The UK's Financial Services Authority has taken a significant step in seeking to lead the international debate on the future architecture and standards for the global financial regulatory system with the recently published Turner Review: a regulatory response to the global banking crisis. Given the politically charged nature of the issue, it remains to be seen whether the FSA's proposals will attract global consensus.

The Review, produced by the Chairman of the FSA at the behest of the Prime Minister, outlines the circumstances which led to the financial crisis and proposes ways to try to fix the problems and prevent them from happening again. Of course, regulators have a very difficult job on their hands. Faced with domestic political pressure to take a hard line on financial institutions, they must not lose sight of the value of a successful financial services sector to the economy as a whole. In the UK, the FSA is charged with the objectives of maintaining market confidence and protecting consumers. However, it is also required by law to have regard to the desirability of facilitating innovation in financial services, maintaining the UK's competitive position and facilitating competition between the institutions it regulates.

The Review proposes to tackle the weaknesses seemingly without prejudicing the UK's position within the international financial system, although it leaves open the possibility of further UK specific legislation on certain issues, such as the introduction of product regulations limiting retail mortgage loan-to-value or loan-to-income ratios. Turner has focused primarily on issues which have been under discussion at an international level for some time and concerned himself very much with prudential regulation and supervisory architecture. Many of the recommendations will only be feasible or successful if adopted on a global basis and so, it is hoped, they should not have a disproportionate effect on the future competitiveness of the UK's financial services sector relative to other countries.

The Review's recommendations are comprehensive and ambitious. They include:

  • Fundamental changes to bank capital and liquidity regulations. The overall quantity and quality of bank capital will be increased, with increased capital requirements for bank trading book activities;
  • Counter-cyclical capital buffers, building up in good economic times so that they can be drawn on in downturns;
  • Avoiding procyclicality in Basel II—effectively, seeking to avoid a situation where bank capital requirements help exacerbate the economic climate;
  • Introducing a gross leverage ratio backstop—basically to limit excessive growth in absolute balance sheet size;
  • Regulation of non-banks on the basis of economic substance;
  • Increased reporting requirements for hedge funds;
  • Offshore financial centers to be covered by international standards;
  • Some regulation of Credit Rating Agencies. Agencies should be subject to registration and supervision to ensure good governance and management of conflicts of interest. Credit ratings should only be applied to securities for which a consistent rating is possible and the use of structured finance ratings in Basel II should be reconsidered;
  • National and international action on remuneration policies. Remuneration policies should be designed to avoid incentives for undue risk-taking and risk management considerations should be closely integrated into remuneration decisions. The FSA supplemented the Turner proposals by simultaneously issuing a consultation paper and draft Code on remuneration applying to larger UK financial institutions;
  • Changes in the FSA's supervisory approach, focusing on business strategies and system-wide risks rather than primarily on systems and processes;
  • Reforms in the regulation of the European banking market, with a new independent European regulatory supervisory authority to replace the current Lamfalussy Committees;
  • Increased national powers to constrain risky cross-border activity and reforms to European deposit insurance rules to ensure the existence of pre-funded resources to support deposits in the event of a bank failure.  

Inevitably, there will be some horse-trading if the proposals, or anything like them, are to be adopted internationally. Particular areas to watch include any future European regulatory supervisory authority and the regulation of cross-border banks. Controversially, the Review potentially proposes limitations to the principle of European passporting for branches of financial institutions under the EU single market rules, proposing that regulators could require locally incorporated subsidiaries to be established instead of a passported branch of an overseas institution. If implemented, this proposal could see the FSA as "lead" regulator of the significant London operations of various European institutions—an extension of its current reach.

Whether or not the recommendations and the new supervisory approach are met with welcome arms or resistance, it seems clear that a radically different—and more stringent—regulatory regime is on the way. The FSA simultaneously published a Discussion Paper (DPO9/2) on March 18 to facilitate market discussion on some of the terms of the Review, with responses due by June 18. Financial institutions and their regulators face significant work ahead in digesting, devising, implementing and complying with these far-reaching changes and, if past experience of regulatory reform is anything to go by, once in place, any new rules are likely to require further refinement over a number of years.