Lord Turner recommends a major overhaul of bank supervision which, if implemented, could radically change capital and liquidity regulations

The UK's financial regulator, the Financial Services Authority (FSA), published a long awaited review into how regulators should supervise banks in light of the financial crisis.

Lord Turner, chairman of the FSA, was asked by the Chancellor of the Exchequer to review the events that led to the financial crisis and to recommend reforms.

The outcome is the Turner Review that identified three underlying causes of the crisis: macro-economic imbalances, financial innovation of ‘little social value’ and key deficiencies in capital and liquidity regulations.

These were underpinned by an exaggerated faith in rational and self-correcting markets, said the FSA.

The watchdog stressed the importance of regulation and supervision being based on a system-wide ‘macro-prudential’ approach rather than focussing solely on specific firms.

The review does not recommend specific action on product regulation in mortgage and wholesale CDS markets.

Lord Turner warned that the transition to higher bank capital would need to be managed carefully. 'UK banks are now capitalised at a level which will enable them to absorb severe stresses, and the short-term priority is to maintain bank lending to the real economy,' he said.

Dow Jones reported here that insurance companies could face greater global regulations following the UK proposals.

Key recommendations of the review include:

• Fundamental changes to bank capital and liquidity regulations and to bank published accounts;

• More and higher quality bank capital, with several times as much capital required to support risky trading activity;

“A global market economy remains the best means of delivering global prosperity.

Lord Turner

• Counter-cyclical capital buffers, building up in good economic times so that they can be drawn on in downturns, and reflected in published account estimates of future potential losses;

• A central role for much tighter regulation of liquidity;

• Regulation of "shadow banking" activities on the basis of economic substance not legal form: increased reporting requirements for unregulated financial institutions such as hedge funds, and regulator powers to extend capital regulation;

• Regulation of Credit Rating Agencies to limit conflicts of interest and inappropriate application of rating techniques;

• National and international action to ensure that remuneration policies are designed to discourage excessive risk-taking;

• Major changes in the FSA’s supervisory approach, building on the existing Supervisory Enhancement Programme (SEP), with a focus on business strategies and system wide risks, rather than internal processes and structures; and

• Major reforms in the regulation of the European banking market, combining a new European regulatory authority and increased national powers to constrain risky cross-border activity.

Lord Turner said: 'The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built, and in particular the theory of rational and self-correcting markets. Much financial innovation has proved of little value, and market discipline of individual bank strategies has often proved ineffective.’

He added: ‘A global market economy remains the best means of delivering global prosperity: it requires a global banking system focussed on serving the needs of businesses and households, not in taking risks for quick return. Major changes in regulation and in supervisory approach are required to deliver that. The approach has to build on a system-wide perspective: failure to look at the big picture was far more important to the origins of the crisis than any specific failures in supervising individual firms. And it must reflect the reality of a global financial system without a global government; we need both far more intense international cooperation and greater use of national powers.’

‘The changes recommended are profound, and the banking system of the future will be different from that of the last decade. The world’s economy will be better served as a result,’ he concluded.'