However, the Chancellor told lenders those engaging in the most risky activities would face a regulatory "tax" that would force them to set aside more cash to cover any future losses. Those paying bonuses deemed to encourage risky short-term speculation could face sanctions, he added.
The Financial Services Authority (FSA) will incorporate a new code of practice on executive remuneration into its rule book and publish an annual report on banks' pay practices. This will give the City regulator the scope to publicly name and shame miscreants, and impose financial penalties on them.
The code includes a requirement that financial institutions must "establish, implement and maintain remuneration policies procedures and practices that promote effective risk management". But Mr Darling said suggestions that banks should have limits placed on their size were "simplistic", and pointed out that the failure of smaller institutions such as Northern Rock could present as big a threat to the country's financial stability as the failures of its larger lenders.
He also dismissed calls for deposit-taking retail banks to be separated from investment banks, saying that both types of business had failed during the credit crisis. However, he did concede that Britain needed banks and other financial institutions that were "better managed", saying: "We need a change of culture in the banks and their boardrooms, with pay practices that are focused on long-term stability, and not on short-term profit.
"The FSA now has powers to penalise banks if their pay policies create unnecessary risks and are not focused on the long-term strength of their institutions."
With its new powers, which also include the ability to limit the amount banks can borrow, the FSA appears to have won its unprecedented turf war with the Bank of England. The old "tripartite" supervision arrangements which brought together the Bank, the FSA and the Treasury, will be beefed up through the creation of a new Council for Financial Stability, chaired by the Treasury. The Bank will now have a statutory objective to protect the stability of the financial system, as well as a dedicated committee for financial stability.
Speaking at a hearing of the Treasury Select Committee, City minister Lord Myners said of the new council: "I think it elevates the responsibilies of the FSA. It gives the Bank of England a new forum for articulating their concerns. The bank has a new platform, which draws on its core competences in evaluating macro-economic risks."
Mr Myners and Mr Darling both defended the bringing together of the three bodies, which critics argue has led to confusion and turf wars. Both ministers insisted the structure was "a good one".
The Government also outlined plans for a new agency that will work to improve consumer education, paid for by a levy on banks.
Investors in the big high-street lenders reacted poorly to Mr Darling's plans. Royal Bank of Scotland's shares closed down 1.66p at 35.65p, Lloyds Banking Group lost 2.29p to close at 63.71p and Barclays finished on 287p, a fall of 9p. The more internationally focused HSBC was down 9.7p at 493p.
However, commentators said the reforms did not go far enough. Simon Morris, a partner at City law firm CMS Cameron McKenna, said: "This is a wholly inadequate response to the challenge facing the industry. Darling's announcement of a Council for Financial Stability is old wine in a new skin, merely another way of expressing the existing tripartite authority which has not delivered the stability that is needed. Little detail was given on how macro-prudential regulation is to work, or who will be in charge. This leaves the damaging FSA versus Bank turf war in full flow."
The banking workers' union Unite called for a public interest representation on the boards of banks to be included in the Government's vaguely defined proposals to improve management and strengthen non-executive directors. Rob MacGregor, the union's national officer, said: "Without public interest representation, we will simply maintain the risky business models and poor supervision of the past which lack the transparency that is essential and which the Government is apparently now demanding."
Banking reform: The key questions
What are the main points in today's white paper?
A new council will be created, bringing together the Financial Services Authority, Treasury and the Bank of England to ensure financial stability. The FSA will have the power to impose a regulatory "tax" on banks that take too many risks. A code of conduct on bankers' pay will also be put into place and enforced with possible sanctions for those that break it. Banks pay policies will be subject to an FSA annual report. A new agency will be created to improve consumer education paid for by the banks. The financial compensation scheme will be strengthened and there will be new insolvency rules to allow orderly wind ups of bad banks.
What does this mean for consumers?
Probably not much. Most banks are being very cautious about lending in the current climate. Arguably, the economy could do with them taking more risks: one thing that could stifle recovery is that it is still hard for companies and consumers to get credit. The problem with banking crises is that new rules are always designed to address previous disasters rather than preventing new ones.
What does this mean for the City of london?
It could have been worse. Banks will privately grouse about having to put more cash aside if they take too many risks, but the Chancellor has stopped short of doing anything really radical, such as imposing caps on executive pay packages, limiting the size of banks or enforcing a separation of investment banks and retail lenders.
Will the measure on pay have any effect?
There will be a code of practice on pay and the FSA will be able to sanctions banks that flout it. Its views on their behaviour will be published in an annual report. However, banks will argue that they need to retain top talent and doing this means paying top dollar. If bonuses have to fall, basic pay packages will very probably rise, and by quite a lot.
Who has won in the Turf War between the Bank of England and FSA?
The FSA looks to have come out best. Its new power to force banks to set aside more cash and punish those whose pay policies break the rules give it sharper teeth. The Bank of England has been thrown some crumbs: its role has apparently been "enhanced" but ultimately its claws have not been sharpened to anything like the extent of the FSA's. The latter's apparent victory may be short-lived, however.
What does this mean politically?
Getting what will inevitably be complex and tricky legislation (it always is if it involves banking) on to the statute book before the next general election is a big ask. The Tories have their own ideas and will, in any case, sweep much of the legislation away if they come to power next year. They have already said they want to see a much bigger role for the Bank of England.
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