake on lending in a boom. The regulator is also calling for new rules on liquidity to ensure firms can better ride out problems. It believes regulators should widen the net to include stricter supervision of private equity firms and hedge funds when they have the potential to cause systemic disruption to the financial system.

Lord Turner, the chairman of the FSA, admitted mistakes had been made as a cocktail of six interlocking factors had led to the crisis that began in mid-2007, but said the action taken by policymakers would prevent recession turning into a 1930s-style slump.

"I have always believed that while we are not able to avoid a recession, we do have the tools available to make sure the recession is not endlessly self-reinforcing," Turner said.

The report highlighted the risk that banks would lack the credit to keep the economy going – even after the money poured into them by the government. "A major process of deleveraging is now in hand with potentially deflationary effects.

"Without effective policy responses, the banking system and the real economy are in danger of being caught in a self-reinforcing cycle, where constrained lending leads to falling property prices, troubled corporates and credit losses which further impairs banks' ability to lend."

The FSA's Financial Risk Outlook said the six factors that caused the crisis were a rapid extension of credit and falling credit standards; a property boom; an under-estimation of bank and market liquidity risk; the increased complexity of the securitised credit market; increased leverage in the banking and shadow banking system; and a self-reinforcing cycle of irrational exuberance.

Matters came to a head last autumn, the FSA said, when the bankruptcy of Lehman Brothers brought the entire financial system to the point of collapse. "In hindsight, it had become apparent that by mid-October 2008 the fall of confidence in the core banking system was more severe than any since the Great Depression of the 1930s."

It added the rescue package announced by the government had stabilised the situation, largely halting runs on banks and leading to a narrowing of spreads in the credit and interbank markets, "however, the banking system is still in a weakened state and the wider financial system is under significant strain".

Turner said he would cover pay and bonuses at banks in a review for Alistair Darling due by the end of next month. He said, however, the FSA was less concerned about the level of bonuses than whether their structure encouraged excessively risky behaviour. The government, he added, had a "legitimate right and duty" to have a view on pay at the banks where it was a major shareholder, but it was not an issue on which the FSA was focused.

The FSA said it would need to co-operate more effectively with the Bank of England to identify the build-up of risks to the financial system so that pre-emptive action could be taken. It said an average of the forecasts by outside economists suggested the UK would contract by 2.2% this year, but that the risks for developed countries were "on the downside". Turner said that, in the past three or four months, the consensus had moved "in a more negative direction".

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