Proprietary trading - Statutory Instruments Joint Committee

Proprietary trading - Parliamentary Commission on Banking StandardsContents

6 The way forward

The priority for action

79. While a number of witnesses acknowledged the case in principle against proprietary trading by banks, most recommended against taking early action to attempt a prohibition. Many of them questioned the benefits that would result, or warned of the scale of the definitional challenge. Sir John Vickers stressed that he saw few benefits from adding such a measure to the existing ring-fence plans:

I believe that ring-fencing gains not all, but many, of the merits that the Volcker proposal seeks to achieve. Seeking to add Volcker from the outset would add cost and complexity, and could add to uncertainty in undesirable ways.[119]

Bill Winters said:

I do not reach the same conclusions as Paul Volcker does, that proprietary trading should be an area of particular focus. I certainly don't agree that the Volcker rule, which was not primarily a cultural tool, but was primarily a financial stability tool, is the most effective way to achieve the objectives that he, quite correctly, set out.[120] [...] I think the extraordinary focus on proprietary trading is not without relevance, but is misplaced in terms of prioritisations.[121]

The FSA said:

In our view, the ICB took a sensible approach to addressing the issues that can be caused by proprietary trading and a properly designed ring-fence can deliver an appropriate degree of insulation of core banking services while conflicts of interest can be addressed through systems and controls and conduct rules. It is not clear that the addition of a Volcker rule on top of a strengthened ring-fence, will bring further benefits in terms of resolvability. It also seems likely that legislating and then implementing both structural changes in tandem would prove very complex.[122]

The Chancellor of the Exchequer argued:

I do not think it is necessary. We have good reforms now to the structure of our banking industry, and I do not think that we need to supplement them; we need to implement them. I would say that that should be the priority. Engaging in a whole new set of reforms, which would take a long time to legislate for and to implement, not least because there are implementation issues as the Americans are finding out, would distract attention from the primary task in hand, which is to get the reforms that are agreed through and implemented.[123]

80. Martin Taylor took a somewhat different view:

I don't think a prop trading ban is necessary. [...] I don't think it's a bad idea. I just don't think it will make a huge amount of difference; I certainly don't think that it will make a big difference to financial stability. [...] If I favour it, I favour it very modestly. If I were a member of this Commission and other members were very strongly in favour of it, I would not try to stop it. It does not seem to me a mistake-certainly not a bad mistake-but it is not something that I would be proposing.[124]

81. Some other witnesses were more favourable to action, but they nevertheless made clear that they did not believe this to be a high priority. Asked whether the UK should have a Volcker Rule, Douglas Flint responded "I do not see any reason why one could not".[125] However, HSBC's written evidence stated:

As an effective ring-fence should protect the retail activities, having gone down the ring-fence route, it is difficult to see what additional practical benefits would arise from a total prohibition on proprietary trading, unless there are now concerns about the systemic importance of the wholesale activities to be contained in the non ring-fenced bank. Any conclusion that this is the case would logically re-open a discussion about the positioning of the ring-fence so that all economically-critical activities, whether wholesale or retail, could be protected from proprietary trading.

Asked whether a prohibition on proprietary trading would be in the public interest, Sir David Walker, Chairman of Barclays, responded favourably:

I would not, on the face of it, see a problem with that, because the market-making activity and the proprietary trading activities that we would defend are designed to promote, in the interest of our clients, their ability to undertake flow business with us to hedge whatever exposure they want to hedge on in reasonable terms, which would not be available to them if they were not a market maker in the market. If we agree on that proposition, as I believe we do, from your conversation, I don't have a difficulty with the proposition you make.[126]

However, Barclays' written evidence suggested that this support was conditional on a prohibition being limited only to stand-alone proprietary trading desks:

Our position was, and still is, supportive of a prohibition, providing that the definition of proprietary trading is suitably narrow and concise. More specifically, we support a prohibition on proprietary trading desks that are established by a bank for the specific purpose of trading for the firm's own account. These desks tend to be set-up with segregated capital and with separate teams of people whose compensation structure mirrors those of hedge fund managers, rather than other traders within the bank, and have minimal or no interaction with client business. These "stand-alone" proprietary traders typically sit apart from traders who serve clients as a part of steps taken to address the potential for conflicts of interest. A wider definition could bring considerable limitations.[127]

82. Martin Taylor commented on this type of conditional support:

Many of the banks—Barclays among them—have, I believe, said publicly that they do not do that kind of thing anymore. That certainly gels and chimes with Barclays' support for the idea of a prohibition. What I think the banks are talking about is that they are abandoning specific proprietary desks, or internal hedge funds, where you have people coming in every morning and, irrespective of what the bank's position is elsewhere or what the customer flows are, simply saying, "We like the yen; let's buy the six-month position and go hard on it."

