The UK’s Financial Services Authority is proposing fundamental changes to trading regulation in response to the financial crisis.

The FSA published a discussion paper Wednesday that contemplates a series of trading regulation reforms in the wake of a crisis that included crippling trading losses. The regulator reports that a study of the losses suffered in the investment banking operations of 10 major international banks operating in the UK amounted to US$240 billion, which represented approximately 160% of the total average market and credit risk capital held by the banks during the period; and which was why government intervention was necessary to prop up the banks.

Turning to reform, among other things, it recommends an increased regulatory focus on the valuation of traded positions, and calls for a specific assessment of valuation uncertainty. It recommends 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. And, it recommends measures to improve firms’ risk management and modelling standards, to better align them with regulatory objectives.

The FSA says that this assessment of trading activities was one of the key recommendations of the Turner Review; which was also taken up by the Basel Committee on Banking Supervision. The FSA concludes 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.”

“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,” said Paul Sharma, FSA director of prudential policy.

“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,” he added.

The deadline for comments on the discussion paper is November 26, and the FSA plans to issue a feedback statement in the first half of 2011.

IE