LONDON (Reuters) - Banks will have to retain more capital in future, curtailing their ability to make bumper profits in boom times, but making them less toxic to the global economy when things sour, Britain's financial regulator warned.
In a landmark report aimed at identifying ways of preventing a repeat of the global banking crisis, the Financial Services Authority (FSA) also called on Wednesday for a new European banking regulator, and urged G20 leaders to deliver on promises to create an early-warning system for the global economy.
The report, commissioned by Prime Minister Gordon Brown at the height of the banking meltdown last October, suggested banks hold a minimum core tier one capital ratio of 7 percent during the peak of the economic cycle.
The ratio, a key measure of financial strength, is currently set at 4 percent under British and international guidelines.
That 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.
"There is a strong prima facie case that minimum bank capital requirements should in future be significantly above those which have applied in the past," FSA chairman Adair Turner said in the report.
"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."
Shares in British banks fell following the report's publication, with traders saying concerns over tighter regulation had added to the air of gloom after a record jump in those drawing unemployment benefit in Britain.
The FSA also proposed that banks build up their capital reserves during boom times, creating a buffer that can be run down when the economy shrinks and give them the flexibility to continue lending through the downturn.
The watchdog stressed the need for international cooperation ahead of a meeting of the Group of 20 leading nations in London next month.
Andrew Baker, Chief Executive of the Alternative Investment Management Association, described it as a good document that "puts down some good markers for other regulators to absorb.
"It's going to set off a useful debate between now and the G20," Baker said.
The FSA said measures such as reform of bankers' pay, changes to the way off-balance sheet vehicles are accounted for, increased regulation of hedge funds and credit agencies, and higher capital reserves against bank trading losses, would only work with a coordinated global approach.
"Two key messages seem to stand out: first, no matter how you dress it up, banks will need more liquid capital, will take less risk and will make less money - and so borrowing will be more expensive," said James Perry, financial services partner at law firm Ashurst.
"Second, as Turner acknowledges, a number of the proposals need international agreement, and the G20 have already shown how difficult that can be to achieve."
Brown has repeatedly called on fellow heads of government to agree a coordinated response to global financial turmoil but a meeting of G20 finance ministers earlier this month failed to deliver anything more concrete than a pledge to take all necessary action to revive growth.
Turner also called for the creation of a new European Union regulatory body, triggering a mixed response.
The Association of British Insurers said a "supervisor of supervisors" for the 27-nation bloc would be good for their business although others fretted that greater EU input would lead to over-regulation and harm competitiveness.
"The development of London as an international financial centre has dropped a long way down the list of priorities, if it's even on the list at all," said Simon Gleeson, partner at law firm Clifford Chance, adding that the FSA may be hoping that it would have a big say within any new EU regulator.
At the same time, national regulators would be strengthened, gaining the power to ensure that local subsidiaries of banks based in other countries had enough capital, the FSA said.
Turner denied his blueprint for reform would undermine London's status as a leading global financial centre, however.
"We're not worried about major banks moving out of London," he told reporters. "We anticipate a lobby of pushback, but these are proposals, and we will listen to well thought out responses."
The FSA acknowledged that its failure to consider threats to the financial system as a whole had contributed to the crisis.
The watchdog proposed that it join the Bank of England's Financial Stability Committee, which would bring together the two organisations in assessing emerging risks.
"The FSA has claimed authority over many by publicly reporting on its shortcomings in a manner more frank than any other financial regulator," said Angela Knight, chief executive of the British Bankers' Association.