Turner – financial industry was 'mugged' by recession

BRITAIN's financial regulator told business chiefs yesterday that it was no longer right to believe financial markets would always behave rationally, or that all banking innovation was good for the sake of it.

Lord Turner, chairman of the Financial Services Authority, admitted the industry had become over-confident and had been "mugged" by the recession.

He told the CBI's annual conference: "Prices … can at times be subject to momentum and herd effects, which can cause economic harm and which can provide poor information on which management or regulators might seek to make decisions."

He added: "Markets are not always wise."

In future, he said, there had to be a bias towards regulatory conservatism "whenever we are worried about risk and whenever the real value of the (financial services activity] is unclear".

Turner said a debate about the economic value of the financial system should focus on the positive functions that banks and other financial institutions should perform in the economy – such as linking savers to productive investment, and allocating capital to efficient use.

He said there was a general feeling in the country that we had an independent central bank monitoring low and stable inflation. It became conventional wisdom that efficient financial markets would provide effective discipline, Turner said.

As such, a mistaken belief had developed by early 2007 "that the fundamental problems of economic management had been solved".

"Over the last two years, that confidence has been mugged by a new reality – a huge economic setback, across the world and particularly in the UK," he said.

Turner, a former director-general of the CBI, told delegates that the past two years had shown that over-risky innovation in complex financial products could cause harm, as well as large banker bonuses.

And, unlike in other industries, such as fashion, the arts or the media, banking's exotic products were part of "the plumbing of the economy, but a very complex plumbing, and if we get it wrong, potentially explosive", he said.

Turner said the FSA, along with regulators and central banks around the world, had got it wrong before the crash in assuming financial innovation was always a beneficial thing.

He admitted it "was almost part of our DNA", and adversely affected the approach of financial regulators and central banks in their setting of capital requirements on trading activities.

As a result, he agreed with CBI director general Richard Lambert's weekend comment that "financial engineering is yesterday's story". Turner added: "Certainly it should be."

The CBI published a paper yesterday saying that companies should adopt a more cautious approach to business even if it means accepting lower profits.

A poll it had carried out showed the credit crunch had made firms more risk averse.