Proprietary trading losses in banks: do banks invest sufficiently in control?

Abstract

This paper analyzes management and control issues linked to the employment of traders who engage in proprietary trading activity for their employer (a bank). The bank can invest in control and monitoring of these traders, and the paper evaluates the profitability of such investments. We find that the investment in control is distorted due to interfering market microstructure effects. The bank is inclined to underinvest in control of its traders because traders who are not too closely monitored generate extra liquidity in the market. Bank supervision might be needed, therefore, to correct for such effects. We evaluate the effectiveness of the value-at-risk capital adequacy requirement proposed by the Bank for International Settlements, and find that this approach correctly targets the banks that are the most vulnerable, i.e. those that are the most at risk of underinvesting in its control and monitoring systems.