Parts of the City breathed a sigh of relief on Wednesday as the threatened crackdown by the Financial Services Authority (FSA) appeared less draconian than their worst fears.

In unveiling his long-awaited proposals on reform to banking supervision, Lord Turner of Ecchinswell, the chairman of the regulator, rejected calls for a separation of investment banks from commercial banks, played down the need for serious reform of City bonuses and hinted that hedge funds need not be troubled by the regulatory changes.

Tim Dolan, a partner with Pinsent Masons, the law firm, said: “While Lord Turner's review contains fundamental proposals to change the manner in which banks are regulated, it does not go as far as many were fearing.”

Lord Turner said that separating investment banks from commercial banks was impractical — only 12 hours after Mervyn King, the Governor of the Bank of England, said that there needed to be a national debate on just that issue. Lord Turner also played down the importance of flawed bonus structures in triggering the crisis, arguing that they were “considerably less important than other factors”, and he appeared to give a green light to most hedge funds to carry on as before.

Nevertheless, he foreshadowed a significant change to bank supervision, outlining proposals for banks to carry more capital, hold more liquid assets and be more beholden to “intrusive” supervisors. Banks engaged in proprietary trading would be targeted in particular, required to back their bets with three times as much capital as before.

He said he was confident that, if his proposed measures had been implemented ten years ago, the present banking crisis would have been averted.

One measure not flagged in advance was his plan for a new pan-European supervisory institution with the power to regulate and set standards. Bob Penn, a partner with Allen & Overy, the law firm, said: “The real surprise is in the FSA's willingness to give up powers to Europe. This would have been unthinkable a year ago and is a politically brave recognition of the need for international solutions to international problems. However, the devil will be in the detail.”

Credit rating agencies will be regulated to limit conflicts of interest and inappropriate application of rating techniques, and the FSA will take a greater interest in the “shadow banking system”: off-balance-sheet vehicles and those hedge funds that behave like banks.

Mr Dolan said the FSA's conclusion that many hedge funds did not behave like banks suggested that they would not be the focus of a crackdown. “It appears that many hedge fund managers will not be subject to profound changes,” he said.

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