Commission On Banking Standards Publishes Proprietary Trading Report

16 03 2013

In its First Report (which said that the ring-fence needed electrification) of 21 December 2012 – see volume 1, volume 2 (written evidence) and post here – the Parliamentary Commission on Banking Standards embarked on considering fully the consequences and practicalities of supplementing the proposed UK ring-fence with something similar to the Volcker Rule (see First Report at para 94, see Chairman of the Federal Reserve Paul Volcker’s evidence to the Commission here). To this end the Commission published its Third Report – entitled “Proprietary Trading” – on 15 March 2013; the report contains its conclusions and recommendations; see also volume 2 (written evidence). The Commission has explained that it will produce a further report in May 2013 which will make wider recommendations in connection to banking reform.

Proprietary Trading

The term “proprietary trading” when applied to a bank could in theory refer to any trading activity which results in a proprietary position for that bank – in other words, where price movements in the relevant market affect the bank’s bottom line.

At paragraph 10, the report explained that:

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.

The Chairman of the Parliamentary Commission on Banking Standards, Andrew Tyrie MP, commented:

    • Proprietary trading carries large risks, both prudential and to banking standards.
    • Many banks based in the UK agree. Their evidence to the Commission makes clear that, at the moment, they do not engage in proprietary trading, nor do they wish to.
    • As the US experience demonstrates, the use of legislation to define and prohibit proprietary trading may be difficult. In any case, it may impose an additional burden on regulators already charged with implementing a ring-fence.
    • Therefore, the Banking Commission does not feel it appropriate to recommend the immediate prohibition of proprietary trading.
    • Instead, the Prudential Regulation Authority (PRA) should use its existing tools such as capital add-ons or variations of permission to bear down on these risks. This may require some amendment to the legislation currently before Parliament to give the PRA a mandate to act.
    • Banks should be required to agree with the PRA a regular statement of risk exposures in their trading book. More transparency is needed. These statements should be published and Parliament will require an annual report from the PRA on them.
    • Banks which the PRA judges to be engaged in trading activities that cannot be shown to be serving their clients should be incentivised to exercise greater control.
    • The immediate risk to UK banking standards from proprietary trading may be limited. However, effective regulatory oversight will be particularly important for the future. At a time when banks are under less intense scrutiny, proprietary trading could re-emerge as a greater risk.
    • Were this approach to prove ineffective, further measures, including prohibition, could be desirable.
    • We expect the PRA to report on the implementation of our recommendations, drawing also on the experiences of other countries which are currently implementing restrictions on proprietary trading. This should be followed by an independent review of the case for further action.”

The conclusions and recommendations in the Third Report are set out on pages 47 – 51. Some of the conclusions and recommendations contained within the Report include:

1. On prudential concerns

Para 22:
 Proprietary trading gives rise to prudential risks…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.

2. On cultural concerns

Para 31:
 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.

3. On the extent of proprietary trading in UK banks

Para 39:
 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.

4. On defining proprietary trading

Para 76:
 The Commission has 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.

5. On prohibiting proprietary trading

Para 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.

6. On the Commission’s recommendations for regulatory action

Para 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. The Commission 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. The Commission 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.

7. On the Commission’s recommendation for review

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

      • Analysis of the monitoring and corrective actions conducted in  accordance with the recommendations in paragraph 97;
      • An assessment of any impediments encountered to such actions;
      • The impact, by then, of the moves towards ring-fencing on banks’ trading activities;
      • 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
      • A full assessment of the case for and against a ban on proprietary trading.

Para 99:
 The Commission expects 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. The Commission 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.



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