Banking StandardsWritten evidence from Lloyds Banking Group (V003)
We refer to your letter of 21 December 2012 and welcome the opportunity to comment on the implications of introducing a prohibition on banking groups containing a ring-fenced bank from engaging in proprietary trading, as being considered by the Parliamentary Commission on Banking Standards (“PCBS”). For clarity, we assume your question related to whether banking groups can conduct proprietary trading anywhere in the group.
Defining Proprietary Trading
To answer the specific questions raised in your letter, it is useful to start by defining proprietary trading. We would define proprietary trading as the risking of a bank’s own capital by taking positions in financial instruments in order to make gains from market movements, where such activities are speculative or run as a specific business with the sole aim of the bank making a profit for itself. It would typically be an activity that banking groups would undertake through a dedicated unit, segregated from client facing business areas and often with segregated capital, limits and remuneration policies. Typically the positions would be recorded in the trading books of the entity.
Lloyds Banking Group (the Group) has no such segregated unit.
Answers to specific questions:
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?
Having “true” proprietary trading within the same legal entity as insured retail deposits raises the risk that capital and funding could be mis-allocated and a “cross-subsidy” could occur, in terms of lower cost of funding and lower cost of capital. Placing any such proprietary trading activities into a separately capitalised and funded subsidiary outside the ring fenced bank ensures that these activities would be subject to a stand-alone cost of capital and funding that appropriately reflect the activities’ risk.
Standards
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?
As noted above, to the extent that the presence of insured deposits alongside “true” proprietary trading results in proprietary trading activities not facing a cost of capital and funding that appropriately reflects the risk of these activities, then this could result in a mis-allocation of capital and funding towards these risky activities.
In view of the cyclical nature and higher risk of proprietary trading, the remuneration of management and staff should be designed to discourage conflicts of interest. Remuneration at banks (as is the case at the Group)—including that of trading staff—should always reflect a balance of a broad range of objectives. These should cover client service and franchise development, risk management and financial performance.
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 rules provide an adequate framework for the identification and management of potential conflicts of interest. The current regime combines a high level principle (Principle 8: “a firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client”) with detailed requirements contained within the Senior Management Arrangements, Systems and Controls requirements (“SYSC”) section of the FSA’s Handbook. SYSC requires firms 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. SYSC 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.
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?
No, all other things being equal, there should be lower concerns. 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. Banning proprietary trading would therefore be redundant if the activities which are permissible within the ring fenced bank are clearly set out, including those activities indicated above as not constituting proprietary trading.
For the avoidance of doubt, the Group does not have a segregated proprietary trading unit.
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?
Different jurisdictions are taking different approaches to containing risk taking activity in banks. In the US, via the Volcker rule, a ban on proprietary trading is being developed as an alternative to the UK’s ring-fencing of core activities. The Liikanen proposals are another option where the proposal is that large-scale market activities are ring-fenced from the rest of the bank group.
In our view, a properly implemented ring fence should be sufficient to insulate the key economic functions of a ring fenced bank from any risks posed by any proprietary trading elsewhere in the group. Furthermore, ensuring the continuity and security of key economic functions is better served by identifying those activities, rather than the reverse, as proposed by Liikanen.
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?
The regulator already has the powers to restrict or suspend any permission which a firm has to carry on regulated activity, including dealing in investments as principal. Exercise of these powers would be subject to the existing constraints on the FSA’s exercise of its regulatory authority.
7. What are the main challenges in defining proprietary trading, and how could these best be addressed?
Defining proprietary trading as distinct from market-making is clearly difficult, as evidenced by the volume of regulation that has sprung up in the context of the Volcker Rule. Given the importance of providing groups which contain retail and commercial banks with the tools necessary for providing a sufficient range of services to their customers and managing their own balance sheet in a prudent manner, it is particularly key to identify activities which should be excluded from the scope of any discussion on proprietary trading, and therefore permissible in a group containing a ring-fenced bank.
In our view, the purpose for which activities are undertaken should play a role in determining whether an activity is classified as proprietary trading. In particular, the following should be excluded from the definition of proprietary trading, to the extent undertaken by a banking group containing a ring fenced bank:
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(a)
(b)
(9)
Market making is an essential part of the services provided by retail and commercial banks to their clients, and should be distinguished from proprietary trading. As a simple analogy the bank will, like a retailer, hold a certain number of days of anticipated turnover of relevant inventory to meet future client demand efficiently and cost-effectively. If the bank was unable to hold inventory, this would impact clients both in terms of timing—the client may have to wait until the bank could find an offsetting order against which to match the demand—and effectively would leave the client carrying the market risk exposure until an offset could be found.
At the Group, and many other banks, the degree of market risk taken in order to facilitate client activity, is carefully controlled and sized relative to the volume of that client activity. Specifically the scale of market risk undertaken by the (Trading) market-making desks is strictly limited by risk controls set by the overall Board risk appetite and specific risk limits for:
Overall Group risk limit which are determined by the Board Risk appetite. These limits are cascaded down to business divisions and ultimately desks and are monitored by an independent Risk function which reports via the CRO to the CEO; and
A specific Value At Risk (VAR) limit for the Trading desks in aggregate and at a sub-desk level (calculated on a 1-day 95% confidence level, ie a 1 in 20 day worst case scenario) This is sized as a very small percentage of the overall revenue budget for the Sales & Trading (client market transactions) business. The VAR limit can be temporarily increased in exceptional cases to meet larger than normal client flows with clearance from the Risk function.
Since some of the activities listed above may evidence similar characteristics to proprietary trading, even though they pursue different objectives, it is important to have strong risk policies, procedures and regulation to help overcome these challenges.
We agree that banking entities should have and maintain a robust and comprehensive set of internal policies and procedures, meeting regulatory standards, to ensure that only permitted activities are carried out and to identify when breaches have occurred. By way of example, it could be required that banking entities produce operating procedures for each business/desk regarding permitted trading activity, and including (i) the mandate of each trading unit/profit area, (ii) a description of how revenues are generated and positions hedged, (iii) activities engaged in by the trading unit/profit area, (iv) a list of the types of products approved for transactions, (v) a description of the remuneration policy for those engaged in risk-taking activities; (vi) the types/levels of risk which are permitted to execute the stated mandate of each such trading unit/business, and (vii) the review and escalation procedures for breaches of limits and controls.
Developing and maintaining these policies and procedures at the level of each business/desk will help avoid a generic approach in a banking institute which could inadvertently prohibit a permitted activity or permit a prohibited activity. It would also assist with the supervisory assessment of the appropriateness of overall compliance programmes.
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
(b) Implementing or creating reserve powers for a proprietary trading ban through some other form
(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
(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
As outlined above, we reaffirm our support for strong and clear rules to be put in place to create a ring fenced bank to establish a delineation between traditional client-oriented banking/banking group management and higher-risk activities to be kept outside the ring fenced bank. To the extent that the above guidelines can be agreed for identifying what should be excluded from the scope of proprietary trading, or identifying what activities should be permitted within a ring fenced bank/its group, this will strongly support the aim of the ICB and the draft legislation in promoting a stable retail banking system providing client-oriented services. Subject to this, we consider that it is unnecessary and redundant to ban proprietary trading by any banking group containing a ring fenced bank. Additionally it would add a further level of complexity to the regulatory structure without providing additional protection to the ring fenced bank or to general financial stability of the United Kingdom.
As with any extensive new reform, however, 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. Including measures in current legislation to anticipate potential future problems gives rise to the risk that regulators’ tools are ill-suited to their needs.
22 January 2013