FSA chairman pulls back from direct regulation of City pay

Three-pronged approach to reform of banking rules

A new capital adequacy regime for banks, a fresh approach to regulating liquidity, and much greater supervision of "shadow" off-balance sheet banking was promised yesterday by Lord Turner, chairman of the Financial Services Authority.

Lord Turner is due to publish a Government-commissioned review of City supervision in March.

But the FSA chairman appeared to retreat from suggestions that City bonuses might be directly regulated.

Instead, he suggests taming City excess by making the capital requirements for risky proprietory trading much more onerous than for plain vanilla banking.

In a wide-ranging interview with The Independent, Lord Turner said the banking system had been stabilised through the package of measures taken by the Government, the FSA and the Bank of England since last October. The next policy challenge was to make sure the banks were healthy enough to support economic activity, and to reform the system of regulation.

Lord Turner would not rule out the possibility that the crisis could yet end in nationalisation of one or more of the major banks, but for now he believes it unnecessary. The insurance scheme for bad debts unveiled by the Government last week ought to be sufficient in underpinning confidence in bank balance sheets, Lord Turner said.

He also in effect ruled out any enforced separation of commercial banking from investment banking, such as used to exist in the United States under the Glass-Steagall Act before deregulation. He believes modern banking is too complex to allow for such simplistic separation of functions.

"The single most important thing we have to get right," Lord Turner insisted, "is reform of the capital adequacy regime. If we can get this right, then many of the necessary changes in banking will follow." Lord Turner also promised reform of the rules on mark-to-market accounting. "We have to decide when these rules are appropriate and when not, because plainly they played a role in the crisis," he said.

The FSA chairman said that although City pay structures had played a major role in the crisis, he was not sure direct regulation was the right approach. There is "a clear-cut danger in the financial system, where you have a load of assets held on bank balance sheets and accounted for on mark-to-market bases." He added: "As the process of irrational exuberance sets in, the price of those assets can go to unreasonably high levels, generating what are in a sense illusory profits and very large bonuses to the people involved in the process. This in turn makes bankers think they should do even more of what they have just done."

Lord Turner said the question was on how it was appropriate to intervene.

"Very high leverage is clearly a problem which needs to be offset with significantly higher capital requirements for trading books. But we may need to intervene to change the bonus culture and make remuneration within trading activities dependent on return over a long period of time.

"If I had to rank them, the things to do with leverage and capital adequacy are more important than those to do with the structure of bonuses."

Lord Turner regards an international supervisory authority to oversee global financial markets as unlikely for the foreseeable future: "You cannot have global regulation without a global central bank and a global government with fiscal resources.

"If things go wrong, the resources that rescue banks are national central banks and governments with tax and borrowing powers. If that is the case, no sovereign government on the hook to bail out its banks is ever going to hand supervision to a global body."

However, Lord Turner does think there could eventually be a role for a treaty-based organisation, similar to that played by the World Trade Organisation in governing global trade.

"But it will take a long time, and, in terms of the immediate regulatory response, we have to do it through the architecture we have already got of overlapping international forums. We must work through these to get sufficient consensus to sign up to common standards. It's an imperfect system.

"If you are trying to run a global economy without a global government, the only way is through the scrappy, difficult process of creating global governance and standards that everyone can sign up to," he said.