City watchdog warns of 'intensive supervision' under new changes

The City watchdog today said banks would face "intensive supervision" as it outlined fundamental changes to the way it regulates the financial sector.

In his report on the future of the Financial Services Authority (FSA), the regulator's new chairman Lord Turner recommended a more intrusive approach, including new rules to control banks' pay policies and the level of capital firms keep in store to mitigate risky behaviour.

Lord Turner, who said there had been "a failure to design regulatory tools to respond to systematic risks", said previous policies had created incentives for some executives and traders to take excessive risks and resulted in large payments in reward for activities which seemed profit making at the time "but subsequently proved harmful to the institution, and in some cases to the entire system".

He proposed forcing key firms to adhere to a new code of conduct on pay by making it an FSA rule to do so.

The watchdog would also be able to increase the amount of capital firms were required to have to compensate for non-adherence to the code.

Lord Turner analysed the "crucial failures" of the FSA and Bank of England to properly assess the risks in the run-up to the financial crisis.

He said "vital" analysis of the potential implications of trends in the financial sector on wider economic stability "fell between two stools" as neither organisation was focused on the issue.

Lord Turner also mooted the idea of a cap on the level of loan-to-value rates for mortgages, noting the rise in loans worth 100 per cent of property prices.

He said homeowners and lenders assumed house prices would continue their upward trajectory in the years preceding the crisis and an increasing number of mortgages had very high loan-to-value ratios.

And, in a sign that the entire structure of UK economic regulation could be torn up and rearranged, the report raised the possibility of the Bank being the "ultimate arbiter" of judgments over economic risk, with the FSA choosing which levels to pull to reduce the danger.

The watchdog will require firms to have much higher and better quality capital bases to fall back on in tough times, with a risky trading necessitating "several times as much capital".

Bank liquidity would also be much more tightly regulated as the FSA aims to avoid a repeat of the credit crunch which left financial institutions without ready funding.

There would also be more stringent controls on so-called "shadow banking", with unregulated firms like hedge funds required to increase reporting on their activities.

The FSA said its new approach to regulation would "significantly reduce" the likelihood of institutions collapsing and would limit difficulties in lending to the wider economy if banks found themselves in difficulty.

"But the probability of bank failure cannot be reduced to zero," the report said.

The report said the FSA's involvement in analysing bank's balance sheets in the last six months had disclosed "significant" differences in the way companies recorded similar assets on their books.

As a result a new, more in-depth, approach to firms' accounting practices was also in the pipeline, with a potential change in the watchdog's legal powers.

The report raised the possibility of a giant Europe-wide body to regulate banks within the European Union, adding that the current situation, in which regulation and crisis management were on a national basis, was "inadequate and unsustainable for the future".

It said the failure of Landsbanki showed that depositors and taxpayers had been subjected to "unacceptable risks".