UK FSA Says that We have Crossed the Financial Regulatory Rubicon

As the legislative overhaul of the regulation of the financial markers looms, there is a growing consensus that the global financial system has crossed the Rubicon and there will be no return to the world of Glass-Steagall separation of securities and banking activities and the days of originate and hold before securitization.

While acknowledging the theoretical clarity of this model, the FSA Turner report on reform said that it would be difficult for any one country to pursue a clear separation while other countries did not, and there is unlikely to be an agreement on an appropriate division, given the very different historic traditions in the US and Europe. Moreover, it is not clear that in its extreme and simple form, it is practical in today’s complex global economy. Thus, large complex financial institutions spanning a wide range of activities are likely to remain a feature of the world’s financial system.

In the US, the Glass Steagall Act drew a clear regulatory distinction between commercial and investment banking, which survived until dismantled through legislative changes in the 1990s. But in most of continental Europe, there was no such distinction, and universal banks were involved in securities related activities. Moreover, the era of almost complete separation between banking and securities activities was also an era of fixed exchange rates and exchange controls, with far more limited capital flows and trade flows as a percentage of GDP, and a much smaller role played by cross-border corporations.

Serving the financial needs of today’s complex globally interconnected economy, which let us not forget has, over the long term, delivered rising prosperity, said the FSA, requires the existence of large complex financial institutions providing financial risk management products which can only be delivered off the platform of extensive market making activities, which inevitably involve at least some position taking.

Moreover, said the report, if more effectively regulated and supervised, securitization can provide the advantages of lower cost and lower risk. Thus, the optimal financial
system for the future probably will include a significant role for securitized credit.

The FSA said that this approach is broadly in line with that put forward in the Group of 30 Report authored by a committee chaired by Paul Volcker, which seeks to constrain risk taking within large integrated financial institutions, rather than require a disintegration into separate institutions.