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Banks have caused real harm to the economy and reform is needed, the head of the Financial Services Authority (FSA) warned last night.

Lord Turner, FSA chairman, said: "We are in the middle of an economic downturn which, to a far greater extent than any since the 1930s, is the result of developments which were to a degree internal to the global financial system.

"Developments in the banking and near bank system which had been lauded as improving allocative efficiency and financial stability have in fact caused serious harm to the real economy."

He added the changes needed to create a future sounder system "will be profound".

"Their guiding principle should be that they should create a banking system focused on the delivery of the value-added functions of banking which are so essential to a market economy."

Lord Turner also hit out at 'originate and distribute' model of banks offloading assets to investors from their balance sheets – but said it still had a role to play after reform to ensure less complexity and opacity.

He also accepted the FSA had made faults in overseeing the financial world – but the crisis would have still happened.

"The FSA has been more open than I think any institution involved in this crisis in admitting that it made mistakes in the institution specific supervision of Northern Rock," Lord Turner said.

"But I think the best judgement is that better institution specific supervision of Northern Rock, would have made only a very small difference to the shape and impact of this global crisis.

"The far bigger failure… was the failure to identify that the whole system was fraught with market-wide, systemic risk."

Lord Turner also pushed for changes to the capital ratios of banks – suggesting a Spanish model where banks build up capital in the good times to provide a safety net in the bad.

He said: "This new regime and the related reporting requirements will greatly enhance our ability to understand emerging liquidity risks in individual institutions and across the whole economy."

The FSA chairman added the new regime would see banks holding more liquid assets and having a greater incentive for savings from consumers.

He claimed as a result there would be "a check on rapid and unsustainable expansion of bank lending during favourable economic times".