Proprietary trading - Parliamentary Commission on Banking StandardsContents


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


 
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© Parliamentary copyright 2013
Prepared 15 March 2013