Banks that have earned excessive profits because of unusual market conditions over the past year will be forced to pump much of that cash into building up capital, rather than paying bumper bonuses to staff.

The Financial Services Authority (FSA) yesterday warned that it would take a hard line on capital allocation in forthcoming meetings with banks to talk about their remuneration policies.

The FSA is pressing banks to increase their capital in advance of new rules from the Basle Committee on Banking Supervision next year, which will impose dramatically higher capital ratios across the industry.

However, the FSA would “exercise significant caution” with banks whose commitments to lend to individuals and businesses could be jeopardised by having to build up capital too quickly, Lord Turner of Ecchinswell, the City regulator’s chairman, said.

This would not be the case with banks that had made “large profits” because of “exceptional post-crisis” circumstances, Lord Turner said.

The FSA did not name banks in the firing line. Barclays, whose investment bank, Barclays Capital, has had a knockout year and is expected to pay big bonuses, may be among them.

The regulator also pushed on with its plan to use capital and liquidity requirements to force banks to take less risk and to become more transparent.

Banks will have to have “living wills” that can be used to wind them up in an orderly way in the event of failure.

In a discussion paper published yesterday, the FSA said: “Systemically important banks should be required to produce recovery and resolution plans which set out how operations would be resolved in an orderly fashion.”

The FSA warned that if financial institutions could not create satisfactory living wills, this could lead to “restructuring certain parts of the group”. Several big banks will create the wills — or recovery and resolution plans — this year in a pilot scheme.

Rachel Kent, a partner in Lovells, the law firm, said that it was clear that living wills would “have teeth” and would be used alongside capital and liquidity as a lever to force banks to simplify their structures.

The FSA took many by surprise by laying out its vision for reform days after Mervyn King, Governor of the Bank of England, launched a broadside against banks, calling for low-risk retail banks to be split from “casino” investment banks.

Lord Turner refused to contradict Mr King directly, but said that a split along the lines that Mr King described would be unworkable because of the complexities of modern finance. “It is very difficult to write a law that says this is what you can do and this is what you cannot,” Lord Turner said.

However, the FSA chairman said that imposing high capital requirements on riskier parts of a business, such as proprietary trading, could in practice have the same effect as a forced split of different parts of the business. “This could lead to a complete legal separation of retail deposits and trading activities,” he said.

Tim Plews, a partner in Clifford Chance, said that the Bank proposal to force banks to split up would lead to “legal complexity”, but “new capital requirements should cause bank boards to think of degrees of separation as a virtue in the post-crisis world”.

The FSA also proposed a capital surcharge on global banks to reflect the risk they posed to the financial system.

The regulator’s ideas

• Proprietary trading and other risky activities should hold more capital

• Banks should boost their liquidity

• Living wills to make it easier to wind up banks if they fail

• Special capital charge on global financial institutions, but reduced if they operate as national entities

• Investment banks that have made bumper profits should direct cash to increasing capital rather than paying bonuses

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