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FSA Calls for Big Hikes in Banks' Capital

The UK's banking sector watchdog said minimum capital requirements for banks should be much higher than the current ones to avoid a repetition of the financial crisis which has shaken the world over the past year and a half.

A report released Wednesday, written by FSA Chairman Adair Turner and requested by UK Prime Minister Gordon Brown at the height of the financial crisis, recommends sweeping changes to the regulation of bank capital, rating agencies, hedge funds and the FSA itself.

Despite highlighting the severity of the financial crisis by saying it was the worst for at least a century, Turner said that the recession would not be as bad as the downturn between 1929 and 1933.

Regulatory minimum capital should be "significantly" increased from the current Basel 2 regime, which requires banks to have a total capital ratio of 8 percent of risk weighted assets.

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This would make banks less profitable, but would equip them to weather storms such as the credit crunch, which has in the past 18 months caused the collapse of Wall Street giants Lehman Brothers and Bear Stearns, and triggered the full or partial nationalisation of five major British lenders.

"The future world of banking probably will and should be one of lower average return on equity but significantly lower risk to shareholders as well as to depositors," the FSA said.

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Sharon Lorimer

The report did not advance an optimum figure for minimum capital, acknowledging at the same time that raising the ratio to lower risk in the banking sector will also "tend to mean lower return on equity".

It also said capital buffers should be counter cyclical, with capital levels increasing in booms and decreasing in recessions to cut the dangers of instability in the banking system.

Capital allocated against key types of trading risk will also need to increase at least three times from current levels to make sure that the scale of proprietary risk taking will be reduced, the report said.

Excessive risk-taking, seen by many as the catalyst for the economic downturn, should be tackled by national and international action that quells risk-inducing remuneration policies, according to Turner.

The regulation of corporate liquidity should be covered by a central role.

Regulating the Regulators

Meanwhile, credit rating agencies, partly blamed for not spotting the banking crisis in advance, should be regulated, according to the report, to limit conflicts of interest and inappropriate rating techniques.

Hedge funds also came under the spotlight in the Turner report, which called for increased reporting requirements for unregulated financial institutions. It also said that “shadow banking” activities should be regulated on the basis of economic substance not legal form.

The FSA’s approach as a supervisory body should change its focus to business strategies and system-wide risks instead of internal processes and structures, Turner said.

And the European banking market should undergo major reforms to combine a new European regulatory authority and increased national powers to constrain risky cross-border activity, the report said.

- Watch CNBC’s interview with FSA Chairman Lord Turner above.

The report, which will likely be under intense discussion at the next summit meeting between leaders of the G20 countries in early April, also focused on the causes of the crisis.

Turner cites macro-economic imbalances, financial innovation of little social value and important deficiencies in key bank capital and liquidity regulations as the three key causes. These were exacerbated by too much faith in the notion of self-correcting markets, he said.

- Reuters contributed to this report.