Bank of England Governor Mervyn King called for sweeping powers to force banks to implement radical reforms even if they comply with the letter of financial regulation, warning it would be impossible to effectively supervise the industry otherwise.
King told MPs drafting new supervisory legislation that the rules-based approach followed in the run-up to the financial crisis was too easy for banks to circumvent, with supervisors unable to prevent them from borrowing too much.
What needs to change in the culture of regulation is to get away from this game in which the regulators write ever more complex regulation and the banks and their lawyers (write) new products which are the same essentially as the previous products but defined in such a way as to not to be caught by the latest rule and regulation, King said.
Regulators should be allowed to tell a bank: Look, frankly, we don't understand why your organisation needs to be so complex. We can't work out what you are doing, so you're going to have to change it. You haven't broken a rule, but too bad, you've got to change it, King said.
Ultimately, the regulatory framework should be set in a way that allowed banks to fail, King told a parliamentary committee scrutinising the Financial Services Bill, which includes a major overhaul of Britain's regulatory system.
Once regulators get bogged down in excessive detail they'll never be a match for the banks, he said. So we have to have a framework in which most of these firms can fail. If they screw up, that we just let them go, go bust.
Under rules proposed by the government, the Bank will have far-reaching new responsibilities, including oversight over banks and macro-prudential tools to take action in time to shield the financial system from another major crisis.
Britain had to spend tens of billions to rescue its banking system at the height of the crisis, and the country is now tightening the reins on an industry which had been one of the main drivers of growth and sources of tax revenue.
King supported recommendations made by the Independent Commission on Banking, which suggested that banks must ring-fence their retail business and hold more capital for it.
But King stressed that legislators should be as specific as possible about the design of the ring-fence to separate banks' retail operations from their riskier investment arms.
My view quite strongly, is that as far as possible it (the definition of the ring-fence) should be down to legislation and not left to the regulator, King said.
The Bank's dominant role in the proposed new framework has triggered concerns among industry players and some politicians that the central bank and its governor will become too powerful without being properly accountable for their actions.
But King said the Bank was fully accountable to parliament and rejected the idea that the banking industry should be somehow involved in the supervision.
We should not be accountable to the industry, we should be accountable to parliament and the public, he said.
Proper consultation and a dialogue with the industry was important, he said. But I don't think we should be accountable to the industry -- that's the slippery slope to regulatory capture which was one of the major problems leading up to the crisis.
(Additional reporting by Olesya Dmitracova and Avril Ormsby; editing by Anna Willard, John Stonestreet)