4 Proprietary trading by banks today
Extent
36. Most UK banks told us that they do not now
engage in pure proprietary trading, or that this is only a very
small activity with most of their trading activity being driven
by client needs:
- "Standard Chartered has
a client-focused business and has no dedicated proprietary trading
desks";[57]
- Lloyds Banking Group "does not have a segregated
proprietary trading unit";[58]
- HSBC "do not undertake proprietary trading
activities";[59]
- Stephen Hester said that "we tried to remake
RBS not so that every activity has no element of proprietary—I
think that that is impossible—but so that the guiding rationale
and dominant principle is serving customers".[60]
Barclays did not comment explicitly on their current
activities, but said that they supported "a prohibition on
proprietary trading desks that are established by a bank for the
specific purpose of trading for the firm's own account".[61]
37. It is notable that several banks focused
on the fact that they did not operate dedicated proprietary trading
desks. As discussed earlier, it is also possible for banks to
conduct proprietary trading within teams primarily trading for
other reasons. Given that many banks historically have not been
open about the extent and nature of their proprietary trading
activity, it is therefore difficult to judge to what extent such
activity is truly absent from the UK banking system.
38. One reason why banks may not presently be
engaging in proprietary trading is that it is likely to represent
a poor use of capital in the current economic climate. Bill Winters
explained why he hoped and expected this would persist:
when banks looked at how profitable proprietary trading
really was and properly factored in the cost of funds [...] they
saw it was not profitable, because banks cannot compete with hedge
funds that are unconstrained by the regulatory and political pressures
that we are all correctly introducing for banks. That is not to
say that there are no good traders in banks—of course there
are good traders—but even in the pre-crisis days, the best
traders tended to drift out of banks and into non-banks, because
that was the more natural place for proprietary trading to take
place.
The proprietary trading that became very large inside
banks almost always involved the funding cost benefit that was
coming from the transfer from taxpayers to the banks. The decision
that most banks took to shut most of their proprietary trading
was purely an economic one, and it is unlikely to be changed with
the passage of time, as long as we do not allow Government subsidy
to slip back in. Of course, it has not been completely excised
yet, but the objective is to remove that subsidy completely. Once
we have done that, most proprietary trading will naturally reside
outside a bank.[62]
RBS also noted that "Tighter capital and liquidity
rules, together with prudential controls as proposed by both Basel
III and the ICB recommendations for PLAC will have the effect
of restricting the appetite of any bank for own account trading".[63]
39. Many of the leading UK banks
have told us in evidence that they do not currently engage in
proprietary trading, and a number of them agree that proprietary
trading is not a suitable activity in which customer-oriented
banks should engage. However, such reassurances alone cannot provide
a guarantee against the re-emergence of proprietary trading over
time, as public attention on banks' activities fades, economic
circumstances change and another generation of bank leaders less
scarred by recent events emerges.
Controls
40. Some banks argued that any prudential and
conduct risks from allowing proprietary trading to take place
within banks could be adequately controlled and should not be
of significant concern. RBS said:
we do not believe that own account trading activity
conducted in connection with customer activities within a financial
group (but outside a ring-fenced bank) poses risks to that ring-fenced
bank (or the financial system) that cannot be properly controlled
(or that are disproportionate) by having effective internal controls,
as overseen and supervised through regulatory powers.[64]
Lloyds contended that potential conflicts of interest
from proprietary trading should be effectively controlled through
existing conduct rules which require banks
to take reasonable steps to identify conflicts of
interest, to maintain a record of the kinds of activity and service
which give rise to potential conflicts of interest and to put
in place arrangements to prevent of manage these conflicts. These
arrangements may include physical separation of conflicted business
areas, controls on information sharing and other organisational
and administrative arrangements. [The FSA's handbook] specifically
identifies proprietary trading as one of a number of areas which
require special attention in the context of a firm's conflict
of interest policy.[65]
41. The FSA explained how they manage "the
risk of detriment to clients arising from firms' proprietary trading
activities":
First, across all client categories (including eligible
counterparties), the FSA requires special attention to be given
by firms to their senior management arrangements and systems and
controls where they undertake proprietary trading in addition
to providing services to clients. We expect firms which carry
out proprietary trading to ensure that they take all reasonable
steps to identify, manage, and where necessary, disclose any conflicts
of interest that arise from their activities. The organisational
and administrative measures we expect firms to put in place to
manage the conflicts should be proportionate to the size and organisation
of the firm and the nature, scale and complexity of its business.
