Banking StandardsWritten evidence from The Royal Bank of Scotland Group plc (V006)

Overview

We respond below to the Commission’s consultation in relation to proprietary trading and the potential impact that proprietary trading may have on the stability of financial groups that include a ring fenced bank.

1. Introduction

A. As in most forms of commerce, a degree of build up of stock or inventory forms a component of a bank’s trading activities. In relation to customer driven activities inventory is built up to allow the bank to anticipate and meet customer driven demand.

Trading activity may consist of a combination of activities undertaken purely for the bank’s own account (where the bank trades against its own capital to build up potentially illiquid positions which are held with the intent of generating profit and not as part of supporting customer activities) and other own account trading which is connected to customer activities. If the bank is using its capital for its own account to generate profits (and risking taking losses) from illiquid inventory, disconnected from customer activity, then that is “pure” proprietary trading. If the position taking that results in a build up of inventory is related to actual or anticipated customer activity then that is still a form of own account risk taking (but is not “pure” proprietary trading) but is an activity that we believe is necessary in order to support customer activity and drive overall economic activity (see 3. below).

Given that the own account trading that RBS undertakes is predominantly connected to customer activities and given the risk controls we have in place (see section 5. below) we do not believe that there is a material risk that such trading could disproportionately affect RBS’ financial or capital position. Our analysis is based upon an assessment of both the character of the activity undertaken and the controls and cultural changes we have introduced since 2008 to better manage the risks associated with these activities.

B. When considered through an analytical (objective) lens the trading risk that is created in banks as a result of “pure” proprietary trading is potentially hard to distinguish from that which is connected to actual or anticipated customer activities (including market making), meeting customer portfolio needs and portfolio hedging (as described in section 3. below). Both forms of activity can result in the build up of significant volumes of inventory. Some of this inventory may be present on banks’ balance sheets for extended periods of time. This poses a significant challenge when considering how law and regulation might be used to restrict proprietary activity as there is no bright line that can be drawn to differentiate between the two types of activities.

In the US designing the implementing regulations for the Volcker Rule which seeks to address proprietary trading has proved challenging (please see section 4. and response to Q7. below).

C. We believe the concerns expressed by the Commission about the risks associated with “pure” proprietary trading are fair but that they can be addressed: (i) by ensuring that banks are prudently managed, that their own account trading activities are prudently controlled and restricted to trading connected to customer activities; and (ii) through exercise of existing regulatory and supervisory powers supplemented by granting a reserve power to the regulator to impose a restriction on the nature and scale of own account trading activity undertaken in any regulated institution, which power could be invoked if the regulator concludes the institution is not being prudentially managed.

D. We believe that any absolute prohibition on own account trading activity within a financial group that includes a ring fenced bank would be unlikely to deliver material additional prudential or systemic benefits beyond those that are achievable through a combination of the existing regulatory controls and the other structures proposed by the Commission.

Conversely we believe that such a prohibition (that goes beyond “pure” proprietary trading and extends to own account trading activity connected to customer activity) would: generate very significant costs for the relevant financial groups; be complicated for regulators to administer; call into question the investment case for shareholders in those financial groups; and would have a significantly adverse impact on customer services and related levels of economic activity.

2. Trading, Market and Credit Risk

For banks almost any activity could be described as taking a “proprietary” risk and, if that risk relates to credit, trading or market risk then it is possible for that to be “proprietary” trading in a general common language sense.

For example, even when making a simple loan the bank is taking a credit risk which is itself proprietary. That is the bank has deployed capital under the reasoned assumption that it will see its capital plus interest in return, within an agreed time period. The bank will then consider its risk and either dispose of some of that risk through a proprietary transaction or alternatively hedge its credit risk in the market by entering into a transaction with a market counterparty which hedge itself will be a proprietary transaction.

The hedging of its loan position creates its own trading risk, where the bank may or may not realise a profit on that transaction with reference to price agreed at the purchase and sale of the asset. Another common trading activity which is needed by our customers and which gives rise to trading risk is market making (where we offer prices to buyers or sellers of assets traded in those markets in order to create liquidity), a core activity necessary to support stable economic activity.

There are risks created by any kind of trading, proprietary or not and whether in financial assets or physical goods. Businesses looking to sell traded goods to customers need to hold inventory in order to allow prompt satisfaction of customer orders. The holding of inventory also gives rise to trading risk—before inventory can be sold to clients the prevailing market price may move against a trader (or in his favour). It is the change in the underlying economic indicators and market confidence (equity prices, interest rates, commodities) that may result in a market risk that needs to be managed and controlled.

