The Financial Services Authority has told investment banks to improve checks to prevent mis-pricing of trading positions and to stop firing staff who work in valuation control functions.
Hector Sants, the FSA's chief executive, sent his warning to the bosses of banks and investment firms last Wednesday, the day the watchdog announced a £5.6m fine for Credit Suisse for failing to prevent traders deliberately mis-pricing assets. The stern letter, published yesterday, was the first such "Dear CEO" missive issued by Mr Sants this year.
"The current market conditions increase the valuation challenges and risks faced by banks and investment firms," Mr Sants wrote. "Firms' valuation processes and controls have become increasingly stretched and in some cases have proven to be materially flawed or inadequate."
Weaknesses included inadequate checks on traders by senior front-office staff, product-control staff not challenging the trading floor, and poor technology for verifying prices.
He added that the FSA had noticed cost-cutting in middle and back offices whose job it is to manage risk and check trades.
"We recommend that you consider carefully any headcount reduction exercises that will affect valuation control functions at this sensitive time," Mr Sants told the chief executives.
He warned that the FSA would be carrying out checks in the first half of next year to make sure their systems were up to scratch after a string of mis-pricing incidents in London.
Credit Suisse said last week that its inadequate systemsdid not spot mis-marking and pricing errors by its traders for five months. Initially the bank thought the traders had made mistakes but it found evidence that some had deliberately used old data to inflate values. Re-pricing of the positions prompted the bank to write down $2.65bn (£1.42bn) in February after the traders were suspended.
Lehman Brothers suspended two equity traders in February after it discovered incorrectly valued exotic equity derivatives. In June, Morgan Stanley had to take a $120m charge for the second quarter after discovering that a senior trader overestimated the value of assets made difficult to value by frozen markets.