Secondly, we recognise that some clients need to
be afforded higher regulatory protection than others depending
on their knowledge, skills and expertise and the FSA's rules reflect
this through placing a number of more onerous requirements on
the conduct of the firm when providing services to retail and
professional clients. For example, best execution duties, the
requirement not to misuse information they have on clients' pending
orders, and the requirement to provide appropriate information
to clients outlining the key risks of any service provided. We
do however recognise that some proprietary trading activities
are undertaken in pursuit of legitimate business, for example,
market making or risk management purposes. Therefore an exemption
to the rules is available in certain circumstances.[66]
The FSA also noted how the FCA's new approach would
enhance its scrutiny on potential conduct risks in wholesale markets
and suggested that "areas which have not been a focus for
the FSA in the recent past will be looked at more closely".[67]
42. Existing supervisory measures
address some of the risks—particularly prudential—arising
from proprietary trading within banks. Reforms to capital requirements
since the financial crisis have made proprietary trading a less
attractive activity for UK banks. Greater attention to risk management
and control frameworks both within firms and from the supervisor
should help to limit the extent of prudential risk.
43. Rules already exist to address
potential conflicts of interest between banks and customers. However,
these measures as currently applied do not at all adequately address
the risks to culture and standards which have been identified.
44. Supervisors already have
broad, discretionary powers which they could use to discourage
or prevent proprietary trading. These include imposing additional
capital requirements and the ability to require firms to reform
or cease activities which cause concern. However, it is not clear
that supervisors would currently be willing to use such powers
specifically to restrict proprietary trading, except where it
poses a clear prudential risk. Since supervisors do not appear
to view proprietary trading as a significant threat on these grounds,
it is also unlikely that they currently seek actively to identify
where a bank is undertaking such activity.
Reforms currently in progress
45. Structural reform proposals in the US, France
and Germany have focused on separating proprietary trading from
the main business of banks, either through a prohibition in the
case of the US Volcker rule, or by requiring a separate subsidiary
to carry out proprietary trading in the case of the French and
German proposals. The Volcker rule was passed as part of the Dodd-Frank
Act in 2010, with a target implementation date of July 2012, but
as of February 2013 regulators were still working on the detailed
rules to underpin it. In the meantime, Comptroller of the Currency
Thomas Curry wrote in July 2012 that:
many of the largest national banks [...] have shut
down, or are in the process of winding down, exposures in trading
books that appear most clearly to fall within the statutory definition
of proprietary trading, specifically those desks which do not
face clients and do not have a purpose other than speculating
on markets.[68]
The French and German proposals are more recent and
have not yet been passed into law.
46. In the UK, the Government has proposed legislation
to implement a ring-fence, originating from the report of the
ICB, and following on from draft legislation which we considered
in our First Report. The UK approach takes a broader view of the
investment-banking activities which should be separated, also
including market-making and underwriting. Finally, the High-level
Expert Group on structural bank reforms established by the European
Commission and chaired by Erkki Liikanen also made structural
reform proposals which are under consideration by the European
Commission; their scope would fall between the UK and other approaches.
The table below provides a necessarily simplified comparison of
the broad principles of the five current versions of structural
separation. Grey and dark-blue activities must be conducted in
separate entities. White activities can be conducted in either:
| UK
| Liikanen
| USA
| France
| Germany
|
| Retail and SME deposit-taking
| |
| |
| |
| Retail and SME overdrafts
| |
| |
| |
| Retail and SME lending
| |
| |
| |
| Corporate deposits and lending
| |
| |
| |
| Hedging services
| |
| |
| |
| Underwriting and structuring securities
| |
| |
| |
| Market making
| |
| |
| |
| Proprietary trading
| |
| |
| |
| Type of separation
| Ring-fence
| Ring-fence
| Full separation
| Ring-fence
| Ring-fence
|
47. The ICB considered whether separating proprietary
trading alone would solve the problems it had identified with
the present structure of banking in the UK, and concluded that
it was preferable to separate a wider range of investment banking
activities from retail banking.[69]
As Martin Taylor pointed out:
We obviously looked at the Volcker rule, because
it was pre-existent. [...] We did not see that it would solve
the problem we were trying to solve. [...] A Volcker rule is of
course a lot less radical from the banks' point of view than a
ring-fence.[70]
48. The proposed ring-fence will address some
of the concerns specific to proprietary trading discussed in the
previous section. First, by proposing to create a degree of organisational
separation between proprietary trading and retail banking—the
functions most important to the real economy—the danger
of prudential and cultural contagion between the two can be reduced.
