Capital adequacy proposals in a new Financial Services Authority (FSA) discussion paper on banks' proprietary trading risks could increase execution costs for their institutional investor clients.
The paper follows recommendations put forward in the Turner Review, a response to the financial crisis published 18 March 2009 by FSA chairman Lord Adair Turner, which called for tighter capital and liquidity requirements to “constrain commercial banks' role in risky proprietary trading activities”.
Turner later voiced support for a proposal in the US to restrict proprietary trading, known as the Volcker rule. Commentators had warned that this rule, which was adopted as part of the Dodd Frank reform bill, would have a limited effect if it was ignored in Europe.
Since the Turner Review, 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.
Earlier this week, the FSA said in a statement that it 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.
Anthony Kirby, director for the regulatory and risk management practice at consultants Ernst and Young, says that if capital requirements prove too onerous the effects could be felt by the buy-side. “There would be two costs – firstly the cost of raising extra capital could be passed back to the buy-side in terms of higher commissions and potentially higher spreads as well. Second, there could be an unintended cost. If trading thinned out as sell-side firms were less inclined toward proprietary trading then liquidity could suffer, affecting the buy-side,” he said.
The FSA discussion paper's recommendations on the valuation of traded positions include changing the structure of the capital framework to reduce the opportunities for structural arbitrage within the banking sector. It also recommends 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 and the FSA will issue a feedback statement in the first half of 2011.