Conclusions and recommendations
What is proprietary trading?
1. There is no commonly-accepted definition of proprietary trading. Most activity undertaken by banks results in some form of proprietary position. In principle, the type of trading which causes the greatest concern is where the bank is using its own funds, raised from shareholders, depositors and creditors, to speculate on markets, without any connection to customer activity. This has been the main focus of our consideration. Some banks, particularly US investment banks, historically had units dedicated to such activity. However, an examination of proprietary trading which only considered such units would be inadequate, because speculative activity can also take place alongside customer-related trading.
(Paragraph 10)
Prudential concerns
2. 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.
(Paragraph 22)
Cultural concerns
3. 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.
(Paragraph 30)
4. 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.
(Paragraph 31)
Social utility and the implicit guarantee
5. 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.
(Paragraph 35)
Extent
6. 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.
(Paragraph 39)
Controls
7. 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.
(Paragraph 42)
8. 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.
(Paragraph 43)
9. 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.
(Paragraph 44)
Reforms currently in progress
10. 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.
(Paragraph 55)
11. 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.
(Paragraph 56)
12. 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.
(Paragraph 57)
Conclusions on controlling proprietary trading
13. We have received extensive evidence from banks, and particularly from regulators and independent experts, about the practical difficulties of establishing a definition of proprietary trading which meets the standard necessary to support effective enforcement. An individual proprietary trade may outwardly appear to be similar or identical to trades arising from client activity such as market-making, with the main difference relating to the intent behind the trade.
(Paragraph 76)
14. Attempting to categorise individual trades as proprietary or non-proprietary is likely to be particularly challenging. Attempting to use a broad definition would risk capturing activities which all would accept perform a useful economic and social function, such as serving clients, supporting markets or mitigating risk; in such cases supervisors could be faced with a burdensome task of having to assess firms' justifications for exemption on a case-by-case basis. However, using a narrow definition, or setting out category exemptions up-front, risks making it too easy for creative traders or firms who wish to continue speculating to evade the rules by re-classifying or disguising their activity. Another argument advanced by several witnesses was that attempting to prohibit proprietary trading in the UK would risk distracting attention from implementation of the ring-fence.
(Paragraph 77)
15. An alternative way of enforcing prohibition, as currently being developed by US authorities, would be to use a range of metrics to monitor and track patterns of trading activity in order to identify where it appeared to have the characteristics of proprietary trading. Although this would not identify which individual trades are proprietary or client-related, such metrics could be able to signal which banks are engaged in proprietary trading, highlighting risks to the regulator. While this new approach appears more promising than attempting to categorise individual trades, it remains unproven, relatively complex and resource-intensive.
(Paragraph 78)
The priority for action
16. 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.
(Paragraph 86)
17. 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.
(Paragraph 87)
18. 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.
(Paragraph 88)
The way forward: our recommendations
19. 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.
(Paragraph 97)
20. 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. (Paragraph 98)
21. 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.
(Paragraph 99)
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