Banking StandardsWritten evidence from the Financial Services Authority (V005)
Stability
1. What prudential concerns does proprietary trading within banks give rise to? To what extent are any concerns being addressed through existing measures and proposals, including ring-fencing?
Whenever banks engage in trading activities they take on risks—in particular the risk that their investments will fall in value (market risk) and the risk that the counterparties to their investments will fail to pay them (counterparty credit risk). Losses caused by these risks will erode a bank’s capital base. Banks are required to hold capital to protect against such risks. Whether banks are trading for proprietary reasons, or to facilitate client business, they will be exposed to some market and counterparty risks. The key difference is the scope and breadth of these risks.
When facilitating client business a bank is likely to try and “hedge” most of its risks. However this will never be certain as: (i) there will often be some mismatch between the position and the hedge—known as basis risk; (ii) there will be a need, and a cost, to “rebalance” hedges as market moves alter risk profiles; (iii) there will always be a reliance on the “hedge counterparty” to remain solvent.
When undertaking proprietary trading, banks will try and target certain risks that they wish to take, and hedge others—thus all the same hedging risks apply. However, 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.
We consider that a strong ring-fence should help insulate the provision of core financial services from losses that could arise from proprietary trading. We also note that the Basel Committee is conducting a review of the capital requirements for trading activities which will further supplement the changes to the capital regime made following the banking crisis.
2. To what extent does the presence of proprietary trading activity alongside client-facing activity in banks create the potential for conflicts of interest and affect remuneration practices, culture and banking standards?
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.
In terms of remuneration, front office staff across different industries tend to have pay and bonuses linked to sales and profitability. In a highly volatile environment such as trading in financial instruments, this can bring along unwelcome incentives in the form of excessive risk taking and short-termism.
To help address this, the objective of the FSA’s Remuneration Code, which implements the remuneration provisions of the Capital Requirements Directive III, is to ensure that firms adopt remuneration policies which are consistent with and promote sound and effective risk management. The code recognises that perverse incentives encourage excessive risk taking. These incentives exist in varying degrees across banks’ operations as a whole and are not restricted to one type of activity.
Overall, the PRA’s approach to improve banking standards will be to expect the banks’ governing bodies to embed and maintain a firm-wide culture that supports the safe and sound management of the firm. The PRA will expect boards and management to understand clearly the circumstances in which the firm’s viability would be under question and to take action to address risks on a timely basis.
3. How adequately do current conduct rules manage any potential for conflicts and harm to standards? To what extent could stronger conduct rules address any problems?
The current conduct regulatory framework (both rules and high level Principles for Businesses) provides the requisite degree of flexibility for supervisors to exercise the necessary degree of supervisory judgment. The framework takes into account the variety of activities and business models in the financial sector, together with the multiplicity of circumstances in which conflicts of interest and risks may arise in practice as a result of firms’ proprietary trading activities.
For these reasons, it is not currently envisaged that the FCA will introduce additional conduct rules to strengthen the current framework. That said, it is important to note that the FSA’s rules derive from European legislation with the trend continuing to be for Europe to adopt directly applicable regulations.
Conduct risks, and potential conflicts of interest are ubiquitous in the financial services industry although the potential for risks to arise is likely to be greater under the universal investment banking model where firms provide a wide range of financial services and activities. In this context, the potential for conflicts of interest where firms engage in proprietary trading in addition to providing services to their clients is particularly acute.
The FSA manages the risk of detriment to clients arising from firms’ proprietary trading activities in two ways.
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.
With the changes to the UK’s regulatory structure the FCA’s approach to supervising the conduct of firms’ wholesale activities will undergo an evolution. The regulatory framework will not change, however the FCA’s approach to supervising against it will. The FCA will place more focus on the rules and supervising against them. The FCA will recognise that the wholesale conduct and the internal organisation and arrangements of firms can pose risks to all participants in the conduct of their activities and cause harm to retail consumers.
For this reason, in order to enhance trust and the integrity of financial markets, the FCA will be willing to intervene in a greater range of client relationships. This will mean that areas which have not been a focus for the FSA in the recent past will be looked at more closely. This will be through the FCA’s Supervisory Framework or event-driven work.
4. Are there stronger grounds for concern about proprietary trading when it is conducted in a group which contains a ring-fenced bank than if it is conducted by a standalone wholesale bank? If so, why?
Yes, potentially. There are three reasons for this.
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.
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.
Practical Considerations
5. How, if at all, would prohibiting proprietary trading by banking groups affect the case for implementing a ring-fence? Would there be any practical benefits from implementing both such measures at the same time?