The difference in the level of trading risk associated with a given transaction relates principally to the relative liquidity of the goods traded—ie the ease with which the goods can be sold—and how long the trader is likely to hold them for, not whether the trader’s intent at the time of purchase was to sell the asset to an end user or for its own financial gain. This risk is “market risk”.

The same risk analysis applies whether the trader is buying and selling refrigerators, commodities or financial products singularly or in bulk, ie, building inventory of goods or financial positions or assets. In more volatile and illiquid markets the management of this market risk is much more important, particularly for businesses taking market risk on a material scale. The longer the inventory is intended to be held the greater the exposure to price volatility and market risk.

The key issue to address in order to determine whether the credit, trading and/or market risks the bank or other commercial party is taking are manageable is whether the quality of the controls and analysis that that party is using to measure and manage its trading activity on an informed risk basis are sufficient to allow that party to take controlled risks within its stated risk appetites. Please see section 5. below for a summary of the controls we have in place and which we believe are satisfactory to manage the own account trading risks we undertake in connection with our customer activity.

Given the analysis in Section 1. and this Section 2. above, our response is intended to explain both why: (i) the risks associated with “pure” proprietary trading are not wholly different, except in relation to the motivation for the original build up of inventory, from those associated with trading connected to client activities, market making and client related hedging activity; and (ii) nevertheless we do not believe our business model would be adversely impacted by restrictions upon “pure” proprietary trading.

3. RBS Context and Customer Activity

As part of its post-2008 restructuring plan RBS decided to exit and transfer to its Non Core division those activities which it regarded as involving material levels of “pure” proprietary trading. Further, as part of the State Aid resolution reached by HMG with the European Commission RBS was committed to not re-engage in any such activities. The scale of “pure” proprietary trading which remains within the RBS Group today is not material and is predominantly held within the Non Core division. We do, however continue to provide a range of customer services that require us to undertake own account trading activities. These result in the Bank holding market positions and substantial volumes of inventory for its own account. These activities include:

Being an active participant in government bond auctions, in both the UK and other countries. This activity results in inventory holdings of government bonds which, while generally liquid, normally are not driven by specific client demand and consequently create market risk for RBS.

Market making in the markets we are active in to ensure liquidity for our customers and the issuers we support.

As part of offering services to our investor/customer base we trade actively to build inventory, in particular in expectation of forthcoming customer orders. Moreover, where we are trading to fulfil client orders, the available trades in the market may not exactly match the order, leaving a residual balance on the RBS trading book. Controls are in place to ensure the liquidity of the portfolio, and the quality of the balance sheet held at any time (see section 5. below).

In some instances, we also conduct trading, and build and hold strategic inventory positions, in anticipation of longer-term customer orders. (Those strategic inventory positions are taken in connection with our customer related activities which include providing our customers with related asset analysis and market intelligence). This activity can result in the build up of significant volumes of inventory and result in our holding that inventory for significant periods of time. Again, this activity is conducted within specific controls and risk appetites including specified risk limits and inventory ageing policies.

We execute trades to hedge the risks held in our banking and trading books. These hedges are often necessarily undertaken at portfolio level and not ascribed to specific client transactions, particularly where we are supporting SMEs and smaller corporate.

The purpose of these activities is to support actual or anticipated customer business needs or to enable us to manage the risks we take when supporting our customers.

We presume the type of activities listed above would be exempted from any prohibition on “pure” proprietary trading as they are connected to offering services to our customers and are core components of economic activity. If our presumption is correct, the impact on RBS of a prohibition would mainly be associated with the challenges and expense of monitoring and tracking any additional regulatory requirements introduced to measure and control “pure” proprietary trading and/or own account trading rather then any significant reduction in activities undertaken in connection with our customer activities.

4. Providing a Clean Definition of Proprietary Trading is Challenging

We do not oppose the introduction of a rule that restricts the conduct of “pure” proprietary trading within a group that includes a ring fenced bank. RBS’ strategy is focused on the own account trading activities described at 3 above. Nonetheless we do not think there is a simple analytical way to distinguish an asset bought with the intent solely to speculate upon the future value upon sale to another trader (which would be “pure” proprietary trading) from the same asset bought with the expectation of sale to an end user customer—as we said above there is no bright line that allows the activity to be readily and objectively differentiated solely on the basis of the intention that motivated the purchase of the inventory. The principle distinction between these two types of trading activity is the intent or motive for entering into the trade. The key way to control the risk is the same—through effective controls, surveillance, capital charges and by ensuring the culture in the business is the right one (see section 5. below).