It is very easy to tell the banks not to do that and it is easy to police it. What is not easy to police, of course, is the banks building up positions that are expressive of a proprietary view by the way in which they build their trading books.[128]

83. In view of the fact that one of the main objections to a prohibition related to the uncertainty about whether a workable definition of proprietary trading could be found, a number of witnesses suggested delaying any decision in the UK until the efforts of other countries that are proceeding with a proprietary trading ban can be properly evaluated. Andy Haldane said:

I would like to take time to see how the US experience pans out with their Volcker rule. Down the line, if we have a review of Vickers in four or five years' time, as you proposed in your earlier report, we might see whether imposing the Volcker rule on top is a practical proposition.[129]

Referring to our proposals for periodic independent reviews of the effectiveness of the ring-fence and the case for full structural separation, Sir John Vickers suggested that "This might be a good topic for the first of ... [these] reviews [...] because I believe that these are really very difficult and vexing questions".[130] Lloyds Banking Group said:

it is reasonable (as suggested by the PCBS) to conduct reviews into the effectiveness of the legislation after a suitable period of time has elapsed, and of the relevant banking groups internal controls and compliance, risk management and conflicts of interests systems. If these reviews find that the ring fencing reforms are not meeting the objectives of the legislation or that the internal measures put in place by the groups are not sufficient to identify and restrict risk, then it would be at that stage that further measures could be designed to address any shortcomings identified.[131]

HSBC recommended that any future consideration of proprietary trading should be considered alongside other elements of the design of the ring-fence:

given that the ring-fence is intended to prevent contagion from non-core activities, any requirement for a prospective review to consider the possible case for a prohibition of proprietary trading should be part and parcel of a more general review of the effectiveness of ring-fencing, the appropriateness of the location of the ring fence, and the sustainability of critical business activities and infrastructure across both the ring-fenced and non ring-fenced banks.[132]

84. Bill Winters set out the arguments between acting now against proprietary trading and waiting:

The argument for now would be that there's enough uncertainty surrounding the operation of UK banks today that it's better to get the bad news out now than to have a longer period of uncertainty, with the prospect of bad news down the road. Clarity is a good thing; it's a good objective. British banks need to be able to have access to capital markets to properly capitalise themselves and to serve their customers. Clarity is good, and that would argue for now.

But since I don't think that the Volcker rule is a particularly helpful tool for our economy and for the regulator to impose, I would suggest we wait, because we may change our mind. Whatever we think today, we may have a different view a year, two years or five years from now, especially having benefited from whatever experience the Americans have. I think the Europeans will have a similar experience as they try to introduce the Liikanen proposals. [...][133]

He concluded by saying "on balance, and recognising my bias against the Volcker rule as a practical matter, I'll say waiting is better."[134] However, Martin Taylor pointed out another argument for not waiting, namely that "if you are going to do it, the time to do it is when the banks say that they are not doing it anyway."[135]

85. Some witnesses discussed the possibility of legislating now to give regulators a reserve power to bring in a Volcker rule, should current controls prove inadequate to contain proprietary trading over time. Sir John Vickers said:

In the long term, I would be open minded. One simply does not know how these things will develop. If enshrining a reserve power in statute at the outset catered for those future contingencies, there might be an uncertainty point that needed to be weighed in the balance. To use the word you quoted from my paper, that would seem a perfectly "coherent" thing to do. One could then imagine a family of reserve powers: the full split reserve power, the sibling reserve power and a Volcker reserve power.[136]

Lloyds Banking Group warned against attempting to design powers now that would only be used in response to uncertain future problems, since this would give rise "to the risk that regulators' tools are ill-suited to their needs."[137] Bill Winters warned that it could be difficult to use such a reserve power:

The idea that the regulator has that reserve power could in some scenarios be helpful, but it would be very difficult to actually implement it. I suspect that the regulator has many more tools at its disposal to encourage or force banks to behave in a way that is different from how they are behaving without having that particular reserve power.[138]

RBS argued that a reserve power could be justified in relation to an individual out-of-control bank, but not the sector as a whole:

We have no objection in principle to the regulator holding a reserve power to impose a restriction on the nature or scale of proprietary trading of any individual bank. However, as discussed above, we do not consider that an outright prohibition on proprietary trading is likely to deliver benefits in any way proportionate to its costs. Therefore, we see no advantage in creating either a mandate for regular review of the need for such a prohibition or reserve powers to implement a blanket ban.[139]

86. In the previous chapter we noted the challenges associated with defining those types of proprietary trading that are undesirable. We also noted the concerns expressed about the possible distraction that an attempt to prohibit such undesirable activities now might represent to other regulatory priorities. One or both of these arguments have led many, including Sir John Vickers, Mark Carney and the FSA, to oppose the introduction of a ban on proprietary trading in the UK now.

