Proprietary trading - Statutory Instruments Joint Committee

Proprietary trading - Parliamentary Commission on Banking StandardsContents

3 Concerns about proprietary trading by banks

Prudential concerns

12. Proposals in other countries to separate proprietary trading from banking have been motivated in part by concerns about the prudential risks which proprietary trading poses to the rest of the bank. In advocating adoption of the Volcker rule in 2010, President Obama said:

These kinds of trading operations can create enormous and costly risks, endangering the entire bank if things go wrong. We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets.[18]

Paul Volcker, in an article at the same time that President Obama endorsed the rule bearing his name, wrote that "adding further layers of risk to the inherent risks of essential commercial bank functions doesn't make sense, not when those risks arise from more speculative activities far better suited for other areas of the financial markets".[19]

13. Announcing a French proposal along similar lines in late 2012, Finance Minister Pierre Moscovici said:

In effect the crisis showed the very serious risks posed by financial market trading which banks carry out on their own account and for their own profit, putting at risk the deposits of their clients.[20]

German Finance Minister Wolfgang Schuble announced similar proposals in February 2013, saying "separating risky activities from retail banking will increase the solvency of an institution and contribute to the stabilisation of financial markets".[21]

14. HSBC listed three main areas where proprietary trading could give rise to prudential risks:

(a) the ability of banks and supervisors to properly understand and thereby calibrate the risks which are being taken in this area, in particular tail risks, and so apply the correct capital treatment so that banks have sufficient resources to absorb losses if these occur;

(b) the risk that unexpected losses in proprietary trading may diminish capital resources and curtail the ability of a bank to provide sustainable support to the real economy - with the potential consequence that some form of intervention is required to restore such lending, thereby creating a moral hazard; and

(c) the risk that an unexpected loss is of such magnitude or nature that unsecured creditors restrict or withdraw funding until they have clarified and understood the cause of the loss, once again thereby causing credit capacity to be curtailed.[22]

15. However, as RBS pointed out, "the prudential risks inherent in any 'own account' positions are independent of the intent of the trade (whether proprietary or client-driven)".[23] In other words, the risk to the bank from a trading position—such as being long £10m in a particular market position—is the same whether that position results from client-related activity or a desire to speculate. Barclays also suggested that prudential risks from proprietary trading were no different from other trading risks and should be manageable using the same set of controls.[24]

16. The FSA noted that while both non-client-related proprietary trading and client-related trading can give rise to similar risks on individual trades, the key difference is in breadth and scope of how these risks are likely to build up:

When undertaking proprietary trading [...] additional risks will be taken in order to try and profit from a wide range of market movements. Whilst this activity can be extremely lucrative it also means that a much wider scope and breadth of risks can impact a bank's capital base. Ultimately, as with any risk, if losses are large enough this could lead to a bank's insolvency.[25]

17. Proprietary trading was the cause of some losses during the crisis. UBS reported that its internal hedge fund Dillon Read Capital Management accounted for $3bn of losses before being closed and reintegrated into the investment bank in late 2007.[26] It is difficult confidently to attribute many other losses to proprietary trading, in large part because most banks did not report such activity separately. Also, for many of the large trading losses which were incurred—particularly by the large US investment banks—it is not clear to what extent these related to client activity. For example, many banks lost significant amounts on collateralised debt obligations (CDOs)—structured securities created by packaging together mortgages or bonds and slicing them up into different risk tranches. Many banks held these in trading portfolios and they certainly did involve proprietary risk. However, one reason why the US investment banks held CDOs was that they were a by-product of structuring CDOs for clients, because sometimes parts of the securitisation would need to be "warehoused" before being sold on.[27]

18. A number of smaller European banks also suffered losses on such assets, not because they were involved in the origination, but because they had bought them from the US investment banks. They had been drawn into this activity because the highly-rated CDOs offered much better yields than other AAA assets such as government bonds, but were just as acceptable to regulators as liquidity management tools. Having enjoyed the higher yield, some banks devoted more and more of their balance sheet to investing in such assets as opposed to their regular business of extending domestic credit.[28] While this business model proved flawed, it is again hard to say how much of it could be regarded as "pure" proprietary trading, given that it had its origins in liquidity management.