The US regulators preparing the detailed regulations for the Volcker Rule have struggled with the problem of definition for two years. The current draft implicitly recognises the difficulty of identifying what is “pure” proprietary trading and relies on complex analysis of 17 different indirect metrics they have determined might be indicators of proprietary trading. (See response to Q7. below for more detail.)

We believe that monitoring and tracking such indicators will be expensive both for institutions involved and for the regulators. 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.

5. RBS Controls Around its Own Account Trading

During the past four year, RBS has reviewed and enhanced its risk and control environments and has put in place a comprehensive Supervisory Control Framework (the SCF) to address and manage the trading risks of the Bank. The SCF establishes Risk Limits (Golden Rules) and addresses trading and markets risks in turn through: i) Dealing Authorities, ii) Independent Pricing Valuations (IPV) and Reserving, iii) Aged Position Marks and iv) Aged Asset and Stale Inventory amongst other indicators. The SCF places upon the senior managers of the business the authority, responsibility and accountability of addressing trading risks with a robust focus on the correct culture and behavioural standards.

The Bank’s Golden Rules place upon the senior business management, in conjunction with market risk management the responsibility to define the overall market risk limits, structure, ownership and delegation for business units. Along with credit risk management, senior business leaders define the overall credit risk limits, structure, ownership and delegation of risk controls. The Golden Rules provide for clear determinations and sanctions of rule transgressions.

More specifically, these trading risk management measures provide senior executives and control teams with the risk programme and the tools to approve and monitor:

traders’ permissions, overall position limits and utilisation triggers,

monthly P/L, reserve balances and IPV data, including inputs on explanation, methodology and justification, Independent Pricing Valuations and Reserving,

Key Risk Indicators (KRIs), trends and trigger breaches as well as the review of position marks across trading desks, Aged Position Marks, and

Review of KRIs that assist in the responsibility and review of a desk’s stale/aged positions with the intent to take action or escalate any concerns identified (Aged Asset and Stale Inventory).

With respect to Aged Assets and Stale Inventory monitoring, RBS calculates the position age at issue level of the individual security/ISIN. The data points used are very granular and include:

position age that accrues on a “First-In” basis—the oldest transaction on record after a zero balance in inventory is set as the age date,

measurement of directional increase of the position which after the first trade inherits the inception date of the “First-In” exposure,

age measures that reset to zero when reduction of 20% of the nominal amount of the position is achieved in one day, and

designation of an asset as “aged” if held for more than 90 days without a reset.

Conduct Risk

In addition to the empirical data that make up our markets and trading risk measure, the SCF is supported by our Conduct Risk programme which focuses on conduct risk and staff behaviours (including ensuring incentives are aligned to behaviours, not pure revenue targets).

To back up our words with actions, we have made conduct risk management a commercial imperative. For our staff, we have enhanced our recruitment and performance measurement disciplines (eg, 360° feedback, independent Risk function inputs); ensured that all bonus awards are subject to objective remuneration committee oversight, and robust risk adjustment; and claw back has been applied to historic bonuses awarded to individuals responsible for risks and losses that have been identified after the fact.

6. Responses to the Commission’s Questions

Q1: 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?

Uncontrolled “pure” proprietary trading exposes a bank’s capital to significant risks as well as exposing the bank to reputational harm and posing potential risks to overall financial stability. Any form of own account trading activity and risk taking requires robust controls and a culture where risk is taken on a controlled and informed basis. As described at section 5. above at RBS we have implemented detailed risk management controls that measure and manage the scale of market and other risks that the bank is exposed to and have implemented significant cultural changes to ensure that a prudent approach is taken to managing risk and servicing customer needs. 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. We believe the existing controls (plus the regulatory powers described at section 4. above) are sufficient to control trading activities within a group that includes a ring fenced bank.

The prudential risks inherent in any “own account” positions are independent of the intent of the trade (whether proprietary or client-driven), and we consider them to be adequately covered by the current legislative framework and our own risk controls. The resolvability of a bank and overall systemic risk would of course be materially affected by the presence of uncontrolled trading and inventory within a banking group.

ICB regulation will of course ensure that depositors in the ring-fenced bank are further protected from risks posed by permitted trading activities.

Standards

Q2: 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?

Q3: 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?

Q4: 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?

The nature of any trading activity requires buyers and sellers to take different market positions. As such any trading activity can give rise to potential conflicts of interest between a bank and its customers. This is true for all trading that results in the bank holding positions on its own account, regardless of whether the intent is hedging risk, building customer inventory or generating proprietary gain; these risks also exist where the bank is providing non-traded products and services to customers. These are risks managed through existing, well established, regulations and controls (including the requirements under FSA General Principle 8).

