Turner's revolution: FSA chairman reveals his plans

Lord Turner believes his review of banking regulation will prove radical. His call for a Europe-wide regulator will certainly ruffle feathers, says Sean Farrell

So was it worth the wait? Lord Turner had promised that his review of financial services would amount to a "revolution" in regulation. After five months in the making, the report from the chairman of the Financial Services Authority held few revelations because Lord Turner and his chief executive, Hector Sants, had trailed many of the ideas in recent speeches.

The review is essentially a forensic analysis of what went wrong in the banking system in the last decade and rubbishes many of the ideas that dominated, or stifled, debate during that time.

The main surprise was Lord Turner's call for a European super regulator, an idea that the UK has resisted for many years to prevent any undermining of Britain's position as a hub for financial services.

He recommended the creation of a new European institution bringing together three existing committees to act as a standard setter and coordinator of supervision. At the same time, he called for stronger national powers to restrict the growth of retail deposit-taking branches.

After the collapse of Icesave, the FSA boss also said there may be a need for Europe-wide deposit insurance to cope with big banks from small countries that have branches in other jurisdictions.

Lord Turner says he is trying to bridge two extreme models to cope with international banking in Europe – that foreign branches should become fully capitalised subsidiaries or that there should be a federal system.

Simon Gleeson, a partner at the law firm Clifford Chance, said: "They have done a 180 degree turn on European regulation. They seem to be saying if we don't get a single regulator we are going to stop EU banks passporting into London. That may be why Lord Turner was describing the report as being revolutionary."

Mr Gleeson said the FSA might feel confident enough in calling for an overarching European watchdog because it has more employees than all the other regulators in Europe put together.

But Peter Snowdon, a partner at Norton Rose, said there were dangers in that assumption because if the combined regulator was based in Paris, the French would be willing to fund it generously to create "a centre of gravity to draw things into Paris".

The big problems were in the banking system, which relied for profits on the trading and creation of structured credit instruments – bonds backed by loans such as mortgages and repackaged into unfathomable "products".

Banks were able to carry out this activity with increasingly thin capital buffers against future losses, while regulators let them get on with it, trusting management and the market to stop things getting out of hand. At the same time, individuals were also "leveraging" themselves up by using the credit created by the banks to buy houses and consumer goods.

Lord Turner pointed out that the increasing reliance of commercial banks, such as Royal Bank of Scotland, on trading profits meant that when capital markets froze, confidence in the core banking system – which serves the real economy – was undermined. He was scathing about the growth of trading and "financial innovation", which he warned served little social purpose. But he stopped short of calling for a renewed split between commercial banking and "casino" investment banking. He argued that a securities business is an important service for commercial banking clients, that investment banks are part of the wider system, and that "narrow" banks such as Northern Rock have imploded.

Instead, he proposed increasing the amount of capital banks have to hold against proprietary trading, making it less attractive, and a regulatory clamp-down on risky activities. There will be a "gross leverage ratio" limiting bank lending relative to capital, and a "core funding ratio" to stop banks relying too much on short-term funds for their lending as Northern Rock did.

"We need to be able to apply discretion to say, 'What you are doing is far too risky and if you keep doing it we will apply very expensive capital or liquidity requirements to stop you doing it'," Lord Turner added.

The review suggests that the outcome may end up being a split between the two forms of banking.

"Faced with the new regime, an increased number of banks are likely voluntarily to pursue strategies which are primarily focused on classic commercial and retail banking activity," the report said.

Lord Turner believes his reforms will make banks less profitable but also less risky. He denied that his plans will make UK banks or London's position as a financial centre less competitive because other countries are heading in the same direction.

"There is a very strong determination across the world not to fall into the trap of trying to gain minor competitive advantages by making regulation a little bit lighter [than in other countries]," he said.

This was what the UK was accused of doing in adopting regulation that gave lots of freedom to companies to operate as they saw fit within "principles". Lord Turner now uses the phrase "light touch" – rejected by the FSA at the time – to describe the old approach.

Having said that he would consider regulating banking products, with possible limits on mortgage lending, Lord Turner instead left the question open. While doing so could stop reckless lending and borrowing, it would also favour borrowers who could get a deposit from their families, he said.

The FSA chairman, who took over in September, said the regulator had found a wide discrepancy between how different banks account for similar assets. It will take a tougher stance on how they account for banks and their auditors treat these assets and will call "outliers" to account.

John Liver, regulatory and risk management partner at Ernst & Young, said: "The FSA's proposals mark a watershed in regulatory philosophy, policy and approach. Banks face a much more intrusive and challenging future supervisory regime."

Fat cats under fire: Targeting excessive pay

The Financial Services Authority had always insisted that bankers' pay was none of its concern. But last year pressure built for change as people realised that massive short-term rewards had encouraged bankers, from the boardroom to the trading floor, to take excessive risk.

Lord Turner says the watchdog now intends to clamp down on pay to make sure rewards do not encourage too much risk-taking. The FSA wants more of a bonus to be deferred, even for cash bonuses, with a "clawback" if the payout proves unwarranted.

Banks have argued strongly against this measure, saying that it is too complex and legally difficult, but the FSA says it and other regulators are pressing for the reform.

Lord Turner also argues that paying people with more stock instead of cash over longer periods will help to keep risky business in check. But he pointed out that employees of Lehman Brothers, which went bust in September, had lots of long-term stock options. Hence the need for other measures to limit risk.

"Business leaders believe their own stories; traders are swept up in irrational exuberance," Lord Turner said.