The Financial Services Authority, the UK’s financial regulator, has laid out the events that led to the credit crisis and called for banks to set aside more capital to guard against risks in a wide-ranging report authored by FSA chairman Lord Adair Turner.

Lord Turner's said regulations should be based on a "macro-prudential" approach rather than focus solely on specific firms. He also called for fundamental changes to bank capital and liquidity regulations and to bank published accounts.

The FSA, like some other national regulators, has come under fire for not doing enough to act in the run-up to the financial crisis and to warn about the risks that were posed by the large accumulation of credit risk in the financial system. The very existence of the FSA, set up in 1997 by the incoming Labour government, has been criticised for having removed bank supervision from the Bank of England.

The FSA review identifies three underlying causes of the crisis: macro-economic imbalances, financial innovation that it regards as having little social value and important deficiencies in key bank capital and liquidity regulations.  These were underpinned by an exaggerated faith in rational and self-correcting markets, it said.

"The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built, and in particular the theory of rational and self-correcting markets.  Much financial innovation has proved of little value, and market discipline of individual bank strategies has often proved ineffective,” said Lord Turner.

Lord Turner calls for more and higher quality bank capital, with several times as much capital required to support risky trading activity. These counter-cyclical capital buffers, would build up in good economic times so that they can be drawn on in downturns, and would be reflected in published account estimates of future potential losses.

He believes in a central role for much tighter regulation of liquidity; regulation of "shadow banking" activities on the basis of economic substance not legal form; increased reporting requirements for unregulated financial institutions such as hedge funds, and regulator powers to extend capital regulation.

The review says there should be strict regulation of credit rating agencies to limit conflicts of interest and inappropriate application of rating techniques. In addition, it proposes national and international action to ensure that remuneration policies are designed to discourage excessive risk-taking.

Lord Turner foresees major changes in the FSA's supervisory approach, with a focus on business strategies and system-wide risks, rather than internal processes and structures. He also wants major reforms in the regulation of the European banking market, combining a new European regulatory authority and increased national powers to constrain risky cross-border activity.

The review distinguishes between those areas where the FSA has already taken action, those where the FSA can proceed nationally, and those where international agreement needs to be achieved. It also recognises that there may be alternative specific ways to achieve the essential objectives of effective regulation.

The review highlights areas where it is premature to recommend specific action, but where wide-ranging options need to be debated. These include product regulation in retail and wholesale markets. 

Published alongside the Review is an FSA discussion paper which sets out more detail on specific policy proposals.  As the current crisis arose in the banking, investment banking and "shadow banking" sectors, most of these proposals focus on these sectors. Possible implications for some other sectors are however identified.

The UK’s alternative investment managers welcomed the review in a statement. “We welcome the publication of the Turner Review, which is an impressive and comprehensive piece of work. It is about the banking system’s role in the current financial crisis and as such its principal focus is the banks, not the hedge fund industry.

"We are grateful to Lord Turner for his even-handed and measured approach and for not making hedge funds the scapegoat for this crisis,” said Andrew Baker, chief executive of the Alternative Investment Management Association.