Lord Turner of Echinswell, the chairman of the Financial Services Authority (FSA), yesterday published his review of the global banking crisis and the regulatory response. It provides a useful framework for understanding the crisis. But it goes only part of the way to addressing how to achieve financial stability. The regulators themselves need to become more expert and less inclined to defer to the judgment of bankers.

The proposed reforms, which aim to curb banks’ ability to take excessive risk, pass the dual test of relevance and practicality. They recognise that asset markets are susceptible to bubbles and crashes, and that an asset-price collapse will contaminate the banking system. Banks are tied together through the wholesale lending market. If one bank has a problem with bad debts, then other banks will be reluctant to lend to it.

The financial crisis has gone through each of these stages: the collapse of the housing market; the failure of a bank (Northern Rock) with a ferociously irresponsible business strategy; and a contagious effect of bad debts throughout the banking system. The outcome is a steep economic downturn as credit facilities are withdrawn from businesses and consumers. The rise in UK unemployment to more than two million testifies to the depth of the recession.

This is the background to Lord Turner’s review. While the remedies to the recession lie in monetary and fiscal stimulus, there is an obvious need for regulatory reforms. The business cycle is a permanent part of a market economy, with its periodic expansions and contractions. But structural weaknesses in the financial system are not. Better regulation is needed to create financial stability. Lord Turner raises the right issues.

First, the regulators must consider not only particular institutions but also the wider systemic risk posed by bank strategies. Repackaging asset-backed loans into marketable securities has economic benefits, but has been shown to spread risk rather than diversify it.

Second, banks lacked adequate reserves to bear the risks of their lending (Royal Bank of Scotland being a particularly gross case). Capital requirements should be tougher, and Lord Turner is right to recommend that they be counter-cyclical to prevent banks lending too much in a boom.

Third, the pay of bankers should be tied more closely to the risks that they take on. It would be a bad idea to cap bankers’ pay or abolish discretionary bonuses, but the costs of failed strategies ought not to be borne by the taxpayer.

Fourth, credit rating agencies have contributed to the crisis through a flagrant conflict of interest. The ratings and consultancy activities of these firms need to be separated.

Fifth, the so-called shadow banking system, including hedge funds, needs direct regulation. The responsibility for this financial crisis rests with the banks; but the shadow banking system can also contaminate the economy.

Lord Turner’s review is lucid in addressing remedial measures. But the quality of thinking is only part of the remedy. The quality of people — on the boards of the banks, and among the regulators — is also crucial. The FSA failed to perceive the risks to financial stability. It was dilatory in its supervision of Northern Rock. The culture that allowed such negligence must change.