Light-touch regulation and a belief in the fundamental rationality of the market will be replaced by a "bias towards conservatism", says Lord Turner, chairman of the FSA.
Financial institutions will face higher capital and liquidity requirements, including counter-cyclical capital during good years to be drawn down in bad, with the FSA "taking away the punch bowl before the party gets out of hand" in future, he said.
Turner told delegates at the CBI annual conference: "In setting capital against trading activity we will move from a bias in favour of more trading to a bias to conservatism, whenever we are worried about risk and whenever the real value of the activity is unclear."
He said confidence in the financial service industry has been "mugged by the reality of a huge economic setback".
Light touch regulation placed too much confidence in "the theory of efficient and rational markets", allowing banks to over-leverage, rely too much on risky wholesale funding and produce innovations of no real use to humanity, he said.
Narrow reliance on the power of low, stable inflation for macroeconomic stability had also been a mistake.
"Low inflation is not the magic single objective which ensures financial stability. We need to consider a wider range of policies to stabilise a potentially unstable financial system and economy," he said.
The regulator will be given statutory responsibility for financial stability in the upcoming Financial Services Act. However, Turner questioned the scale of FSA ambition and said it had to go beyond simply making banks more robust and should also protect the economy against the fallout of risky lending.
He also voiced concern about 50% of bank lending to non-financial corporations going to real estate companies, up from around 20% in 1998: "Does that simply reflect the realities of a mature service based economy, or a bias in credit assessment which disadvantages other sectors of the economy?"
In closing, the former director-general of the CBI asked whether the UK was altogether "too reliant" on bank finance, resulting in an inadequately developed securitised credit markets.
He forecast a closer working relationship between the Bank and the FSA going ahead, "whatever the formal organisational relationship which might follow from whatever the next general election brings".
Read the full speech here
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20-plus years of consecutive dividend increases
Make process simple
Will assess regulation