Make banking boring to avoid boom and bust

Banks will have to hold more liquid assets, return to raising funds from private savers and rely less on instant-access accounts, under a new regulatory regime to be revealed on Wednesday by Lord Tur-ner, chairman of the Financial Services Authority.

In future, lenders will be forced to build up capital during boom years to provide a cushion against crises such as the current credit crunch. There will be curbs on banks gambling their own money to trade in complex investments and on unsustainable expansion during booms.

Lord Turner describes his wide-ranging reforms as "profound". They cover regulation of banks that are "too big to fail" as well as hedge funds, bankers' pay and the use of credit-rating agencies – plus the FSA's own deficiencies.

It is the second time the regulator has been allowed to put its own house in order even though some critics see it as part of the problem and believe it should be split or replaced.

Sir James Sassoon, a former investment banker who was a managing director at the Treasury and Gordon Brown's special representative until last year, presented his own regulatory reforms to the Conservative Party last week, claiming the FSA must share the blame for the financial crisis.

"The FSA's conduct of the micro-prudential regime was weak in the period prior to 2007," claims Sir James.

The regulator admitted mistakes after Northern Rock collapsed and has retrained staff and recruited new regulators. But while Lord Turner, who only joined the FSA in September, will this week outline the causes of the crisis, he claims better regulation of Northern Rock would have made only a small difference to the global crisis that ensued.

According to Lord Turner: "The far bigger failure – shared by bankers, regulators, central banks, finance ministers and academics across the world – was in failing to identify that the whole system was fraught with market-wide systemic risk."

His main analysis of the crisis, the lessons learnt and action already taken, plus his proposed remedies, will be accompanied by a series of consultative documents dealing with specific areas of regulation. However, many of his reforms will require international co-operation because Lord Tur-ner blames US banks and regulation for the global problem.

Securitisation and the "originate and distribute" system of selling loans caused the crisis because it lacks transparency and can leave risk with the bank that sold the loans, says Lord Turner. But he does not advocate ending this practice, nor does he favour splitting investment banking from "narrow" banking – accepting deposits and issuing loans.

Lord Turner accepts that the FSA must in future look at the big picture as well as monitor individual banks. The regulator must stop acting as an auditor that checks the books and should question a bank's business model and restrain lenders from growing too quickly, moving into unknown areas or relying too much on particular sources of funds.

Rather than return banking supervision to the Bank of England, which lost that role when the FSA was established in 1997, Lord Turner believes in greater co-operation between the two institutions, even if the City regulator overlaps the Bank's monitoring of financial stability.

The reforms will mean greater monitoring of liquidity and capital to ensure that banks meet their obligations, even in tough times. "We need to ensure the regulation of liquidity is recognised as being at least as important as capital adequacy," he says. "The new regime will result in major changes in the overall banking system, with banks holding more liquid assets and a greater proportion of those assets held in government securities – an incentive for banks to encourage more retail time deposits and less instant-access, less reliance on short-term wholesale funding."

That, he adds, will curb rapid and unsustainable expansion of lending during economic booms.

All big banks will be given their own liquidity assessment and told what buffer they must hold. He believes the crisis was exacerbated by investments that the banks had claimed could be sold instantly, but which turned out to be illiquid when the crisis came.

All lenders will also be required to build up capital reserves during booms to well above minimum levels, so write-offs can be absorbed when markets turn without seeking new capital from shareholders or the Government. Forcing banks to hold excess capital will restrain their ability to grow rapidly.

UK banks fear unilateral action by the FSA will give Britain tighter rules than other countries. Lord Turner accepts a new regime must, ideally, be agreed internationally and is lobbying the Basel Committee on Banking Supervision, the Swiss body that sets capital adequacy rules, to make changes.

In particular, he wants to persuade the committee to impose much tougher rules on proprietary trading – banks using their own funds to deal in shares, bonds or other assets. These have resulted in major losses, either from rogue traders or from toxic assets such as sub-prime mortgage bonds.

Lord Turner does not intend banning such activity, but proposes that banks back up such trading with three or more times the current capital. That, and a requirement for the City's 2,000 proprietary traders to pass fit-and-proper tests for the first time, is expected to result in a dramatic fall in the level of own-book trading.

According to Lord Turner: "The level of capital required against trading books has been simply too low relative to the risks being taken."

He also has tough proposals for hedge funds, often based abroad and providing insufficient information on their activities. They are currently regulated as fund managers but Lord Turner believes that if they act like banks, they should be treated like banks. Although hedge funds are relatively small, he claims their collective action can affect markets. Their rapid sale of assets to repay debt last autumn exacerbated financial instability.

Lord Turner will also consider monitoring of banks doing business in many countries, and the possibility of global regulation. The failure of Icelandic banks operating in the UK means the FSA should rely less on foreign banks' home regulators. And although the big credit-ratings agencies are US-based and outside Lord Tur-ner's remit, he will tell investors to rely less on their assessments.

He also has views on accounting standards, including whether auditors should comment on how banks would cope with future downturns and whether investments should be marked to market values.

The FSA chairman will also say that bankers' pay and bonuses should be based on long-term performance with no incentive to take undue risks.

THE OPPOSITION'S REMEDY

The FSA fell short in 'pursuing its mandate'

The Conservative Party tried to steal Lord Turner's thunder with a review of regulation last week by former senior Treasury official Sir James Sassoon (pictured). The ex-banker criticised the handling of the financial crisis by the tripartite authorities – the Treasury, Bank of England and the FSA – but reserved his greatest criticism for the financial regulator.

"The FSA did not adequately pursue its existing prudential mandate, partly due to an excess focus on conduct of business regulation at the expense of prudential regulation," claimed Sir James.

His report contains 40 recommendations but many are merely to consider subjects further. He suggests a review of whether the FSA should lose its role of improving consumer awareness and give the Treasury its responsibilities on financial crime. He also suggests further debate about the FSA – "or its successor" – retreating to its core operations, being split into separate regulatory bodies for specific activities, or giving the Bank greater responsibility for bank regulation.

He calls for more study on splitting "narrow" banking from investment banks and regulating unregulated "shadow" banks. He concedes that breaking up the FSA could create short-term problems and admits: "There remains much work and consultation to flesh out key areas of my recommendations."

Sir James joined the Treasury from Warburg in 2002 and for three years was the senior official responsible for UK financial services. Although the Bank and FSA helped him produce his report, the Treasury refused to co-operate.

George Osborne, the shadow Chancellor, said he would "carefully consider" Sir James's report but did not commit the party to any policy, saying: "The regime needs a radical overhaul, and this report sets out the options that we need to consider."