19. More recently, in 2012 JPMorgan suffered nearly $6bn in trading losses in the synthetic credit portfolio of its Chief Investment Office (the so-called "London Whale" trades). JPMorgan's special report on the losses claimed that this portfolio was "intended generally to offset some of the credit risk" that the firm faced, and that the losses were the result of "flawed trading strategies, lapses in oversight, deficiencies in risk management, and other shortcomings".[29] However, the scale and nature of the positions which gave rise to the losses seem hard to explain except through there being a considerable degree of speculative proprietary trading. A Bloomberg article prior to the losses noted "One public sign that the chief investment office does more than hedge: Its trading risk is on par with that of JPMorgan's investment bank". The article also cited JPMorgan sources saying that the unit responsible for the losses had shifted its strategy after 2005 away from simply managing risk towards generating profit.[30]

20. No evidence the Commission has received viewed proprietary trading as the primary cause of any failures during the crisis. Standard Chartered stated:

we do not believe that proprietary trading was a significant contributory factor in the financial crisis. If we look at those banks that failed during the crisis their failures were broadly driven by a range of simple failures such as highly leveraged structured credit, ineffective liquidity or risk management and/or poor corporate governance.[31]

21. The possible impact of proprietary trading on the resolvability of banks also did not feature much in evidence. RBS noted that "the resolvability of a bank and overall systemic risk would of course be materially affected by the presence of uncontrolled trading and inventory within a banking group".[32] Individual trading positions are treated the same way in resolution whether they result from client activity or speculation, so the presence of proprietary trading could affect the quantity of positions needing to be resolved, but not their nature. This is in contrast to the intended effect of the ring-fence, which, by separating all investment banking from core banking, is intended to simplify resolution of the retail entity.

22. Proprietary trading gives rise to prudential risks. Concerns about the prudential risks from proprietary trading have been cited, not least by Paul Volcker himself, as one of the justifications for legislation to prohibit banks engaging in certain forms of proprietary trading in the USA. They are also the principal justification for proposed legislation to require partial separation for banking entities engaged in certain forms of proprietary trading in Germany and France. The Commission has concluded that the prudential risks associated with banks engaging in proprietary trading are not necessarily different in kind from those associated with a range of other banking activities, many of which made a greater contribution to the recent financial crisis. However, having greater exposure to markets than is necessary for client servicing increases the potential for risks that may not be fully understood until the next crisis.

Cultural concerns

23. Paul Volcker said that his desire to restrict proprietary trading was not primarily driven by prudential risk, but by the cultural effects of allowing such activity within banks:

I get a little irritated by people saying, "Why are you worried about proprietary trading? That didn't cause all the bankruptcies or failures." It certainly contributed to some of them, as they say, but that is not the point. It is the cultural damage that it does.[33]

He also argued that the cultural effects did in fact play a significant part in encouraging the wider excesses that led to the crisis:

I think, in part, that is where banks got in trouble, as that kind of activity became attractive—dare I say dominant—in some institutions. It employed a different form of compensation—heavily incentivised, very high levels of compensation—that inevitably affected the rest of the organisation.[34]

[...] people who criticise the so-called Volcker rule might say, "Sure, there were speculative excesses, but that was not the heart of the banking crisis." In fact, a lot of things were the heart of the banking crisis but, just in terms of losses at the banks, it was excessive lending on home mortgages—a traditional business of banks. It went wild. Why did that go wild? I would argue that the compensation practices that crept in, and the very large compensation in the trading parts of banks, infected the culture of the institutions generally, so the lending offices dreamt things up—how to make a lot of money in the short run and get a big bonus.[35]