We recognise the risk that the presence of “pure” proprietary trading could give rise to cultural issues and consequent misconduct. However, we do not agree that own account trading connected to actual or anticipated customer activities per se creates a negative influence on a bank’s culture. Issues such as Libor manipulation or swap mis-selling are more likely to stem from a poor, revenue driven, culture in which incentives are not aligned with the creation of long term value for clients and prudent risk management.

Within RBSG, very significant efforts have been made to address these broader cultural concerns and to enhance our overall control environment. Details of these changes do not properly belong in this letter but we have summarised them in section 5 above.

The creation of the ring-fence will create an additional legal and financial fire break to protect customers within a ring-fenced bank from any volatility in market risk exposures that arise as a result of banks conducting own account trading activity connected to customer services.

Based on the analysis in this letter 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.

Practical Considerations

Q5: 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?

We believe that the simultaneous imposition of ringfencing and a ban on own account trading would create additional costs for both the banks and the regulators, increase costs and materially and adversely impact liquidity, customer services and economic activity without materially reducing either risks of resolvability for a bank or systemic risks.

Q6: 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 FSA and other international lead regulators have multiple powers to require financial institutions to be run on a well managed/prudent basis, to have effective controls in place and to ensure that operations are run with skill, care and diligence, effectively controlled and that customer interests are respected and conflicts managed. We believe the existing powers available to the FSA, including the ability to impose additional capital requirements on firms that are not being prudentially managed and ability to vary regulatory permissions are sufficient to control the own account trading activities continuing within banking groups that include a ring-fenced bank. 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.

Q7: What are the main challenges in defining proprietary trading, and how could these best be addressed?

The experience of US regulators suggests that establishing a clear and unambiguous definition of proprietary trading is difficult. There is no bright line that can be drawn between “pure” proprietary trading and own account trading connected to customer activity including market making. After several years the US regulators have yet to agree upon a clear definition and have moved away from attempting any direct operational definition. Latest drafts focus on establishing a process for monitoring the relative trading position of any organisation vs. its peers, across a range of 17 different metrics, which the regulator regards as useful indirect indicators of whether an activity is proprietary in intent. Senior US regulators have queried the rule and its implementation. Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, was quoted as saying “Work on the [Volcker] rule is diverting resources from more essential requirements in the [Dodd Frank] act”, while Sheila Bair, former Head of the Federal Deposit Insurance Commission, was quoted as telling Congressional hearings that “the Volcker rule is so complicated that regulators should consider starting over”.ⁱ

There is a danger that the implementation and subsequent monitoring of highly complex rules across multiple metrics could serve more to distract from ensuring that “pure” proprietary trading is prevented (or controlled depending on the institution) and that all own account trading is otherwise conducted in an appropriately controlled way, with controls being placed at the heart of a well managed culture aimed at serving clients’ best interests. In particular, past experience across many spheres of regulation suggests that complex regulations promote a search for workarounds and loopholes whereas a simpler, principle-based approach can be more effective. Given that, if a definition were required, we would advocate a simple, principle-based view—for example, requiring all trading that results in an own account position to be conducted in connection with actual or anticipated client activity or for the purpose of hedging the bank’s risks.

Overall Assessment

Q8: 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

Since 2009 RBS Group has changed its’ operational focus, and consequentially we do not envisage that our business model would be significantly affected by the introduction of a Volcker style rule in the UK presuming this is designed to restrict “pure” proprietary trading but to still allow own account trading in connection with customer activity of the type referred to at 3. above.

Nonetheless we do not believe that there is likely to be a material benefit from introducing a full prohibition on banks conducting “pure” proprietary trading in the UK. We consider that the tighter capital and prudential controls put forward post-crisis and the other controls referenced above will have the effect of restricting the appetite of any bank for increasing its “pure” proprietary activities. It is also clear from the US example that the complexity of operationally defining proprietary trading and the cost of development, implementation and monitoring of these proposals is likely to be substantial, both for the banks and the regulators. This is unlikely to be proportionate to the perceived benefits and could detract from the already complex process of introducing the ring-fencing reforms.

Nevertheless, we do consider it appropriate that the regulators satisfy themselves that banks have appropriate risk controls in place (and that the culture and incentive schemes in the trading businesses rewards good, risk sensitive and client focused behaviours and punishes poor risk decisions and bad behaviours) such that regulators are satisfied banking groups are being prudently managed and do not pose reasonably avoidable systemic risks.

(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

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.

10 February 2013

Reference

ⁱ Both quotes from Bloomberg article, 4 April 2012: Fed’s Lacker Says Volcker Rule May Be “Impossible” to implement