London to fundamentally redefine trading regulation

The Financial Services Authority (FSA) has today published a discussion paper (DP) that considers fundamental changes to the regulation of trading activities – one of the key recommendations of the Turner Review following material trading losses incurred during the crisis.

Since the Turner Review was published, the Basel Committee on Banking Supervision (BCBS) has proposed several reforms to the prudential regime for banks and in addition has mandated a fundamental review of trading activities called for in the Turner Review.

The FSA believes that the delivery of a new, robust, long-term, approach to prudential requirements for trading activities is one of the key areas of regulatory reform that must be delivered to build a stronger financial system. The outcome of the BCBS’s fundamental review is central to achieving this objective internationally.

The DP describes the FSA’s current views and ideas in relation to major areas of reform that need to be considered to address areas of structural weakness that exacerbated the build up of risk before the financial crisis.

Paul Sharma, FSA director of prudential policy, said:

"There are clear benefits of participants in traded financial markets taking risks to facilitate a more efficient allocation of resources across the economy – where these gains in efficiency are real and the risks posed are adequately captured or controlled we are not seeking to undermine these activities.

"However, the financial crisis has highlighted that, for trading activities in particular, an over-reliance on the principles of efficient financial markets can lead to severe consequences when risks are misunderstood at a system-wide level. The balance needs to be redressed to ensure that risks posed to the system as a whole are more adequately reflected in the structure of prudential regulation."

The DP sets out a number of recommendations which are grouped into three key areas:

  1. Valuation: We recommend an increased regulatory focus on the valuation of traded positions and think there is a need for a specific assessment of valuation uncertainty.
  2. Coverage, coherence and the capital framework: We recommend changing the structure of the capital framework to bring greater coherence and reduce the opportunities for structural arbitrage within the banking sector and the wider financial system.
  3. Risk management and modelling: We recommend specific measures aimed at improving firms’ risk management and modelling standards, and ensuring that these are aligned with regulatory objectives.

The closing date for responses is 26 November 2010. The FSA will issue a feedback statement in the first half of 2011.

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