FSA's call for 'capital tax' pours fuel on banking row

Watchdog says light touch at an end and regulators should instead 'be the best'

Leading international banks are set to face a substantial "capital tax" to protect taxpayers against them becoming too big to fail, the Financial Services Authority said yesterday.

Outlining reform proposals to prevent a repeat of the financial crisis, the FSA chairman Lord Turner also said it was time for countries to stop competing over how "light touch" their rules could be for banks and instead "compete to be the best".

Lord Turner said: "In the past, large banks have been allowed to run with lower levels of capital than small banks because they were seen as more sophisticated, knew more about risk management and had a broader spread of operations.It is now clear that that was wrong. They need more capital to reduce the problem of them being too big to fail, and more of that capital needs to be equity capital."

This, he said, would address the moral hazard of banks knowing they could take huge risks because the taxpayer would bail them out. The peer wants shareholders to put up more cash to back banks, so that they – rather than the state – lose in the event of a failure.

Lord Turner said an alternative to banks facing a "capital tax" would be for national subsidiaries to be made more independent within major international banking groups, holding enough capital to ensure they would be protected in the event of the failure of the parent company.

Currently, a bank's home base will find itself responsible for bailing out the whole of a large and diversified international bank if it finds itself in difficulty, as Britain did in the case of Royal Bank of Scotland. However, if big banks could show that national subsidiaries would be able to survive a collapse, they would face lesser surcharges.

Lord Turner also said there would be close scrutiny of bonus pools, to ensure that they were compatible with capital requirements. But he warned against "crude measures" to force banks to become smaller or to stop risky trading. He also said capital taxes on risky banks would ultimately work better than new laws such as a revived "Glass-Steagal" Act, named after the US law that previously sought to enforce a separation of retail/commercial and investment banks.

The FSA favours reducing the way wholesale markets that trade in complex financial instruments are interconnected, an enforced "bias to conservatism" with more capital required when banks engage in risky trading, and the much talked about "resolution and recovery plans" – or living wills enabling the orderly wind-up of a failing bank. He said these could force banks to separate and ring-fence riskier activities from deposit-taking. Two are likely by the end of the year, and they are being trialled in the industry.

He said: "We have set out a range of options in our discussion paper and highlighted those we believe in and which we are actively pursuing. That said, we are open-minded and willing to listen to alternative suggestions."

The FSA's announcements come against a background of increasingly fraught debate between politicians, regulators and the Bank of England over how to reform the supervision of banks. On Wednesday, Gordon Brown slapped down a call from the Governor of the Bank of England, Mervyn King, for the big lenders to be broken up and state support withdrawn for their investment banking activities. That tension was highlighted again by the deputy governor Paul Tucker, who called for "macro-prudential instruments" – powers for the Bank to tackle the build-up of systemic risk in the financial system. He also highlighted the need for banks to hold more capital "which is properly loss-absorbing, and high-quality liquidity". He said he favoured reviving a supervisory culture centred on making forward-looking judgements about an institution's management and business resilience.

He said: "The current crisis has reminded everyone that our primary interest in regulating the banking sector is the preservation of systemic stability and so of the vital services banks perform in our economy and financial markets."

Power struggle: Who thinks what about banking regulation

THE FINANCIAL SERVICES AUTHORITY

Open to ideas but wants biggest banks to face a "capital tax". If national subsidiaries are protected against the failure of a big group, this would be reduced. Rejects calls for break-up of banks as "crude". Wants taxes on risky activities.

THE BANK OF ENGLAND

Says reforms so far imposed have not gone far enough. Only "narrow" banks that take deposits should be protected by state. This guarantee should be removed from investment banks. Has suggested overly large banks should be broken up.

THE LABOUR GOVERNMENT

Has dismissed the Bank's calls and slapped down Governor Mervyn King. Supports FSA and a tougher version of the "tripartite" supervision of banks and financial system involving Treasury, FSA and Bank of England.

THE CONSERVATIVE PARTY

Favours the abolition of the FSA, with "prudential" supervision of banks returned to the Bank of England and a the creation of a Consumer Protection Authority. Backs Mr King's calls for more radical reform but also wants role for the FSA's chairman, Lord Turner.