Michael Cohrs, a member of the Financial Policy Committee and a former investment banker, echoed this concern, saying that proprietary trading had wider cultural effects which were incompatible with banks being focused on client service:

if a bank is allowed to do proprietary trading, or proprietary investments, you will not have a culture that you like, because de facto, you are then competing with the client, and it is a heck of a lot easier to do proprietary work than it is to do client service. The best and the brightest within the institution will gravitate to the proprietary activity and we will end up where we have ended up, which is with bankers who sometimes do not understand right from wrong, or at least a pool of them. I think that Volcker was on to something [...] this concept that proprietary activity exists within a client-serving organisation is false.[36]

24. Bill Winters suggested that the cultural differences between traders and other areas of banks did stem from compensation approaches:

if you have people sitting on a trading floor who are paid a percentage of their profit—recognising that they are given a lot of capital to deal with so the profits can be very large, which means that their bonuses could be very large—that just is not consistent with good customer service or traditional banking with the guy sitting next door. So this person over here is paid £60,000 and this person over here might make £6 million if he happens to roll seven at the right time and in the right sequence.[37]

He also considered that such differences could cause problems in the non-trading parts of a bank, based on his experience with the merger of JPMorgan and Chase. He argued that "the two cultures do not need to be incompatible in a single organisation, but it is very difficult to manage".[38]

25. However, Barclays argued that proprietary trading was unlikely to have a broader effect on remuneration and culture across the firm as a whole:

The risk of any proprietary trading influencing broader remuneration practices, culture and standards depends entirely on the specific scale and nature of the proprietary trading, especially in relation to other activities undertaken by the relevant firm. We would posit, based on our experience, that any proprietary trading (even broadly defined) would have to be unusually large in order to have any discernible influence on any of these.[39]

26. Paul Volcker said that, as well as the effect on remuneration, he was also concerned about the conflicts of interest that arose when banks engaged in proprietary trading:

When you are conducting on the one hand a straight-up trading operation, where you deal with the customer in an impersonal way and do not have a continuing responsibility, and on the other hand you are lending that customer money or not lending them money—whatever you are doing—you get conflicts, or you get conflicts with your investment management business. How can you run an investment management business completely insulated from the trading book you are running on a speculative basis? I guess that my biggest concern is not actually the risks; it is the damage that it does to the culture of the whole institution.[40]

The FSA noted that "where a bank decides to engage in proprietary trading there is a potential for increased principal-agent conflicts with its clients":

This is because the bank stops being a mere provider of banking/financial services to its clients and becomes a potential competitor. This means that the bank's incentives may become less aligned with its clients. This conflict becomes more pronounced when the proprietary trading operations of any given bank are more material to the bank's profitability than its client operations.

Where a bank conducts proprietary trading the handling of client information is a particularly sensitive issue. For example, client order flow information has to be shielded from the bank's proprietary trading desks, as the bank could make improper profits off the information to the detriment of its clients. This can be challenging to do if, for example, the proprietary trading desks are located in close proximity to the client trading desks on the trading floor.[41]

27. HSBC also acknowledged the risk of conflicts of interest arising from proprietary trading:

the most obvious example in the recent crisis was where some firms were positioning for a collapse of the US housing market while continuing to service and promote client demand for exposure to that market. Although firms have clear 'chinese walls' - internal separation - to reduce potential conflicts of interest, there will inevitably be instances when a bank will profit from a proprietary transaction positioned on the other side of client facing activity.

There is no reason why the current rules should be viewed as inadequate in principle, yet it is clear from recent experience there is little confidence that in practice they are being adequately monitored and enforced. In reality, no matter how strong the conduct rules are, there will always be concerns over their application particularly where a proprietary trading function is seen to benefit at the expense of clients.[42]

Finance Watch referred to research from Germany into banks which both managed assets for clients and undertook proprietary trading, which indicated that:

- Banks systematically push stocks from their proprietary portfolio into their retail customers' portfolios.

