By Huw Jones
LONDON, Aug 25 (Reuters) - Ending the regulatory dividing line between a bank's trading and core books would price risk better and help avoid more public bailouts sparked by the financial crisis, Britain's markets watchdog said on Wednesday.
The Financial Services Authority unveiled a 126-page discussion paper looking at different approaches to tightening up the rules, from beefing up the current framework to fundamental change that would end the distinction between trading and bank books.
However, tweaking the existing system whereby a bank's trading positions and main book are treated differently in terms of capital requirements, won't be enough, the watchdog said.
"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 strong financial system," the FSA said in a statement.
In the run up to the financial crisis, banks were shifting some assets from their banking books to their trading books to benefit from lighter capital requirements, and regulators are now seeking a clearer picture of how much risk banks and wider financial system is exposed to.
An FSA spokeswoman said the watchdog believes it is leading the way in proposing new standards but that any changes should be delivered on an international basis, signalling no plans for unilateral action for now.
The FSA outlines several "paradigms" with increasingly tougher changes such as determining capital requirements only by the risk each individual position presents rather than in which "book" it is housed.
Changes that avoid a fundamental shake up would still address deficiencies, the FSA said.
"However, the real fundamental recommendations put forward in this paper, and those that we think are necessary for real changes in behaviour to make the system safer, will require structural changes to the prudential framework," the FSA said.
The watchdog also warned banks they are expected to give it an early heads up when developing new financial products to ensure they can be properly regulated.
Bankers said they were already making trading book changes.
"The FSA and regulators around the world have signalled they are keen to undertake a fundamental review of this issue and the industry looks forward to engaging in this debate," said Simon Hills, a director at the British Bankers' Association.
"But banks are now looking a lot more carefully at how they value positions in trading books, the role of modelling in the decision making process and are already holding more capital against trading book exposures," Hills said.
BASEL LOBBYING
The FSA said its discussion paper is aimed at shaping globally led reforms of bank trading book rules being thrashed out at the Basel Committee on Banking Supervision.
The Basel Committee has already agreed a quick fix to trading book rules to end the incentive for banks to shift assets from their main banking book to the trading book.
This change, due at the end of 2011, will force big banks to set aside three times more capital against their trading books.
A core FSA recommendation would tighten up how banks price trading positions and end a reliance on "market implied" measures which, before the crisis, showed that markets had "entered a new paradigm" of lower risk.
"This proved illusory as it became clear that the market had been systematically under-pricing risk," the FSA document said.
The FSA is due to be scrapped and its functions divided between the Bank of England and a new markets authority from 2012 but the tougher policies now being formulated are expected to remain in place.
The FSA will issue a feedback statement on Wednesday's discussion paper in the first half of 2011.
The British government has also set up an independent banking commission to look at whether trading activities at banks should be separated from other operations to ring-fence risks from harming deposit holders and lessen the likelihood of more public rescues in a future crisis.
To access the FSA discussion paper click on:
http://www.fsa.gov.uk/pubs/discussion/dp10_04.pdf