Second, by permitting different resolution strategies for each
entity, ring-fencing— combined with other measures such
as resolution plans and bail-in—should reduce the perception
of an implicit guarantee for the investment bank. This should
result in the investment bank's funding costs more accurately
reflecting the risks it runs, limiting their ability to increase
leverage and making proprietary trading more costly for banks
to undertake. Lloyds Banking Group told us:
Ring fencing should be sufficient to remove risks
that any proprietary trading within the remainder of the group
poses to a bank's retail and commercial operations. Ring fencing
would eliminate any potential mis-allocation of capital and funding
which could result from banks which conduct proprietary trading
having access to the insured deposits at a retail and commercial
bank. Furthermore, ring fencing ensures that if problems emerge
in relation to any proprietary trading activity, this will not
impact the continuity of the bank's retail and commercial operations.[71]
Bill Winters emphasised the ICB's focus on addressing
the implicit guarantee:
culture or the migration or the perversion of the
culture no doubt had a lot to do with the incentives that were
in place along the way. I think the incentives in turn really
came both endogenously and exogenously. Endogenously, they came
as much as anything from the fact that Governments were implicitly
allowing banks to operate with tremendous advantages relative
to any other participating capital markets. That was the transfer
of value from taxpayers to banks and from banks to bankers, not
just proprietary traders but clearly they were part of the beneficiary.
What we can see in retrospect was grotesque and completely inappropriate
and highly damaging. That is a clear observation. Certainly through
the ICB's work we have tried very hard to remove that transfer
from the taxpayer to shareholders or to the bank.[72]
49. However, although implementation of a robust
ring-fence is an important priority, this measure alone does not
fully address the concerns relating to proprietary trading. Proprietary
trading will still be able to take place within the non-ring-fenced
bank, leaving two main potential areas of concern which we consider
further below: first, that the ring-fence may prove less than
completely impermeable despite this Commission's recommendations
for strengthening it; second, that, even if the ring-fence is
impermeable, problems may remain from allowing proprietary trading
to take place alongside other important wholesale activities in
the non-ring-fenced banks.
50. The FSA listed three channels of possible
concern from proprietary trading taking place within a group containing
a ring-fenced bank:
Firstly, if the ring-fence does not prove to be fully
effective then there could be contagion from the non-ring fenced
bank to the ring-fence entity threatening the provision of core
banking services.
Secondly, it would be inappropriate if the cost of
funding of the proprietary trading business in a group with a
ring-fenced bank would be lower than a standalone wholesale bank
solely because of the presence of the ring-fenced bank in the
former group. Whether this will be the case depends on how the
legislation and rules pertaining to the height of the ring-fence
develop and the markets view on whether this removes the potential
for any government support from the non-ring fenced bank.
Thirdly, depending on the height of the ring-fence,
proprietary trading may directly impact on retail clients either
through losses threatening the provision of core services or through
the group putting its interests ahead of those of its clients
in an improper way, such as the miss-selling of financial products.
Finance Watch also noted the remaining possibility
of contagion:
As the PCBS's First Report notes, ring-fences are
fallible [...] Given a leaky, badly maintained or weak ring-fence,
there is a danger that losses from proprietary trading could cause
problems for ring-fenced entities. Resolution tools, no matter
how well designed, can only deal with so much. Therefore, there
remains a danger that State intervention at taxpayers' expense
will be required and that "perceived implicit guarantees"
will remain.[73]
51. HSBC noted how the UK ring-fence leaves important
wholesale bank activities potentially vulnerable to risks from
proprietary trading:
By combining proprietary trading activity with other
markets activity, neither the UK nor the Liikanen proposals address
the risks that contagion from proprietary trading could disrupt
other important markets activities which support customers [...]
these markets activities are also systemically important. They
are considered to be Critical Economic Functions by the FSA for
resolution purposes and, in the case of market-making, the creation
of a deep and liquid trading market is essential to the financing
of the real economy through securitised funding.[74]
Douglas Flint, Chairman of HSBC, echoed this point
in oral evidence:
I also believe that the non-ring-fenced bank is systemically
important. Therefore, if you believe that one of the risks to
the non-ring-fenced bank is proprietary trading, you should not
want it there, because the non-ring-fenced bank is going to be
systemically important to the payments systems, to large corporates,
to credit creation[75]
52. The FSA acknowledged the potential systemic
importance of non-ring-fenced banks, citing potential effects
similar to those experienced when Lehman Brothers failed:
It is important to note that even standalone wholesale
banks can indirectly threaten the provision of financial services.