87. The issues we have identified have not prevented proposals from being developed in other jurisdictions. The progress—or otherwise—of the USA, and, to a lesser extent, France and Germany, in establishing a definition of proprietary trading and enforcing their measures should become apparent over time. This will provide valuable evidence to enable a better assessment of the feasibility and likely effectiveness of similar action in the UK, although the different banking and legal traditions and regulatory approach in each country mean that experiences will not be fully transferable.

88. The UK ring-fence, in its electrified form, is intended to protect core banking services by separating all investment banking activity, including proprietary trading, in contrast to other jurisdictions which are proceeding with structural reforms focused solely on proprietary trading. Given the present uncertainty about the feasibility and burden of prohibiting proprietary trading within banks, the Commission believes that it would not be appropriate to attempt immediate prohibition using the legislation currently before Parliament.

Our recommendations

89. Some witnesses said that similar outcomes to prohibition could be achieved through greater use of supervisory powers, but at a lower cost. Martin Taylor suggested that if action was needed, such an approach would be preferable to complex new legislation:

I think that if you want to do this, the way to frame it is to ban the outright proprietary desks and to say that you expect the risk positions that arise in the course of normal market-making to be kept within reasonable bounds, and let the banks understand that, if they don't observe that, the regulators are likely to hit them with more capital on their trading book. Do that in a relatively informal way. It seems to me that under the new arrangements that are coming in for bank regulation in this country, there is some chance of making that kind of thing work, without resorting to an enormously complicated piece of legislation.[140]

[...] If the supervisor lets it be known that the intention is that the banks should not take on proprietary risk positions, that the position should arise from customers flows and be hedged to keep the total value of risk at a reasonable level, and that it is necessary to report to the supervisors when it goes above that level and explain why, maybe you are beginning to get a sensible regime.[141]

90. Martin Taylor further explained that one way to put this into practice would be through using capital requirements to discourage proprietary trading:

the way for the regulator to do that would be to calibrate the capital against the degree of market risk being run, and let the bankers know that if they increased their market risk appetite rapidly, their capital would go up even more rapidly, so it would become, at the margin, less and less profitable to them. I understand that in the new macro-prudential world, that kind of idea is on the table, and I certainly would not be hostile to it.[142]

HSBC explained how the supervisor already has discretionary powers to vary capital which could be used in this way:

We believe that if the supervisor has concerns about the risks involved in any proprietary trading operations, it has the ability and authority already effectively to prohibit these activities in an individual bank if so required. At the simplest level, this could be achieved by increasing the capital requirements under the bank's Individual Capital Guidance (Basel Pillar 2) on the basis of protection against prudential risks, to levels which would effectively make the targeted proprietary trading activities non-viable.[143]

91. Standard Chartered also referred to these supervisory powers to apply capital charges or amend permissions.[144] The FSA's Pillar 2 Assessment Framework document sets out that the regulator may make capital adjustments up or down "to reflect underlying weaknesses or strengths in governance, oversight, risk management and controls".[145] Because banks currently claim that they do not engage in proprietary trading, if the supervisor were to discover evidence of such activity it would potentially imply a control or governance failure, thereby providing grounds for the FSA to make a capital adjustment under Pillar 2. It is unclear whether the legal position would allow such action to be justified on cultural rather than strictly prudential grounds, particularly in light of any EU-level restrictions on the use of capital add-ons which may emerge from the new Capital Requirement Directive.

92. HSBC pointed out that supervisors have discretionary powers to prevent activities which are deemed to pose risks beyond the capacity of the firm to manage them:

Additionally, supervisors have wide powers to constrain activities based upon their assessment of the capabilities and capacity of individual firms to control and manage the underlying risks.[146]

RBS noted that although the FSA has considerable existing powers which could be used to control proprietary trading, there could be a case for bolstering these:

It is possible that the current powers may take some time to exercise and therefore the introduction of an additional overarching power that allows the FSA to act immediately to require own account trading activities of a bank that is not being well managed to be reduced or suspended at short notice (whilst maintaining effective management of risk and avoiding unintended systemic consequences) may be additive to the overall powers of the regulators.[147]

93. As we noted in our First Report, the regulator has powers to vary or cancel a firm's permission to carry on regulated business under section 45 of FSMA. This power can, however, only be exercised subject to a number of limits and safeguards to which we referred in that Report, including a requirement that it be in pursuit of regulatory objectives and that any restriction must be proportionate to the objective the regulator is seeking to achieve.[148] The FSA told us that, while they had existing powers which could be used to prohibit proprietary trading, primary legislation could strengthen their ability to use these:

Firms' permissions could potentially be restricted to prohibit such trading. That could be done under present regulatory authority, but it would be highly preferable that if such restrictions were to be imposed across a class of firms (i.e. all RFBs) for reasons designed to promote structural separation that primary legislation specifically authorise the regulator to impose such restrictions across such a class. This would be to reduce litigation risk.