- Those stocks systematically underperform compared to both other stocks in banks' proprietary portfolio and other stocks in households' portfolios.

- Customers' portfolio performance at banks with prop trading is significantly worse than at those without.[43]

28. However, some witnesses pointed out that principal-agent conflicts were not simply confined to proprietary trading. Martin Taylor warned:

I do not want us to ban proprietary trading and imagine that the problem of bank-client, agency-principal conflict has been solved. However you frame this, banks are, in their own way, highly leveraged, highly expert organisations that are trying to make money out of the financial flows in the economy, and most of those financial flows come from their clients. There is sometimes a tiny flavour of proprietary trading being wicked because there is not a client involved - whereas client-related flows are thought to be virtuous because they help the client. Banks have always made far more money out of client flows than out of any naked proprietary trading desks. I think that banks can still get into trouble by abusing their leverage and their market-making position[44]

He went on to cite the example of Libor manipulation, suggesting that the traders at the heart of the scandal were not engaged in proprietary trading but rather in managing trades that had arisen due to client activity:

I do not know [...] the extent to which the misbehaviour in the LIBOR scandal was the result of people trying to get proprietary trading permissions right, la Volcker, or whether it was simply the endless struggle that these very big organisations have to keep their derivative back books in order, which have probably arisen in the first place from satisfying customer demands of one kind or another.[45]

Stephen Hester, Chief Executive of RBS, said that he understood the individuals involved in Libor manipulation to be market makers rather than proprietary traders:

I think that the LIBOR setters are a form of market maker, if I could put it like that [...]the derivatives traders were making markets in derivatives from which, again, there is end customer usage.[46]

29. The Chancellor of the Exchequer argued that cultural problems are neither "restricted to proprietary trading, [nor] particularly inflamed by proprietary trading".[47] Bill Winters also rejected the assertion that proprietary trading was to blame for the wider cultural failings in banks:

I don't see proprietary trading, from a cultural perspective, as any more damaging, egregious or likely to create the wrong sort of culture in a bank than any other banking activity. We have seen plenty of instances of misbehaviour. Almost certainly we have seen many more instances of misbehaviour outside of proprietary trading than inside.[48]

RBS similarly suggested factors other than proprietary trading were more likely to be to blame for cultural failings in banks:

We recognise the risk that the presence of "pure" proprietary trading could give rise to cultural issues and consequent misconduct. However, we do not agree that own account trading connected to actual or anticipated customer activities per se creates a negative influence on a bank's culture. Issues such as Libor manipulation or swap mis-selling are more likely to stem from a poor, revenue driven, culture in which incentives are not aligned with the creation of long term value for clients and prudent risk management.[49]

30. This Commission was set up to address the problems of culture and standards in banking. While there is clearly a big difference between the cultures of retail and investment banking, both exist to make a profit for shareholders by providing services to customers. In principle, the carrying on of proprietary trading by banks can be thought to embody a different culture, because in such a case the bank's aim is to make a profit without providing services to customers. In recent years, there have been too many examples of banks having benefited themselves at the expense of customers across a range of activities. The wider reforms relating to banking standards that we are considering are concerned with returning customers to the heart of banking. To the extent that the presence of proprietary trading within a bank affects its wider culture, this could put at risk efforts to place customers at the heart of banking.

31. The argument that the trading function within banks, in particular the proprietary trading function, could have harmful cultural effects has been convincingly made. The Commission is concerned that the conflict of interest which can arise from a bank attempting both to serve customers and trade its own position cannot be easily managed, and can be corrosive of trust in banking no matter what level of safeguards are put in place supposedly to separate these activities. The Commission is also concerned that the presence of proprietary trading within a bank, with its potential to generate high short-term rewards for individual traders, could have a damaging effect on remuneration expectations and culture throughout the rest of the firm.