For example, the failure of a large wholesale bank may cause the
wholesale funding market to temporarily dry up leaving retail
banks unable to access wholesale market funding.[76]
53. Barclays argued that if proprietary trading
was felt to be an issue, there was no reason to confine any response
to just those groups containing a ring-fenced bank:
we see no distinction in terms of the risks to financial
stability between a proprietary trading entity that sits within
a group containing a non-ring-fenced bank, and one on its own,
especially if ring-fencing has been completed. So no particular
benefit would be gained from applying such a prohibition only
to a non-ring fenced bank within a group containing a ring-fenced
bank.[77]
HSBC expressed a similar view:
In terms of standards of conduct, it is difficult
to see a material difference between proprietary trading conducted
in a group which contains a ring-fenced bank (which will necessarily
be in a separate subsidiary from the ring-fenced activities) and
through a stand-alone wholesale bank. Again we note the US and
proposed French solution is simply to prohibit proprietary trading
absolutely in banks of any shape.[78]
54. The present structure of the UK banking system
is such that most large UK-headquartered banks with the capacity
to engage in proprietary trading will probably be part of a group
containing a ring-fenced bank once the legislation before Parliament
comes into effect, with the likely exception of Standard Chartered
under a de minimis exemption which we have previously examined.[79]
As an international financial centre, the UK also hosts a number
of foreign investment banks. The failure of Lehman Brothers showed
how these can pose a prudential threat to UK interests, while
the JPMorgan "Whale" trader, the UBS Libor scandal and
the UBS rogue-trader scandal all had an impact on the trust and
reputation of the City of London despite originating in foreign-owned
banks. If the USA, France and Germany do implement intended restrictions
on proprietary trading by their banks, this would cover a significant
portion of the foreign investment banks operating in the UK.
55. Implementation of a robust
ring-fence in the UK, strengthened by measures to give effect
to the recommendations in the Commission's First Report, will
create a degree of organisational separation between those parts
of some banks which might in future carry out proprietary trading
and the core banking services provided by those banks. By seeking
to confine the benefits of the implicit guarantee to retail banking,
with a view to its eventual elimination, the ring-fence should
also further raise the cost for a non-ring-fenced bank in funding
risky trading activity, including proprietary trading.
56. However, no measures proposed
under legislation currently before Parliament would directly restrict
the ability of non-ring-fenced banks to engage in proprietary
trading. The possibility of contagion between a non-ring-fenced
bank and a ring-fenced bank will not be eliminated. A ring-fence
is not the same as full structural separation, and potential channels
of contagion will remain a cause for concern. In addition, the
risks and conduct of investment banks—including those which
are not part of a group containing a ring-fenced bank—remain
grounds for public concern, because such firms may still be of
systemic importance and could contain critical economic functions.
57. The Commission believes
that, while current and planned reforms will mitigate the risks
(although not the full extent of the cultural threat) from proprietary
trading within certain banks, these do not go far enough. Further
measures to address proprietary trading within the banking sector,
including outright prohibition, could therefore be desirable in
principle, provided they can be implemented in a proportionate
and effective way.
57 Ev w25 Back
58
Ev w17 Back
59
Ev w12 Back
60
Q 4174 Back
61
Ev w1 Back
62
Q 3686 Back
63
Ev w20 Back
64
Ev w20 Back
65
Ev w17 Back
66
Ev w8 Back
67
Ibid. Back
68
Letter from Thomas Curry to Rep. Carolyn Maloney, July 2012, http://maloney.house.gov/sites/maloney.house.gov
Back
69
Independent Commission on Banking, Final Report, September 2011,
p 45 Back
70
Q 390 Back
71
Ev w17 Back
72
Q 3681 Back
73
Ev w3 Back
74
Ev w12 Back
75
Q 3869 Back
76
Ev w8 Back
77
Ev w1 Back
78
Ev w12 Back
79
First Report; Second Report Back
| 