The Banking Consolidation Directive (BCD) is silent on the question whether such restrictions on firms that would otherwise qualify to undertake such activities is consistent with it. The FSA's General Counsel Division has taken the view that because the ICB's proposals go beyond matters within the BCD, it would not be impermissible for such constraints to be imposed. However, this view has not been tested and is open to argument. Primary legislation that specifically authorises the regulator to impose such restrictions is therefore desirable also to anticipate and blunt such a criticism.[149]

94. In our Second Report we recommended that in addition to the regulator having the power to "electrify" the ring-fence and force full separation between a ring-fenced and non-ring-fenced bank, there should also be a specific power to require a bank to divest itself of a specified division or set of activities, and that such a power should be able to be exercised to secure protection for the cultural position of ring-fenced activities. If the Government were to adopt this recommendation in the legislation before Parliament, it should help to overcome the potential obstacle to supervisory action described in the FSA's evidence.

95. RBS described how a more general application of existing powers to trading-book risks would be preferable to something focused specifically on proprietary trading:

We believe the better approach is to impose general principles requiring own account trading activity to be connected to customer activity, with specific requirements (as already exist) for capital, market and risk limits and controls to be in place, supported by robust compliance, monitoring and surveillance activities and with a strong emphasis on the correct culture and risk appetite. If at any time the regulators are not satisfied that a bank is managing its own account trading activities prudently the regulator can then invoke a standing power to restrict that activity, use existing powers to vary the bank's permissions or otherwise impose additional capital requirements.[150]

96. Standard Chartered also suggested that the concerns about proprietary trading would be better dealt with through a more general change to how supervisors monitor and control risks in banks:

Rather than spend time defining proprietary trading and splitting it out from risk taking associated with market-making, regulators ought to monitor the overall risk profile of banks. This approach is likely to lead to a more fruitful discussion on the approaches being taken by banks rather than a tick box approach to compliance with rules. It is the sustainability of a bank's business model with which regulators ought to concern themselves. Regulators should measure how a bank is allocating its overall risk envelope. Is it for facilitating client business or is it undertaking standalone proprietary trading? Furthermore is the risk envelope appropriate given its client flows and revenue streams? This is really only a task that can be undertaken through effective supervision and not blunt rules.[151]

97. The main UK-headquartered banks have told us that they do not engage in proprietary trading at the present time and do not wish to do so. We recommend that the PRA, with immediate effect, ensure that their regular scrutiny of banks monitors this assertion and holds banks to it. In particular, the PRA should play close attention to trading units which have characteristics such as large open or arbitrage positions and volatile revenue flows. Were a bank unable to demonstrate satisfactorily that certain trading activities relate to their core business of serving customers, this would be an indication of proprietary trading or of a more general prudential weakness in the bank. In such cases, the PRA should use its existing tools such as capital add-ons or variations of permission to bear down on such activity and incentivise the firm to exercise tighter control. As part of their commitment to enhanced disclosure, banks should be required to agree with the PRA a published statement of risk exposures in their trading book and of control issues in their trading operations raised by the PRA during the last year. Parliament will expect the PRA to report on these statements. It is possible that the PRA may not be able to justify use of existing tools in this way under its current mandate. We therefore further recommend that the Government consult the regulators on whether the current legislation needs amendment to give regulators the authority to carry out activities in pursuit of these regulatory aims.

98. We further recommend that the current legislation require the regulators to carry out, within three years of the Act being passed, a report to include:

i) analysis of the monitoring and corrective actions conducted in accordance with the recommendations in paragraph 97;

ii) an assessment of any impediments encountered to such actions;

iii) the impact, by then, of the moves towards ring-fencing on banks' trading activities;

iv) lessons about the feasibility of defining and prohibiting proprietary trading within banks, based on the experience of other countries, in particular the USA, attempting to do this; and

v) a full assessment of the case for and against a ban on proprietary trading.

99. We would expect this report to be presented to the Treasury and to Parliament and to serve as the basis of full and independent review of the case for action in relation to proprietary trading by banks. We recommend that legislation be introduced to provide for such a review and to provide assurances about its independence, including a role for the House of Commons Treasury Committee in the appointment of the persons to carry out the review.

119 Q 2592 Back

120 Q 3681 Back

121 Q 3691 Back

122 Ev w8 Back

123 Q 4331 Back

124 Q 2897, Q 2900, Q 2912 Back

125 Q 3868 Back

126 Q 3660 Back

127 Ev w1 Back

128 Q 2890 Back

129 Oral evidence taken before the Parliamentary Commission on Banking Standards Panel on Regulatory Approach on 21 January 2013, HC (2012-13) 821-ii, Q 178 Back

130 Q 2588 Back