Enforcing total separation of proprietary trading alongside or instead of ring-fencing could provide a stronger barrier against global market contagion to core financial services, but the difficulty is in designing a proprietary trading prohibition that works in practise.
The ICB concluded that its reform package for the UK would achieve the main aims of full separation at a lower cost, and without creating a potential risk to financial stability that could come from having undiversified, correlated, stand-alone domestic retail banking.
A strong ring-fence can achieve the banking reform objectives as set out by the ICB; however, if the intention is to focus additionally on reducing the potential for conflicts of interest to arise then some form of the Volcker rule may provide additional benefits to ring-fencing but, as stated previously, we consider that enforcement of existing conduct rules and principles can address conflicts of interest issues that arise.
6. What powers does the regulator already have that could be used to prohibit banks from conducting proprietary trading? What are the constraints on any such powers?
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 (ie 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.
The exercise of the regulator’s powers to prohibit groups containing a ring-fenced bank from engaging in proprietary trading is likely to be constrained by provisions of EU law which limit the grounds on which a competent authority may object to a proposal to acquire a qualifying holding in banks. These provisions were introduced by the Acquisitions Directive [2007/44/EC] which amended the BCD to provide that a competent authority may oppose a proposed acquisition of a bank only if there are reasonable grounds for doing so on the basis of specified criteria.
We consider that a ban on the acquisition of UK retail or ring-fenced banks by UK investment banks would be beyond the scope of the BCD, provided it is for the purpose of the prudential supervision of UK investment banks. However, a blanket prohibition on the ownership of UK retail or ring fenced banks by EEA investment banks or holding companies that also own investment banks could be incompatible with the BCD.
7. What are the main challenges in defining proprietary trading, and how could these best be addressed?
The main challenge is defining proprietary trading in a manner that banks could not circumvent by claiming to be engaging in some form of market making activity on behalf of their clients. For example, some banks may claim that they are hold positions (stock) in a market in the expectation of future client needs. This is because it is always possible to sell products to a client and then immediately hedge the resulting market risk. However, clearly until they offset the market risk they have a proprietary position.
There are two ways of addressing this issue. The first way is through very prescriptive rule-making combined with intensive supervision. The second way is through a purpose based restriction.
There are problems with both of these approaches which is part of the reason why the ICB and Liikanen both avoided trying to distinguish between proprietary trading and market making.
A prescriptive approach is resource intensive to supervise and banks, if they are so inclined, will eventually find a way around the rules. A purpose based approach will not provide clarity to banks or their clients about what is permitted. It also does not provide supervisors with a clear consistent framework for exercising their judgement, particularly as derivative trading is a highly complex area where “risk management hedges” can quickly become sizable proprietary losses due to poor modelling of risk.
A combination of these approaches is currently being considered in the US and it may be a number of years before we can be sure that such a prohibition is possible to enforce in a meaningful way.
Overall Assessment
8. Given the factors above, how would you assess the case for:
(a) Including a prohibition on groups containing a ring-fenced bank from engaging in proprietary trading within the Banking Reform Bill
This proposal amounts to overlaying (some of) the Volcker rule on top of ring-fencing. Both ring-fencing and the Volcker rule seek to address similar objectives. In our view, the size of the benefits arising from overlying the Volcker rule on top of ring-fencing is dependent on two factors: (i) how robust the fence will be, and (ii) whether in practice we will end up with ring-fenced banks that effectively undertake all banking services that we would want to preserve in a time of crisis.
The stronger (and wider) the fence the lesser the case for overlying the Volcker rule on top of ring-fencing. In any event, trying to do both ring-fencing and the Volcker rule at the same time may lead to overly complex pieces of legislation and regulation.
Assessing the development and practical effects of the Volcker rule in the US could form part of the proposed independent review of the ring-fence.
(b) Implementing or creating reserve powers for a proprietary trading ban through some other form
The reserve power that was suggested in the Parliamentary Commission’s first report could potentially be used to impose some form of prohibition.
(c) Requiring that future reviews of the operation of the ring-fence have an explicit mandate to consider and report on the case for such a prohibition
If this is an issue that Parliament wishes to consider then it could be included in the terms of reference of the future review of ring-fencing.
(d) Using the Banking Reform Bill to give the regulator a reserve power to impose such a prohibition on individual banks if it concluded that it was necessary
See response to b) above. There is a legitimate question as to whether powers giving effect to structural reform of this magnitude is a matter for the regulator or for Government and/or Parliament. Although clearly there is a role for the regulator in advising Parliament as to whether such a prohibition would help it meet its statutory objectives.
15 January 2013