Social utility and the implicit guarantee

32. Proprietary trading is not unique in the risks it poses. Many banking activities carry risks—indeed risk is in some ways at the heart of banking. However, most banking activities can be seen to have a corresponding social utility, for example in providing credit, facilitating transactions or performing maturity transformation. Referring to the risks posed by proprietary trading, Paul Volcker asked "where is the corresponding or the offsetting public benefit?"[50] Bill Winters pointed out, "there is no particular societal value to proprietary trading, beyond a relatively small amount that is necessary for efficient, functioning markets".[51]

33. It has been argued that proprietary traders provide important market liquidity, and one of the criticisms of the Volcker rule has been that it could reduce liquidity.[52] However, there may be merit in differentiating between what has been termed "pure" proprietary trading and market-making. In the former, assuming it is capable of being tightly defined and identified, traders would be using banks' capital and borrowing to speculate on markets as they choose. While this may add to liquidity at the margin, there are other non-bank market participants who trade in the same way—for example hedge funds. If such trading is a profitable use of capital, these other participants might be expected to help fill any void left by banks. The liquidity provided by this form of trading is plentiful in good times, but can dry up quickly in times of market stress. In contrast, in banks' role as market-makers where they openly quote buy and sell prices, they play a more important role in enhancing market liquidity; in a designated market-maker role they are also required to do so in both good times and bad.[53] While it is possible for institutions other than banks to take on a similar role to market-makers, banks do have a natural advantage in acting as market makers because of the high capital requirements associated with it, the fact that banks have a variety of other relationships with the clients who want to make trades, and the fact that acting as a market-maker for a security is often a natural follow-on activity for whichever banks underwrote its issuance.[54]

34. Even after the introduction of a ring-fence and other reforms, it is possible that systemic banks may benefit from an implicit Government guarantee. Lloyds Banking Group warned that this could make it cheaper for banks to fund proprietary trading—effectively using a taxpayer subsidy:

to the extent that the presence of insured deposits alongside "true" proprietary trading results in proprietary trading activities not facing a cost of capital and funding that appropriately reflects the risk of these activities, then this could result in a mis-allocation of capital and funding towards these risky activities.[55]

Bill Winters said:

that lack of alignment between the ultimate back-stop—the taxpayer—and the employees or shareholders is not limited to proprietary trading. It is any risk decision that the bank takes—it is mortgage lending, consumer lending, corporate lending, trade finance, market-making trading and underwriting of public securities. I just wouldn't make the distinction, although proprietary trading is clearly the most pure version of the selfish activity.[56]

35. Although proprietary trading which goes beyond market making can generate social utility by contributing to market liquidity, the case has not been made for banks, rather than organisations such as hedge funds, to fulfil this role. The Commission's First Report emphasised the importance of reducing the perception of an implicit guarantee to banks and the subsidy to which this gives rise. While any subsidy is undesirable, it is particularly objectionable that the Government should subsidise and carry the risk for activities where the benefits might accrue to bank employees and shareholders, much of which would have little or no social utility, and which may pose a threat to banking culture.

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19 "How to Reform Our Financial System", The New York Times, 30 January 2010, www.nytimes.com Back

20 "Séparation et régulation des activitiés bancaires", Portail du Gouvernement, 19 December 2012, www.gouvernement.fr Back

21 German Finance Ministry announcement accompanying approval of draft bank separation law, 6 February 2013 http://www.bundesfinanzministerium.de Back

22 Ev w12 Back

23 Ev w20 Back

24 Ev w1 Back

25 Ev w8 Back

26 Shareholder Report on UBS's writedowns, April 2008 Back

27 "How Wing Chau Helped Neo Default in Merrill CDOs Under SEC View", Bloomberg, 10 May 2010, www.bloomberg.com Back

28 "IKB's experience is the thin end of the wedge", Financial Times, 19 April 2010, www.ft.com Back

29 Report of JPMorgan Chase & Co. Management Task Force Regarding 2012 CIO Losses, January 2012 Back