Banking rules are not strong enough, warns FSA's chairman

Adair Turner also calls for a greater focus on risks of the 'shadow banking' system

The much-trumpeted reforms to international banking regulations are not enough to ensure financial stability, the chairman of the Financial Services Authority (FSA) said last night.

The head of the soon-to-be-dismantled financial watchdog said that in an ideal world Basel III would have required banks to have core capital of 15 - 20 per cent, rather than the 7 per cent it specifies, but regulators have had to keep clear of rules that might slow down the economic recovery.

In the same vein, Lord Turner added that while it was desirable to deal with banks that were too big to fail by making sure that there were ways to impose losses on debt holders, current plans were not "sufficient to address risks of systemic instability".

Moreover, he said rulemakers needed to take a closer look at the risks attached to the so-called "shadow banking" system populated by hedge funds. Fixating on traditional banks alone would leave the door open for another crisis, he said in a speech at City University's Cass Business School.

"The pre-crisis delusion was that the financial crisis, subject to the then-defined rules, had an inherent tendency towards efficient and stable risk dispersion," he said. "The temptation post-crisis is to imagine that if we can only discover and correct the crucial imperfections – the bad incentives and structures – a permanent, more stable financial system can then be achieved.

"It cannot, because financial instability is driven by human myopia and imperfect rationality as well as by poor incentives, and because any financial system will mutate to create new risks in the face of any finite and permanent set of rules," he added.

The FSA chairman's comments come less than a week after Axel Weber, the European Central Bank member and the head of Germany's Bundesbank, highlighted the need to deal with the wider financial system, not just banks. "We need to shine some light into the shadow banking system," Mr Weber told students at University College London.

"Basel III and special rules for systemically important institutions are certainly important instruments in safeguarding the stability of the financial system," Mr Weber said. "However, the best dyke is of little use when there is a whole ocean at our back."

Speaking last night, Lord Turner added his voice for greater attention on the farther reaches of the financial sector. "Since the crisis, global regulators have focused primarily on capital and liquidity requirements for banks, both in general... and for big banks in particular," Lord Turner said. "But the initial year of the crisis, 2007 to 2008, it did not seem like a familiar banking crisis, but something entirely new, a crisis of 'shadow banking'."

When it comes to the traditional banks that are too big to fail, Lord Turner said it was important to ensure that were mechanisms were in place to ensure that authorities can impose losses on all debt holders so that problematic institutions may be recapitalised without resorting to taxpayer support. Equally, it was important to ensure that the banks themselves can absorb losses.

But such measures alone cannot provide protection against the sort of systemic meltdown seen during the dark days of the recent crisis. Other steps, such as equity surcharges on the biggest banks, should be pursued, he argued. The possible break-up of the biggest banks – the pros and cons of which are being looked into by the Independent Commission on Banking – should also be considered, Lord Turner said. "For the UK, with major banks which are very large relative to our GDP, a key policy objective for this year is to ensure that Financial Stability Board decisions on systemically important financial institutions result in higher-than-Basel III equity requirements for most systemically important banks."

He added it was important to keep a closer tab on the industry to ensure rules keep pace with systemic shifts.