UK's Andrew Tyrie wants banks to publish risk exposure by trader

The Guardian reports that the UK's Andrew Tyrie, the member of Parliament who headed the commission on banking standards, wants banks to publish risk exposure by trader so that the new Prudential Regulatory Authority can monitor proprietary trading.

By making this recommendation, Mr. Tyrie shows that he understands that disclosure of exposure details is more effective at minimizing proprietary trading than legislation or regulation.

However, Mr. Tyrie stops short of asking for disclosure that would be truly effective in ending proprietary trading by the banks.  Truly effective disclosure requires disclosing each bank's exposure details to all market participants.

What makes disclosure to all market participants effective at ending proprietary trading is these market participants could trade against the bank so as to minimize the bank's profits and maximize its losses from proprietary trading.

As shown by JP Morgan's London Whale trade, disclosure to regulators is not going to result in a reduction in proprietary trading.

Furthermore, regulators are trained not to approve or disapprove of any exposure that a bank takes on whether it is a proprietary trade or not.  The reason regulators don't approve or disapprove of individual exposures is that it gets the regulators into making decisions as to how capital is allocated by the financial system.

The Bank of England is under pressure from parliamentarians to crack down on banks that use their own money to take potentially risky bets on the financial markets. 

On only his second day at the helm of the new Prudential Regulation Authority inside the central bank, Andrew Bailey faces questions on how he would monitor proprietary trading. 

In a letter from Andrew Tyrie, the Conservative MP who chairs the parliamentary commission on banking standards, Bailey was reminded of the findings of the commission's report into 'prop trading'. 

The report fell short of calling for a US-style Volcker rule banning some elements of trading, but said that the PRA should ask banks to publish the risk exposures taken by their traders, with the regulator then reporting to parliament each year on the scale of the activities.

Your humble blogger has said repeatedly that the way to enforce the Volcker Rule is to require the banks to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can exert discipline so that the banks do not engage in proprietary trading.

"We concluded that proprietary trading is not a suitable activity for UK-headquartered banks to engage in, due to both the prudential and cultural risks it carries," Tyrie said in the letter. "However, we also concluded that it would not be appropriate to attempt immediate legislative prohibition of such activity. 

"Instead we recommended that the PRA should monitor indicators of whether banks appear to be engaging in proprietary trading," Tyrie said, although he raised the prospect of a Volcker rule being introduced in the future. 

The PRA should "bear down" on any such trading by demanding banks hold more capital against those activities or be prohibited from conducting such trading through "variations of permission" by the new regulator, Tyrie said.

Capital requirements are a very inefficient way of addressing proprietary trading.  In fact, increasing capital requirements could cause the bank to take bigger risks with its proprietary trading to cover the cost of capital. 

He also asked Bailey whether any legislative changes were needed to enable the PRA to demand that banks report the extent of their trading activities. 

The banks that appeared before the commission said they were not currently involved in proprietary trading. "The PRA must exercise its judgment. It should hold the banks to their word. If the PRA concludes, after a period, that it lacks the authority or the tools to carry out this work, it should make clear to parliament where the current legislation or tools fall short," Tyrie said.

In fact, there is no need for legislative changes to have the banks report their exposure details to all market participants.  Like the US, the UK has disclosure rules that are based on the notion of ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner.