Proprietary Trading: Regulators Will Need More Comprehensive Information to Fully Monitor Compliance with New Restrictions When Implemented
Published: 2011-07-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In addition to trading on behalf of customers, banks and their affiliates have conducted proprietary trading, using their own funds to profit from short-term price changes in asset markets. To restrain risk-taking and reduce the potential for federal support for banking entities, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the act) prohibits banking entities from engaging in certain proprietary trading. It also restricts investments in hedge funds, which actively trade in securities and other financial contracts, and private equity funds, which use debt financing to invest in companies or other lessliquid assets. Regulators must implement these restrictions by October 2011. As required by Section 989 of the act, GAO reviewed (1) what is known about the risks associated with such activities and the potential effects of the restrictions and (2) how regulators oversee such activities. To conduct this work, GAO reviewed the trading and fund investment activities of the largest U.S. bank holding companies and collected selected data on their profits, losses, and risk measures. GAO also reviewed regulators' examinations and other materials related to the oversight of the largest bank holding companies.
section_title: What GAO Found
paragraphs: Proprietary trading and investments in hedge funds and private equity funds, like other trading and investment activities, provide banking entities with revenue but also create the potential for losses. Banking entities have conducted proprietary trading at stand-alone proprietary-trading desks but also have conducted such trading elsewhere within their firms. GAO determined that collecting information on activities other than at stand-alone proprietary trading desks was not feasible because the firms did not separately maintain records on such activities. As a result, GAO did not analyze data on broader proprietary trading activity but analyzed data on stand-alone proprietary-trading desks at the six largest U.S. bank holding companies from June 2006 through December 2010. Compared to these firms' overall revenues, their stand-alone proprietary trading generally produced small revenues in most quarters and some larger losses during the financial crisis. In 13 quarters during this period, stand-alone proprietary trading produced revenues of $15.6 billion--3.1 percent or less of the firms' combined quarterly revenues from all activities. But in five quarters during the financial crisis, these firms lost a combined $15.8 billion from stand-alone proprietary trading--resulting in an overall loss from such activities over the 4.5 year period of about $221 million. However, one of the six firms was responsible for both the largest quarterly revenue at any single firm of $1.2 billion and two of the largest single-firm quarterly losses of $8.7 billion and $1.9 billion. These firms' hedge and private equity fund investments also experienced small revenues in most quarters but somewhat larger losses during the crisis compared to total firm revenues. Losses from these firms' other activities, which include lending activities and other activities that could potentially be defined as proprietary trading, affected their overall net incomes more during this period than stand-alone proprietary trading and fund investments. Some market participants and observers were concerned that the act's restrictions could negatively affect U.S. financial institutions by reducing their income diversification and ability to compete with foreign institutions and reducing liquidity in asset markets. However, with little evidence existing on these effects, the likelihood of these potential outcomes was unclear, and others argued that removing the risks of these activities benefits banking entities and the U.S. financial system. Financial regulators have struggled in the past to effectively oversee bank holding companies. While the act's restrictions reduce the scope of activities regulators must monitor, implementing them poses challenges, including how to best ensure that firms do not take prohibited proprietary positions while conducting their permitted customer-trading activities. Regulators have yet to gather comprehensive information on the extent, revenues, and risk levels associated with activities that will potentially be covered, which would help them assess whether expected changes in firms' revenues and risk levels have occurred. Without such data, regulators will not know the full scope of such activities outside of stand-alone proprietary trading desks and may be less able to ensure that the firms have taken sufficient steps to curtail restricted activity. As part of implementing the new restrictions, regulators should collect and review more comprehensive information on the nature and volume of activities potentially covered by the act. Treasury and the financial regulators agreed to consider this as part of their rulemaking.

section_title: Letter
paragraphs: Section 619 of the Dodd-Frank Wall Street Reform and Consumer  Protection Act (the act), also known as the Volcker Rule, prohibits  banking entities from engaging in proprietary trading—trading in stocks or  other financial instruments using the institution’s own funds in order to  profit from short-term price changes. It also prohibits these entities from  investing in or sponsoring hedge funds, which are commonly understood  to be investment vehicles that engage in active trading of securities and  other financial contracts, and private equity funds, which are commonly  understood to be funds that use leverage or other methods to invest in  companies or other less-liquid investments. These restrictions were  included in an effort to restrain risk taking at banking entities and to  reduce the potential that these entities could require federal support  because of their speculative trading activity within the banking entity.
Section 989(b) of the act required us to study the risks and conflicts of  interest associated with proprietary trading by and within covered entities.   Given that the act also included the restrictions on proprietary trading and  hedge fund and private equity fund investments, we conducted a study  using available data intended to provide information to the regulators to  assist with their rulemakings, which are due in October 2011. After  discussions with your staff, we conducted a study of (1) what is known  about the risks and conflicts of interest associated with proprietary trading  and the potential effects of the restrictions and (2) how regulators have  overseen such trading and what challenges they might face in  implementing the restrictions going forward. To conduct this work, we  collected and analyzed information from public filings and other reports,  financial institutions, financial regulatory agencies, researchers, and  industry and consumer advocacy groups. After determining that obtaining  data on all potential proprietary trading was not feasible because the firms  do not maintain separate records on these activities, we collected  available data on trading done by these firms’ stand-alone proprietary  trading units or desks—those organized for the specific purpose of trading  a firm’s own capital—as well as their hedge fund investments and private  equity fund investments, including analyzing data on firm revenues,  losses, and certain risk measures. We collected this information from the  six largest U.S. bank holding companies as of December 31, 2010, as  ranked by total assets reported in filings to the Board of Governors of the  Federal Reserve System (Federal Reserve). To provide some assurance  of the accuracy of the data reported to us by the bank holding companies,  we obtained descriptions of how they ensure the accuracy of the systems  used to produce these data and corroborated selected parts with  regulators familiar with these firms’ trading and fund investing activities.  We deemed the data to be sufficiently reliable for our purposes. We also  reviewed bank and broker-dealer examinations and other regulatory  materials that provided information on how regulators oversee the largest  bank holding companies. Finally, we interviewed bank holding  companies, regulators, and firms impacted by prohibitions placed on  proprietary trading and hedge fund and private equity fund investment  activities. Appendix I contains a more detailed description of our scope  and methodology.
We conducted this performance audit from August 2010 to July 2011 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Section 619 restrictions on engaging in proprietary trading or investing in  or sponsoring hedge funds or private equity funds apply to banking  entities, which the section defines to include any insured depository  institution, company that controls an insured depository institution,  company treated as a bank holding company for purposes of Section 8 of  the International Banking Act of 1978, and affiliate or subsidiary of such  entity. The section defines proprietary trading as engaging as a principal  for the trading account of the banking entity, with the term trading account  separately defined as an account used principally for the purpose of  selling in the near term (or otherwise with the intent to resell in order to  profit from short-term price movements). The act’s proprietary trading  prohibition provides a number of exemptions for permitted activities,  including activities related to market making and underwriting, risk- mitigating hedging, transactions on behalf of customers, and transactions  in government securities, among others. The act limits the permissibility  of some of these activities to specific purposes and establishes overall  criteria prohibiting such activities if they would result in a material conflict  of interest, would expose the entity to high-risk assets or trading  strategies, or would threaten the institution’s safety and soundness or  U.S. financial stability. However, the act does not define the permissible  activities themselves. For example, market making-related activity and  underwriting are permitted to the extent they are “designed not to exceed  the reasonably expected near term demands of clients, customers, or  counterparties,” but the provision does not define “market making” or  “underwriting.” Similarly, permissible risk-mitigating hedging activities  must be designed to reduce “specific risks” related to individual or  aggregated positions, contracts or other holdings. The provision does not  define what constitutes the practice of risk-mitigating hedging. As a result,  regulations that further define what are and are not permitted activities  could significantly impact the scope of the new restrictions. Similarly, the  act’s restrictions on hedge fund and private equity fund investments allow  for a de minimis amount of investment to facilitate customer focused  advisory services. This amount cannot exceed 3 percent of the total  ownership interests of the fund 1 year after it is established and must be  immaterial to the banking entity as defined by the regulators, and no  banking entity’s aggregated investments in all such funds may exceed 3  percent of its Tier 1 capital.
Section 619 of the act generally requires the appropriate federal banking  agencies, the Commodity Futures Trading Commission, and the  Securities and Exchange Commission (SEC) to promulgate regulations  governing proprietary trading by the entities they regulate. The Federal  Reserve will issue regulations for any company that controls an insured  depository institution or that is treated as a bank holding company for  purposes of Section 8 of the International Banking Act of 1978, any  supervised nonbank financial company, and any subsidiary of these  companies if another regulator is not the primary financial regulatory  agency. The appropriate federal banking agencies are to issue  regulations jointly with respect to insured depository institutions, including  national banks and federal savings associations regulated by the Office of  the Comptroller of the Currency (OCC), state-chartered banks that are not  members of the Federal Reserve System and state-chartered thrifts  regulated by the Federal Deposit Insurance Corporation (FDIC), and  FDIC-insured state banks that are members of the Federal Reserve.  The Commodity Futures Trading Commission is to issue regulations with  respect to entities it regulates, including futures commission merchants,  which are firms that buy and sell futures contracts as agents for  customers. Additionally, SEC is to issue rules for the entities it regulates,  including registered broker-dealers and investment advisers.
To implement the provisions on proprietary trading and hedge fund and  private equity fund investments, the act required the Financial Stability  Oversight Council (FSOC) to complete a study and make  recommendations on implementing the provisions by January, 2011.  The study included specific recommendations for regulators to monitor  and supervise institutions for compliance. Within 9 months of completing  this study—by October 2011—the regulators are to adopt implementing  regulations. Also as required by the act, the Federal Reserve issued a  final rule on February 9, 2011, regarding the timelines for banking entities  to bring their proprietary trading and hedge fund and private equity fund  investments into conformance with the restrictions, including the process  for the granting of extensions. By October 2011, the Federal Reserve,  OCC, and FDIC must jointly issue rules to fully implement the proprietary  trading and hedge fund and private equity fund restrictions, with SEC and  the Commodity Futures Trading Commission required to issue similar  rules that cover the entities for which they have primary oversight  responsibilities. In developing and issuing these regulations, the  agencies are to consult and coordinate with each other. The chairperson  of the FSOC—the Secretary of the Treasury—is responsible for  coordinating the regulations required by the act.
section_title: Although Stand-Alone Proprietary Trading and Fund Investment Revenues Were Generally Small Relative to Total Revenues, Such Activities Caused Larger Losses during the Financial Crisis
paragraphs: Proprietary trading and hedge fund and private equity fund investments,  like other banking and trading activities, provide revenue and create the  potential for losses at banking entities. Financial institutions have  conducted proprietary trading at stand-alone proprietary-trading desks  and may have also conducted proprietary trading elsewhere in the firm.  We analyzed data on activities of the stand-alone proprietary-trading  desks of the six largest U.S. bank holding companies from June 2006  through December 2010, but determined through our work that collecting  data on other proprietary trading was not feasible because the firms did  not separately maintain records on such activities and because of the  uncertainty over the types of activities that will be considered proprietary  trading until the completion of the required regulatory rulemaking. We  also collected data on hedge and private equity fund investments that the  bank holding companies believed to be restricted by the act. The  revenues from these firms’ stand-alone proprietary trading were generally  small in most quarters relative to revenues from all trading and other  activities. These activities also resulted in larger losses as a percent of  total losses during the financial crisis. Revenues and losses from these  firms’ hedge fund and private equity fund investments followed a similar  trend. Although stand-alone proprietary trading and hedge fund and  private equity fund investments contributed to losses during the crisis,  such activities affected these firms’ overall net incomes less during that  period than did other activities, such as lending and securitization,  including positions in mortgage-backed securities or more complex  financial instruments that some view as proprietary trading. Some  market participants and observers were concerned that the act’s  restrictions could negatively affect U.S. financial institutions and the  economy by limiting banks’ ability to diversify their income stream and  compete with foreign institutions, and reducing liquidity in asset markets.  However, the likelihood of such potential outcomes was unclear.
subsections: section_title: Proprietary Trading and Hedge Fund and Private Equity Fund Investments at Large U.S. Bank Holding Companies Generate Revenues but Also Create Risks and Conflicts that Must be Managed
paragraphs: Proprietary trading can take a number of forms. Proprietary traders often  take positions in securities or other products that they think will rise or fall  in value over a short period of time in order to profit from a trader’s view  of the direction of the market. Proprietary traders also use more complex  strategies such as relative value, in which a trader identifies differences in  prices between two related securities or other financial products and  takes positions in those products to make a profit. For example, a  proprietary trader might identify a discrepancy between the pricing of a  stock index and the pricing of its underlying stocks, and then take a long  position in one and a short position in the other to profit when the  discrepancy corrects itself. Banking entities can conduct proprietary  trading in desks organized with the specific purpose of trading a firm’s  own capital (stand-alone proprietary-trading desks), but some have also  conducted what could be considered proprietary trading in conjunction  with their market making activities by accumulating positions in a  particular asset at levels that exceed the amount of the firm’s typical or  necessary inventory in that asset used to facilitate customer trades. A  trader at a market-making desk may anticipate that the price of a  particular stock will increase over the short term and purchase and hold  more shares of that stock in order to make a larger profit than he or she  would otherwise from buying and selling the product as a market maker.  For example, one regulator described the activities of one of the trading  desks at one of the bank holding companies we reviewed as making  markets for clients but that the firm also allowed that desk’s traders to  hold inventory positions exceeding the amount necessary to facilitate  client trades when the traders had a particular view on the direction of the  market. Also, as discussed later in the report, debate exists about the full  scope of activities that should be considered proprietary trading, and  some define the term to include not only trading activities but other  activities conducted by a firm as a principal, such as long-term  investments.
Trading activities, including proprietary trading, like other banking  activities, can create revenues for bank holding companies. Bank  regulators, financial institution representatives, and others noted that such  activities provide another source of revenues for banks that can diversify  their income from lending and other activities. (We discuss the recent  levels of revenue from trading activities—including stand-alone  proprietary trading—in the next section of this report.)
However, trading also poses several types of risks to bank holding  companies:    Market risk: the potential for financial losses due to an increase or  decrease in the value or price of an asset or liability resulting from  movements in prices, such as interest rates, commodity prices, stock  prices, or the relative value of currencies (foreign exchange).   Liquidity risk: the potential for losses or write-downs to occur if an  institution has to exit a position but either cannot do so or can do so  only at a significantly reduced price because of an illiquid market due  to insufficient buyers or sellers.   Counterparty credit risk: the current and prospective risk to earnings  or capital arising from an obligor’s failure to meet the term of any  contract with the bank or to otherwise perform as agreed.   Reputation risk: the potential for financial losses that could result from  negative publicity regarding an institution’s business practices that  results in a decline in customers or revenues or in costly litigation.   Operational risk: the potential for loss resulting from inadequate or  failed internal processes, people, and systems or from certain external  events.
These risks will vary depending on the type of product traded. For  example, proprietary trading in stocks, which are generally traded in deep  and liquid markets, faces lower liquidity risks than trading in less liquid  credit and other products, such as some of today’s mortgage-backed  securities and collateralized debt obligations (CDO), which would be  harder to liquidate quickly in response to a capital shortage at a firm.
Hedge fund and private equity fund investments can also pose risks to  bank holding companies. Hedge funds, like proprietary trading operations,  are subject to market and other types of risk that can result in significant  financial losses, and private equity funds are additionally affected by  broader changes in the economy that affect the companies in which they  have invested. Some failures at other large financial institutions other  than bank holding companies illustrate the potential for financial losses at  hedge funds. For example, in 1998 following the near collapse of Long- Term Capital Management, a large hedge fund, the Federal Reserve  facilitated a private sector recapitalization. It took this action because of  concerns that a rapid liquidation of the firm’s trading positions and related  positions of other market participants in already highly volatile markets  might cause extreme price movements and might cause some markets to  temporarily cease functioning. In 2007, two hedge funds required  significant cash infusions from their sponsor, Bear Stearns Asset  Management, which was a subsidiary of a broker-dealer holding  company, when they experienced losses from holdings of CDOs that  contained subprime mortgages.
Some policymakers and at least one researcher have raised concerns  that another risk associated with proprietary trading and hedge fund and  private equity fund investments is systemic risk, which is the possibility  that an event could broadly affect the financial system rather than just one  or a few institutions. The extent to which proprietary trading and hedge  fund and private equity fund investments pose systemic risks, if at all, is  difficult to measure and could depend on the size of the activity, the  extent to which other firms are conducting similar activities, and the level  of distress in or concerns already present in the markets.
Representatives of the six largest U.S. bank holding companies described  a variety of methods they use to oversee the risks associated with  proprietary and other trading activities and hedge fund and private equity  fund investments. These financial institutions described having risk- management infrastructures that include regular meetings of firm  executive staff who set policies and procedures regarding firmwide,  business-line, and desk-level trading and risk limits. Among the most  prominent ways that firms measure the risks and potential losses  associated with their trading activities is by calculating their value-at-risk  (VaR), which is an estimate of the likely loss that a portfolio of financial  instruments will incur as the result of any changes in the underlying risk  factors that could affect the value of the assets in that portfolio, including  changes in stock prices, interest rates, or other factors. VaR estimates  are typically calculated using historical market prices to represent the  likely maximum loss that a portfolio will incur with either a 95 or 99  percent statistical probability, and therefore VaR limits are designed with  the expectation that daily losses will exceed the limit as much as 5  percent of the time. VaR calculations, among other inputs, are also used  by firms to determine how much regulatory capital they must hold, so that  as the amount of money the firm could lose under its VaR calculation  increases, so does the amount of regulatory capital required to be held as  a buffer against those potential losses. Each bank holding company  calculates VaR limits for specific trading desks or business lines and also  sets a firmwide VaR limit. This amount is less than the sum of the  individual VaRs because of diversification effects across portfolios—that  is, the results of different or opposite movements among assets held by  groups within a firm whose gains and losses would offset each other in  whole or in part. Trading desks and the firm as a whole are expected to  hold positions whose VaRs are below the established limits. Financial  institutions noted that they do not rely exclusively on VaR, and described  other key aspects of their risk-management activities, including stress  testing and risk constraints and limits at particular trading desks or  business lines.
Financial institutions that conduct both proprietary trading and client- focused activities, such as market making, face a number of what  financial regulators and industry participants consider to be potential  conflicts of interest that could lead financial institutions to put their own  interests ahead of their responsibilities to their clients. However, industry  participants noted that these potential conflicts of interest are not unique  to proprietary trading activities and can occur in other activities conducted  by bank holding companies. In many cases, the activities arising from  such conflicts are illegal and violate securities laws, depending on the  facts and circumstances surrounding the activity. For instance, financial  institutions that conduct proprietary trading could potentially use their  clients’ order information for their own benefit in a way that disadvantages  the client. One example of such prohibited activity is front running, which  can occur when a firm receives a buy or sell order from a client and then  uses information about that order to execute a trade from its proprietary- trading desk in advance of its customer’s order. A proprietary trader,  having received information that a client is about to make a large  purchase of stocks, could “front run” that order by buying shares for the  firm in advance, driving the price of the stock up. Such a move would  harm the client by raising the stock’s purchase price. Another type of  illegal activity resulting from conflicts of interest could potentially occur  when traders who interact with clients share information with proprietary  traders or with other clients about the trading patterns or strategies being  used by other clients. In a recent administrative proceeding, SEC found  that proprietary traders for a broker-dealer were misusing information  about trades done for clients between February 2003 and February  2005. The firm neither admitted to nor denied these practices and  agreed to pay a penalty of $10 million and consented to an SEC cease  and desist order. As another example, proprietary traders could take  advantage of material nonpublic information their firms obtain in other  business lines.
Financial institutions that engage in hedge fund and private equity fund  investments and client-focused activities also face a number of potential  conflicts of interest, which could result in financial institutions putting their  own interests and revenue ahead of their responsibilities to their clients.  For example, bank holding companies’ asset management divisions could  potentially have incentives to inappropriately recommend investment in  certain funds they sponsor or with which they have a preexisting business  relationship. Another potential conflict of interest can involve inequitable  trade allocations. That is, a firm might execute trades for a particular  asset at different prices but allocate the most profitable trades to its own  holdings and the less profitable trades to its client holdings. Such  activities, according to SEC, could constitute violations of federal  securities law, depending on the facts and circumstances.
The bank holding companies we interviewed described a number of  procedures they relied on to try to identify and mitigate conflicts of interest  related to proprietary trading. Some of the institutions described  committees at their firm—made up of senior level business-line, risk  management, and compliance executives—that meet to address potential  conflicts of interest. These committees create and implement policies and  procedures that are designed to identify and mitigate potential conflicts of  interest, and management elevates any potential conflicts of interest to  this committee. These institutions have also in some cases physically  separated proprietary traders from traders engaged in market making in  an attempt to prevent market-making information from leaking to  proprietary traders. For example, some placed proprietary traders on  different floors of their facilities, including sometimes using separate  elevator systems, keycard access to doors, and different telephone and  computer hardware. According to SEC staff, however, some traders that  have conducted activities that may fall within the definition of proprietary  trading have done so on the same trading floor as market-making desks.  Proprietary trading teams also, in some cases, have different information  technology systems, such as software and e-mail systems, that prevent  them from communicating with other areas of the firm. According to firms  we visited, their stand-alone proprietary-trading desks would in many  cases execute their trades through other firms rather than using their own  firms’ traders, as a further means to separate their activities. Some  financial institutions we interviewed also described certain procedures,  such as triggers, that are in place to monitor trading activities to prevent  stand-alone proprietary traders and others from executing trades with  certain companies that are doing business with other parts of the firm.  Finally, institutions also described having policies to prohibit their traders  from trading in their own personal accounts using information acquired  from their work at the firm.
section_title: Although Stand-Alone Proprietary Trading Generally Produced Small Revenues as a Percentage of Total Revenues, It Experienced Larger Losses during the Financial Crisis
paragraphs: According to regulators, researchers, and our analysis, most proprietary  trading among banking entities has been conducted by the largest bank  holding companies in the United States. According to our analysis of  financial data that bank holding companies report to the Federal Reserve,  as of December 31, 2010, the largest six bank holding companies by  assets accounted for 88 percent of total trading revenues reported by all  bank holding companies. Therefore, we focused our analysis on the 6  largest bank holding companies by assets as of December 31, 2010. To  provide information about the extent to which proprietary trading posed  risks to these firms, we attempted to gather information on stand-alone  proprietary trading as well as other proprietary trading that may have  been occurring within other trading activities of the firms. While we  gathered information on stand-alone proprietary trading, we determined  that collecting information on other proprietary trading was not feasible  because the firms did not separately maintain records on such activities  and because of the uncertainty over what activities will be considered  proprietary trading until the completion of the required regulatory  rulemaking. We calculated firms’ combined revenues or losses from  stand-alone proprietary trading for each of the 18 quarters between June  2006 to December 2010, and compared the results to trading revenue— which includes revenue from all trading activities including stand-alone  proprietary trading—and total bank holding company revenue. The data  on stand-alone proprietary trading represented 26 proprietary-trading  desks across the six firms over the time period we reviewed. The number  of stand-alone proprietary trading desks reported by a single bank holding  company ranged from one to eight. These stand-alone proprietary-trading  desks included some that traded primarily in one type of financial product,  such as commodities or equities, to desks that traded a wide variety of  products. The desks also relied on varying strategies for generating  returns, including quantitative-based algorithmic trading as well as more  traditional trading.
As shown in figure 1, stand-alone proprietary trading activities at the six  largest bank holding companies produced combined revenues in 13 out  of 18 quarters since 2006 and losses in the remaining 5 quarters. While  the combined revenue over the period totaled $15.6 billion, the combined  losses totaled $15.8 billion. As a result, stand-alone proprietary trading by  the six firms over the time period we reviewed resulted in a combined loss  of $221 million and a median quarterly revenue for each firm of about $72  million. All of the quarters in which the six firms’ combined stand-alone  proprietary activities produced losses occurred from the third quarter of  2007 through the fourth quarter of 2008—the time period leading up to  and including the worst financial crisis since the Great Depression. Four  of the firms made money, and two lost money, from stand-alone  proprietary trading over the 4.5 year time period as reflected in revenues  and losses.
One of the six bank holding companies was responsible for both the  largest quarterly revenue at any single firm from stand-alone proprietary  trading since 2006, which was $1.2 billion, and the two largest single-firm  quarterly losses of $8.7 billion and $1.9 billion. Stand-alone proprietary  trading at the other five bank holding companies resulted in total  combined revenues over the time period of $9.4 billion and median  quarterly revenue for each firm of about $67 million. At the five bank  holding companies, the largest single-firm quarterly revenue throughout  the time period was $957 million, and the largest loss was $1 billion.
The combined revenues from stand-alone proprietary trading in the 13  revenue-generating quarters since 2006 represented relatively small  amounts compared with revenues from all trading activities—which  included stand-alone proprietary trading revenue—and from all bank  holding company activities (see fig. 2). In the 13 quarters since 2006 in  which both stand-alone proprietary trading and all trading and other  revenues were positive, the combined revenues from stand-alone  proprietary trading represented between a low of about 1.4 percent and a  high of 12.4 percent of combined quarterly revenues for all trading and  between about 0.2 to 3.1 percent of combined quarterly revenues for all  activities at the bank holding companies. In the five quarters in which the  firms experienced combined losses from stand-alone proprietary trading,  they experienced combined losses for all their trading activities in two of  those quarters. In those two quarters, the stand-alone proprietary trading  losses were about 66 percent and 80 percent of total trading losses.
In addition to analyzing combined revenues and losses, we analyzed all  108 individual firm-quarters of data that the bank holding companies  reported and found that stand-alone proprietary trading generally did not  significantly increase quarterly trading revenues during positive quarters.  However, in quarters when both stand-alone proprietary trading and total  trading resulted in losses, stand-alone proprietary trading comprised a  substantial portion of total trading losses. As shown in figure 3, in 77 out  of 108 firm-quarters (or 71 percent), revenues were positive for both  stand-alone proprietary trading and total trading (which included stand- alone proprietary trading.) In five quarters (5 percent), stand-alone  proprietary trading helped offset losses in other trading areas or reduced  overall trading losses. For these quarters, stand-alone proprietary trading  resulted in total revenue of $666 million despite total trading losses of  more than $14 billion. In 17 quarters (16 percent), stand-alone proprietary  trading resulted in losses despite total trading revenues. For these  quarters, stand-alone proprietary trading losses of about $4 billion  reduced total trading revenues to about $56 billion. Finally, in nine  quarters (8 percent), both stand-alone proprietary and total trading  experienced losses, with stand-alone proprietary trading losses  comprising 86 percent of total trading losses.
Our analysis of revenue, loss, and VaR data from 2006 through 2010 at  the six largest bank holding companies indicated that during this period  stand-alone proprietary trading required these firms to take greater risks  than all trading activities on average to generate the same amount of  revenue and that these firms’ VaR risk models were less capable of  predicting the actual risks associated with stand-alone proprietary trading.  We calculated, for a standardized amount of risk taken, how much  revenue bank holding companies produced from stand-alone proprietary  trading as compared to all trading activities, which included stand-alone  proprietary trading. Stand-alone proprietary trading produced average  quarterly revenues of $4.8 million for every $1 million of VaR, while all  trading, including stand-alone proprietary trading, produced average  quarterly revenues of $21.9 million for every $1 million of VaR. These  calculations for specific firm quarters ranged from an average quarterly  revenue-per-VaR of $11.5 million to an average quarterly loss-per-VaR of  $5.4 million for stand-alone proprietary trading and from an average  quarterly revenue-per-VaR of $40.5 million to an average quarterly loss- per-VaR of $7 million for all trading activities. Figure 4 shows these data,  which could be considered “risk-adjusted revenues or losses” for both  stand-alone proprietary trading and all trading during the time period. In  addition, each of these bank holding companies reported to us the  number of times each quarter that their actual daily losses exceeded  those predicted by these firms’ VaR models—which are known as VaR  breaks. For all trading, the actual daily losses incurred by these six firms  over the time period exceeded their VaR estimate 161 times, for an  average of 1.5 VaR breaks per quarter per firm. However, for their stand- alone proprietary trading, the actual daily losses exceeded their VaR  estimate 302 times across the same period, or an average of 3.2 breaks  per quarter per firm. The largest number of VaR breaks at any one bank  holding company’s individual stand-alone proprietary-trading desk in any  one quarter was 42, out of 63 trading days in the quarter. Representatives  from some of these bank holding companies told us that the larger  number of breaks from stand-alone proprietary trading likely stemmed  from the prices of the assets being traded becoming more volatile than  their models had predicted.
Our analysis of the data reported to us by the six largest U.S. bank  holding companies showed that their hedge fund and private equity fund  investments also experienced smaller revenues as a percentage of total  revenues but with some larger losses compared to those revenues during  the period we reviewed. As shown in figure 5, hedge fund and private  equity fund investments at these six firms produced combined revenues  in 14 out of 18 quarters totaling almost $32 billion. In three quarters,  combined losses from these investments were just more than $8 billion,  and in the one remaining quarter, the bank holding companies  experienced combined revenues in private equity fund investments and a  loss in hedge fund investments. As a result, the bank holding companies  had combined revenues of about $22 billion from hedge fund and private  equity fund investments during this 4.5-year period.
During this 4.5-year period, the six largest bank holding companies  experienced combined revenues from investments in hedge funds of $8.4  billion, with average and median quarterly firm revenue of about $77  million and $69 million, respectively. The maximum individual firm  revenues and losses for any quarter during this period ranged from  revenues of $501 million to a loss of $500 million. For private equity fund  investments, these bank holding companies experienced combined  revenues of about $14 billion over the entire time period, with average  quarterly revenue of $125 million and median quarterly revenue of $134  million. The maximum individual firm revenues and losses for any quarter  during this period ranged from a revenue of $1.4 billion to a loss of $3.2  billion.
The revenues from the six largest bank holding companies’ hedge fund  and private equity fund investments were small compared to their total  firmwide revenues during 14 of 18 quarters when these investments  produced combined revenues (see fig. 6). Revenues from these  investments represented between about 0.08 to 3.5 percent of these bank  holding companies’ combined revenues during this period.
The full profits and losses from all activities at the six largest bank holding  companies are represented by their publicly reported net income, which  includes all their revenues less all their expenses for all of their business  activities. Although the period of June 2006 to December 2010 included  the worst financial crisis in 75 years, the firms’ combined net incomes  were positive in 16 out of the 18 quarters, even with combined losses  from stand-alone proprietary trading in 5 of those quarters. To further  examine the impact of stand-alone proprietary trading and hedge fund  and private equity fund investment activities on their overall performance  during this time period, we determined the change in each quarter from  the previous quarter in the combined net income of the six firms—which  would be negative when a firm experiences either less revenue or losses  in particular business activities—and compared them to changes in  revenues or losses from all trading activities, stand-alone proprietary  trading, and private equity fund and hedge fund investments. As shown in  figure 7, in quarters when the bank holding companies experienced large  increases or decreases in firmwide net income from the previous quarter,  changes in revenues or losses from stand-alone proprietary trading and  hedge fund and private equity fund investment from the previous quarter  generally represented only a small portion.
During this 4.5-year period, the six firms usually experienced larger  revenues and losses from activities other than stand-alone proprietary  trading and investments in hedge and private equity funds, including  writedowns on the values of these firms’ positions in CDOs and leveraged  loans, and potentially including aspects of these and other activities that  could be defined as prohibited proprietary trading as part of the  rulemaking. One large bank holding company reported almost $21  billion in writedowns in 2008 as the result of subprime CDOs or other  subprime-related direct exposures. In addition, the three largest bank  holding companies reported combined losses of almost $11 billion in the  same year from leveraged lending. Staff at the financial regulators and  the financial institutions we interviewed also noted that losses associated  with lending and other risky activities during the recent financial crisis  were greater than losses associated with stand-alone proprietary trading.  For example, one of the firms reported increasing the reserves it  maintains to cover loan losses by more than $14 billion in 2008 and  another of the firms increased its loan loss reserves by almost $22 billion  in 2009. Further, FDIC staff, whose organization oversees bank failures,  said they were not aware of any bank failures that had resulted from  stand-alone proprietary trading.
However, whether certain investment and underwriting activities should or  will be restricted has been subject to debate. When expressing concerns  over the impact of proprietary trading, some policymakers and at least  one researcher include certain types of principal investments or  proprietary investment portfolios, which usually refer to the firms’ longer- term investment portfolio activity and in some cases have caused  significant losses or failures. For example, according to the examiner in  the Lehman Brothers bankruptcy case, part of the failure of Lehman  Brothers was largely attributable to that firm’s investments in commercial  real estate and private equity investments in other companies, or what the  report refers to as principal investments, and what in an interview its  author referred to as proprietary trading. An April 2011 staff report by the  Senate Permanent Subcommittee on Investigations provided additional  information on proprietary trading activities of certain financial institutions  and their role in the financial crisis. In addition, policymakers and at least  one researcher have raised questions about whether the riskiest tranches  of mortgage-backed securities, CDOs, or other securities that were  routinely held by the underwriter as part of the securitization and sales  process and that contributed to significant CDO losses should be  considered proprietary trading. Such losses are reflected in our data on  stand-alone proprietary trading only to the extent that they were reported  as revenues or losses at stand-alone proprietary-trading desks. However,  the extent to which these activities were included in the stand-alone  proprietary trading data is not known.
section_title: While Some Market Participants See the New Restrictions as Having Negative Consequences, Information on Such Potential Outcomes Was Limited
paragraphs: Some financial institutions, policymakers, and researchers have  expressed concerns about potential negative consequences of the  restrictions on proprietary trading and hedge and private equity fund  investments. First, some banking industry representatives and other  market observers have said that the restrictions could reduce the ability of  banks to offset risks in other areas. One bank holding company  representative noted that because proprietary-trading desks often use  innovative and in some cases countercyclical trading strategies, their  activities at banking entities have at times allowed for diversification of  risk that has improved the bank holding companies’ overall safety and  soundness. Although such an effect may exist, our analysis of the data  reported by the six largest bank holding companies found that stand- alone proprietary trading and hedge and private equity fund investment  activities represented a small portion of revenues from all trading and  bank holding company activities. Also, the revenues and losses from  stand-alone proprietary trading were not particularly uncorrelated to  overall revenues or losses over the time period we reviewed. In addition,  our findings that stand-alone proprietary trading during the period we  reviewed required firms to take greater risks than all trading activities on  average to generate the same amount of revenue and that these firms’  VaR risk models were less capable of predicting the actual risks  associated with stand-alone proprietary trading reduces the potential  benefits of such trading to offset other losses.
Some market observers believe the restrictions could potentially reduce  the competitiveness of U.S. firms by restricting their activities compared  to their international competitors. According to interviews with foreign  regulatory bodies, many countries are looking at changing capital  requirements for proprietary trading activities, but no other industrialized  countries in Europe or around the world plan to enact provisions that  parallel the U.S. restrictions. The foreign regulators we spoke with  indicated that if the U.S. restrictions were implemented in a way that  restricts the ability of U.S. banking entities to serve their clients through  market-making, underwriting, or in other ways, that U.S. banking entities  could lose business to their competitors in Europe and elsewhere.  Further, two recent reports issued by a research department of J.P.  Morgan Chase—one of the six largest bank holding companies that was  included in our analysis and that would be impacted by the proprietary  trading restrictions—stated that those restrictions represented a material  benefit to certain European financial institutions over those in the United  States because of the regulatory arbitrage that would exist across  countries. However, this analysis does not incorporate the potential  competitive benefits, such as reduced funding costs to these firms if they  were less exposed to risks and losses during periods of economic  instability, as we saw during the recent crisis. In addition, according to  representatives of one foreign financial institution, revisions to  international capital standards, and changes to laws in other countries  could force competitors of U.S. firms to similarly restrict their trading and  fund investment activities, which would minimize the competitive impacts  of the U.S. restrictions.
According to some market observers, the restrictions may also reduce the  amount of liquidity in financial markets, depending on how they are  implemented. They say if the restrictions are enforced too strictly and limit  activities—in particular the taking of principal positions—that are critical to  making markets for various financial instruments, including certain  equities, exchange-traded funds, and U.S. corporate bonds, then the  effects may be detrimental. Representatives at the six largest bank  holding companies and some commentators on the FSOC study  explained that in order to effectively make liquid markets, especially for  products other than stocks, traders sometimes need to assume principal  risk in order to take on inventory and move orders effectively. If the  restrictions limited market-makers’ ability to assume such risk, traders  could stop providing liquidity in certain markets, making it more difficult or  expensive for corporations, state and local governments, or other clients  to finance their activities or hedge their investments. A January 2011  report prepared by a consulting group that was commissioned by the  Securities Industry and Financial Markets Association—an industry group  that represents securities firms, banks, and asset managers—described  the importance of implementing the restrictions in a way that did not  reduce liquidity associated with permitted activities. In addition,  representatives of two bank holding companies expressed concerns that  the proprietary trading restrictions could limit their ability to respond to  individual instances of severe market illiquidity, such as a flash crash, as  occurred in U.S. equity markets on May 6, 2010, or the failure of a large  member of a derivatives clearinghouse. They noted that in these  instances regulators may need to provide financial institutions with  additional flexibility to hold inventories or make purchases that could  resemble proprietary trading in order to support market functioning.  However, limited research exists on these hypothetical outcomes. The  Securities Industry and Financial Markets Association-commissioned  study provided little empirical data to indicate the extent to which the  restrictions on proprietary trading and investments in hedge and private  equity activity might impact the liquidity of financial markets.
Finally, some policymakers, researchers, and others have said that the  restrictions could push risky trading and other activities to less-regulated  financial institutions, such as hedge funds. Financial institutions have  begun to shut down stand-alone proprietary trading operations and in at  least one case announced plans to spin off the operations to unaffiliated  and separately capitalized funds. Opponents of the restrictions argue that  proprietary trading could present greater risks to the financial system if  much of the activity in the future is conducted out of less-regulated  entities, such as hedge funds, whose advisers only recently were required  to register and provide data to SEC, rather than banking entities, which  are subject to on-site safety and soundness supervision and examination  programs. However, losses occurring at hedge funds and other nonbank  entities are less likely to pose risks to the U.S. banking system than those  occurring within bank holding companies. In addition, to the extent that  proprietary trading migrates to entities outside of the banking system, no  actual reductions in the level of market liquidity may occur.
section_title: More Comprehensive Information Will Be Needed to Fully Monitor Compliance with New Restrictions
paragraphs: Federal regulatory oversight has not always been effective in assessing  the adequacy of risk management of the largest financial institutions, a  key part of overseeing the implementation of Section 619.  While  implementing proprietary trading and hedge fund and private equity fund  restrictions poses challenges, effective data collection will be critical to  oversight.
subsections: section_title: Oversight Has Not Always Been Effective in Assessing the Adequacy of Risk Management at the Largest U.S. Financial Institutions
paragraphs: The Federal Reserve, OCC, and SEC share primary responsibility for  overseeing risks associated with trading and investment activities by large  U.S. bank holding companies, including proprietary trading and fund  investment activities. Responsibilities for oversight depend on which legal  entity is conducting the activity. The Federal Reserve, as the consolidated  supervisor of bank and thrift holding companies, plays the primary role in  overseeing these activities across the institution, including its  subsidiaries, but also largely relies on OCC and SEC to oversee activities  conducted out of national bank and broker-dealer subsidiaries of the  holding company, respectively. To oversee the risks of trading and other  activities, regulators conduct ongoing monitoring and surveillance, meet  with financial institution executives and risk management personnel, and  conduct targeted risk-based reviews of specific business lines or key  controls across the holding company. In some cases, regulators have  somewhat different goals in their oversight. For example, OCC focuses  on the safety and soundness of the national banks within holding  companies, while SEC focuses on regulations intended to promote  investor protection, market integrity, and capital formation.
To oversee proprietary trading and investments in hedge funds and  private equity funds, the staff from the Federal Reserve, OCC, and SEC  described following generally similar approaches that focused on how the  institutions managed the risks associated with such activities, which are a  subset of all trading and investment activities. As part of their risk-based  examinations of all trading and investment activities, in recent years these  regulators have conducted examinations that in some cases focused on  internal controls and specific business lines related to proprietary trading  or investments in hedge and private equity funds. However, these reviews  were generally designed to test key controls, compliance, or overall risk  management in these areas rather than to specifically focus on  proprietary trading or investments in hedge and private equity funds.  Representatives of these agencies told us that until the enactment of the  act, their oversight of trading activities generally did not distinguish  between proprietary trading and trading conducted on behalf of  customers, because they examined both activities when assessing a  firm’s overall management of risk arising from all business lines. As a  result, they have generally not had separate procedures in place to  examine proprietary trading activities or to distinguish whether financial  instruments were bought or sold for proprietary or other purposes. In  some limited situations, regulators in the past sought to define market  making and distinguish it from proprietary trading or other activities. For  example, as part of an effort to implement additional requirements related  to short selling—in which a party borrows stock from another party and  then sells it in order to profit from declines in its value—SEC developed  guidance that defined market making in equities markets as making  continuous, two-sided quotes and holding oneself out as willing to buy  and sell on a continuous basis; making a comparable pattern of  purchases and sales of a financial instrument in a manner that provides  liquidity; making continuous quotations that are at or near the market on  both sides; and providing widely accessible and broadly disseminated  quotes. In addition, bank regulatory manuals in some cases instruct  examiners to take steps that would identify proprietary trading, although  given the risk-based nature of oversight at the largest bank holding  companies, these manuals have served as a reference rather than as  specific examination procedures. Finally, OCC examiners said that they  had discussed with bank managers the intent behind certain trading  activities and then verified through profit and loss and other information  that the risk profile is consistent with the financial institution’s stated  intent.
Federal financial regulators have also taken steps to prevent what they  consider conflicts of interest associated with trading and investment  activities. For example, banking regulators told us that they rely on their  safety and soundness authority to require that financial institutions  maintain policies and procedures to address conflicts of interest, including  focusing on conflicts that could create possible reputational risks for the  institutions. As part of regulating securities broker-dealers, SEC staff  oversee compliance with Section 15(g) of the Securities Exchange Act of  1934, which requires all registered broker-dealers to establish, maintain,  and enforce written policies and procedures reasonably designed to  prevent the misuse of material nonpublic information they obtain. In the  past, SEC conducted examinations of the effectiveness of the information  barriers that broker-dealers used to prevent “leakage” of information from  customer-focused trading desks to proprietary-trading desks, which in  part led to the enforcement action discussed earlier. In addition, in 2007,  SEC conducted examinations of 11 broker-dealers that, although not  directly related to proprietary trading, sought to determine whether certain  of these firms were providing nonpublic information about large market- moving orders to certain favored customers, such as hedge funds.  According to SEC staff, determining whether broker-dealers were leaking  customer order information was difficult, even after an extensive multi- year, data-intensive examination, and SEC closed these investigations  without filing charges.
Our prior work showed that these financial regulators have been  challenged in overseeing large financial institutions’ risk management  efforts on a comprehensive basis. Prior to the most recent crisis, the  Federal Reserve, SEC, and the Office of Thrift Supervision each had  responsibilities for overseeing the largest bank holding companies,  investment banks, and thrift holding companies, respectively. In a 2009  review, we found that although these regulators had identified numerous  weaknesses in institutions’ risk management systems before the financial  crisis began, they had not always taken steps to fully ensure that the  institutions adequately addressed the weaknesses. For example,  regulators had identified inadequate oversight of institutions’ risks by  senior management, but the regulators noted that these institutions had  strong financial positions and that senior management had presented the  regulators with plans for change. However, the regulators did not take  steps to fully ensure that these changes were quickly or fully implemented  until the crisis revealed that the systems were still not adequate.  Regulators had also identified weaknesses in the quantitative models that  these firms used to measure and manage financial risks but may not have  taken action to resolve these weaknesses. For example, regulators did  not prohibit at least one institution from using untested models to evaluate  risks and did not change their assessment of the institution’s risk  management program after these findings. Finally, regulators had  identified numerous weaknesses in stress testing—scenarios used to  model the effects of adverse events or shocks on firms’ portfolios—at  several large institutions without having taken aggressive steps to push  institutions to better understand and manage risks. In an earlier report, we  found that holding company regulators lacked full authority or sufficient  tools and capabilities to adequately oversee the risks that these financial  institutions posed to themselves and other institutions.
section_title: The Financial Crisis Highlighted Weaknesses in Oversight and Spurred Efforts to Better Identify Risks
paragraphs: The financial crisis also revealed some significant challenges faced by  regulators in overseeing trading, investment, and other activities at large  U.S. financial institutions. For example, institutions overseen by OCC and  the Federal Reserve, including Citigroup and Bank of America,  experienced large losses or increases in reserves for anticipated losses  during the crisis. The oversight failures of SEC and the Office of Thrift  Supervision ultimately resulted in changes that eliminated their role in  overseeing holding companies going forward. During the recent crisis,  all five of the investment banks that SEC had been overseeing through its  voluntary Consolidated Supervised Entities program either failed, were  purchased at reduced values by other financial institutions, or became  bank holding companies in order to permanently obtain official access to  Federal Reserve emergency liquidity going forward. According to SEC  staff, the voluntary nature of the Consolidated Supervised Entities  Program limited the authority of the agency to enforce new requirements  on investment banks that were part of the program. According to the  report prepared by the bankruptcy examiner for Lehman Brothers, which  failed in September 2008, this broker-dealer had changed its business  strategy in 2007 to focus more on making principal investments in  commercial real estate, providing funding as part of leveraged lending for  mergers and acquisitions, and making more private equity or similar  investments in other companies. However, the bankruptcy examiner  reported that this firm’s staff had disregarded its risk management policies  and limits that had been set for these activities, had not included some of  these positions in the calculations it used to measure its total firmwide risk  levels, and failed to hedge some of these investments to reduce their risk  to the firm. Although aware of some of these actions, the bankruptcy  examiner noted that SEC staff had sought only to ensure that the financial  institution’s board was informed of and had approved these changes. In  testimony on April 20, 2010, in response to the bankruptcy examiner’s  report, SEC’s chairman acknowledged that SEC staff should have  challenged Lehman Brother’s management more forcefully regarding the  types of risks the firm was taking and imposed meaningful requirements  or limitations when necessary. Similarly, the Office of Thrift Supervision  failed to adequately oversee the credit default swap activities of an  American International Group, Inc. (AIG) subsidiary, which added to other  regulatory failures to result in serious liquidity issues and necessitated  significant government assistance. Beginning in July 2011, the largest  U.S. financial institutions will all be holding companies overseen at the  holding company level by the Federal Reserve. Although the Federal  Reserve retains this responsibility, its failures in identifying and  addressing problems at large bank holding companies were revealed  during the financial crisis, when some large bank holding companies  experienced large losses or required significant capital infusions to  remain solvent.
Since the crisis, various regulatory changes have been made or are  underway that are intended to reduce the risks that trading and other  activities pose to the safety and soundness of these large institutions.  Regulators told us they are overseeing significant changes that financial  institutions are making to their risk management models, including  improvements to their stress testing. Representatives of bank holding  companies explained that they now use VaR measures with longer time  horizons that include a fuller range of economic cycles to increase their  models’ accuracy and consistency. According to Federal Reserve staff,  the time frames from which the financial institutions’ models drew their  historical loss experiences—their look-back periods—and which the  regulators used to determine capital adequacy, were not sufficiently long  enough to account for periods of varying market returns. Additionally, the  staff at one large bank holding company we reviewed told us that they  were working to incorporate more complicated, and often illiquid, assets  into their firms’ VaR measures. Officials from another institution noted, for  example, that it had instituted a new policy to incorporate the  warehousing risk from CDOs that arises during the period that an  institution is accumulating the underlying securities that will be used to  create the CDO securities. They indicated having had such a practice in  the past would have helped their firm better identify the risks it was  bearing associated with super-senior CDO tranches, which created large  losses during the crisis. Financial institutions also told us that they were  creating “stress-VaR” models that attempted to model a “doomsday  scenario” of dramatic market price movements similar to those that  occurred during the 2008 financial crisis. The institutions also noted that  they were trying to develop better measurements of returns earned per  unit of risk taken.
In addition, changes to capital requirements, broadly and with respect to  the trading books at financial institutions, should mitigate risks to the  financial system. According to the FSOC study and Federal Reserve staff,  prior to the crisis, capital requirements were in many cases lower for  assets held in trading books (because of an assumed higher amount of  liquidity), which caused banks to move many of their riskier assets there.  Under new rules that are expected as a result of the July 2009 Basel III  international capital accord, mortgage-backed securities, CDOs, and  other complex products will face stricter eligibility requirements for  inclusion in trading accounts. Those that are included will face higher  capital charges to mitigate risks associated with such products. More  generally, Basel III aims to increase minimum common equity  requirements from 2 to 4.5 percent and tier 1 capital requirements from 4  to 6 percent and to add a new “conservation buffer” of an additional 2.5  percent. Section 171 of the act also requires regulators to establish, on  a consolidated basis, leverage and risk-based standards currently  applicable to U.S. insured depository institutions for U.S. bank holding  companies and nonbank financial companies supervised by the Federal  Reserve. Finally, the act’s changes that enhance the Federal Reserve’s  oversight of nonbank subsidiaries of bank holding companies and  nonbank financial companies should help ensure a more consistent and  comprehensive approach to overseeing trading activities at large U.S.  financial institutions.
Given the significant challenges that regulators have faced in overseeing  large financial institutions’ risk management efforts, which includes the  risks arising from these firms’ trading and investment activities, the  restrictions on proprietary trading and hedge fund and private equity fund  investments should reduce the scope of risks that regulators will have to  oversee going forward. However, implementing the act’s restrictions to  fully ensure that such risks no longer exist at the firms raises new  challenges for the regulators.
section_title: Implementing the Restrictions on Proprietary Trading and Hedge and Private Equity Fund Investments Poses Challenges
paragraphs: To make recommendations on effectively implementing the act’s  restrictions on proprietary trading and hedge fund and private equity  investments, FSOC issued a report in January 2011 that included an  overview of the key issues financial regulators should consider when they  issue rules and specific recommendations on how regulators and financial  institutions might monitor and enforce the new rules. Several key  challenges remain, however, including distinguishing prohibited  proprietary trading from market making and appropriately defining terms  associated with the restrictions on hedge fund and private equity fund  investments.
The FSOC study and our interviews with large U.S. bank holding  companies and their regulators found that a key challenge in  implementing the proprietary trading restrictions will be disentangling  activities associated with market-making, hedging, and underwriting from  prohibited proprietary trading activities. For example, when a firm’s  traders purchase bonds from a client as part of market making, the  position they hold in those bonds poses the same risk of loss to the firm  as bonds purchased in a proprietary trade. As a result, regulators face the  challenge of monitoring firms’ market-making activities and positions to  fully ensure they are sufficiently hedged and that inventories of financial  assets being held are appropriate in both size and duration of turnover  consistent with market making activities.
Representatives of the large U.S. bank holding companies we interviewed  expressed a number of concerns about the potential negative  consequences of implementing the proprietary trading restrictions in a  way that prohibited any principal trading. As mentioned previously,  representatives from several financial institutions believed that prohibiting  institutions from holding inventory would reduce liquidity, especially for  already illiquid markets in which buyers and sellers cannot always be  quickly matched. Staff from several institutions said that customer-driven  trades were often hedged with a number of off-setting trades rather than  with a single matching hedge. For example, a manager of trading at one  firm explained that a single large derivatives contract traded between his  firm acting as a market maker and one of its clients could result in the firm  having to conduct as many as 30 smaller offsetting equities trades to fully  hedge the risk. Staff at another financial institution argued that to be  effective market makers and get the best prices for their clients, their  traders needed current information on pricing (i.e., price discovery) and  trends in the marketplace that could be gathered only through active  trading. And staff at two firms told us that having regulators attempt to  ensure that no proprietary trading has occurred would be resource  intensive if not impossible.
The FSOC study approached this issue by recommending that firms  monitor certain metrics that could indicate when impermissible proprietary  trading is occurring within permitted market-making activities. The study  suggested a number of potential quantitative metrics related to revenue,  risk, inventory, and customer flow, which regulators could require banking  entities to implement and review in order to guard against future  impermissible activities. For example, using revenue data, regulators  could identify instances in which revenue over a certain time-period is  outsized compared to recent trends. Regulators could also determine  from revenue data whether traders are acting as market makers by  making most of their profit at the time positions are taken, or if they are  instead profiting from appreciation of assets, which could indicate  proprietary trading. They could also use revenue-to-risk measures to  distinguish market-making from proprietary trading, because the lower  VaR and other risk and volatility measures associated with market- making result in higher revenue-to-risk data than with proprietary trading.  In addition, they can use inventory turnover and aging metrics that track  the length of time assets remain on a financial institution’s balance sheet,  which can help regulators determine whether the holding periods for  assets appears consistent with activities undertaken for customers rather  than for trying to earn profits for the firm by holding for longer periods.  Finally, the FSOC report mentioned that if regulators require institutions to  classify their trading between “customer-initiated” and “trader-initiated”  transactions, both banking entities and regulators would be able to use  this customer-flow data in quantitative metrics and ratios to better identify  impermissible proprietary trading.
Staff at some financial institutions we spoke with supported this approach,  given the difficulties of differentiating between legitimate market-making  and proprietary trading. Financial regulators also noted the challenges of  such a distinction. FDIC representatives said that in 2005 the regulators  tried to define proprietary trading as part of an effort to better oversee  such activity but ultimately could not. They noted that preventing  proprietary trading required a subjective, case-by-case evaluation. Any  other approach, they said, would either be too broad and overly inclusive  or too narrow—that is, it would miss some activities.
The FSOC study recommended a four-part framework to monitor and  enforce the proprietary trading restrictions. First, the study recommended  a programmatic compliance regime that would require banking entities to  implement policies, procedures, and internal controls designed to ensure  that the institutions adhered to the provisions. Second, banking entities  would be required to report and provide sufficient data and records to  regulators on their market-making and hedging activities so that  regulators could determine whether any improper proprietary trading was  taking place. Third, the regulatory agencies would periodically review and  test the banking entities’ policies and procedures to help ensure that they  were in compliance with the proprietary trading restrictions and to address  any potential violations. Finally, as part of the supervisory process,  banking entities would be subject to penalties or legal actions for violating  proprietary trading restrictions.
Regulators will also face challenges in defining terms associated with the  restrictions on hedge fund and private equity investments. The proprietary  trading prohibition defines hedge funds and private equity funds as  issuers that rely on certain exemptions from the definition of “investment  company” under Section 3 of the Investment Company Act or such similar  funds as agencies determine by rule. As the FSOC report noted, those  exclusions are used not just by hedge and private equity funds, but also  by a wide variety of other legal entities. For example, one financial  institution expressed concerns that their firm’s own employee pension  funds could meet the definition of the act, which could mean that the  restrictions could affect investments that firms made to benefit their  retired employees. At the same time, the act’s definition of a covered fund  may not capture funds such as commodity pools that invest in oil or other  commodities and that pose risks similar to those posed by the covered  funds. Staff at one institution also expressed concerns that their  investments in certain of their subsidiaries were structured in ways that  could mean that they met the definition of a fund in which investment  would be restricted. Other firms’ staff noted that by limiting their ability to  invest in a fund they have created at levels greater than 3 percent after  one year, the act may not give them enough time to prove a fund’s  performance track record before seeking outside investors. According to  this firm’s staff, many investors expect to see a history of at least 3 years  of fund returns before they are allowed to, or are otherwise willing to,  invest in a fund. This issue will require regulators to consider the  congressional intent behind the restrictions and appropriately define these  and other terms. As we have seen, taking steps to ensure that the  prohibition on hedge fund and private equity fund investments is  implemented without creating a loophole that would exclude funds that  should fall under its scope, without inadvertently including under the  restrictions other types of funds that were not intended to be included will  be important.
Clearly regulators face challenges in implementing the new restrictions.  Without appropriate monitoring of trading activities, however, financial  institutions could also abuse permissible activities, using them to conduct  prohibited proprietary trading activities. Our review of the proprietary  trading activities of large bank holding companies revealed that some  financial institutions have pursued strategies that were a combination of  client-focused transactions and proprietary positioning, activities which  could be considered impermissible proprietary trading activities but go  unnoticed if they were not monitored appropriately. For example, as noted  earlier, one regulator summarized the trading activities of one business  line of one large bank holding company we reviewed as generating  revenue mostly from client flow but noted that the business line also had  a trading desk that sought to profit from long-term positioning of inventory  based on their traders’ views of the market. Also, according to the  description, the financial institution’s customer flow trading desk may hold  large inventory positions that exceed the amount necessary to facilitate  client trades when the desk has a particular view on the direction of the  market. Implementing and enforcing the restrictions to address activities  such as this will be difficult.
As we have noted, the act requires the Federal Reserve, OCC, FDIC,  SEC, and the Commodity Futures Trading Commission to issue final rules  to implement the restrictions on proprietary trading and hedge fund and  private equity fund investments by October 2011. To inform this  process, in recent months regulators have met with and collected general  information, but not comprehensive data, from the largest U.S. bank  holding companies on their proprietary trading and hedge fund and  private equity fund activities.    To inform the FSOC study released in January 2011, officials at  Treasury said that they and the regulators had collected information  from large institutions on ways the banks could implement the  provisions, including ways of adapting their risk management systems  to monitor compliance.   Representatives of the Federal Reserve and OCC explained and  provided documents supporting that as part of their ongoing  monitoring of the largest bank holding companies, they monitor the  trading and investment activities of the firms they oversee, including  proprietary trading and other activities that may be restricted.   At our request, Federal Reserve and OCC examination staff gathered  some general information on the trading activities at each of the six  firms.
These financial regulators initially considered collecting specific data on  the nature and volume of proprietary trading and investment activity at the  largest firms as part of the FSOC study. However, they instead focused  on meeting with representatives of the largest financial institutions to  gather qualitative information about how the entities monitor and manage  the risks of trading and investment activities. As a result, the regulators  have not compiled specific data on the nature of and volume of trading at  stand-alone proprietary-trading desks, nor have they attempted to get a  more comprehensive understanding of the extent to which the firms are  taking proprietary positions as part of conducting other trading or  investment activities. Having such information, including more complete  data on the amounts of revenue and VaR levels of these firms’ market- making desks that may be conducting proprietary trading now would help  regulators monitor the changes the bank holding companies make and  provide them with a comparative baseline to assist in quantitatively  observing that the firms’ trading inventories and revenues change in the  ways expected once the act’s restrictions are in place.
While examiners have collected some information on certain trading and  fund activities, they have yet to collect comprehensive information. Staff  from some of these regulators told us that they have not collected more  comprehensive information because they have not yet written the final  rules to define with greater specificity the types of trading and investment  activities that will be prohibited. Indeed, collecting such information before  the rule is finalized would be difficult without more specificity about  permissible activities and the scope of coverage of certain types of fund  investments. However, such an effort could be effective if regulators  identified and collected information on a broader set of activities than may  be prohibited to help ensure they are aware of all trading and funds that  could potentially be covered. Such a process would almost certainly  inform the regulators about definitional and other issues that could be  useful as part of the rulemaking.
Such information could also be collected after the rules are finalized but  would likely require each regulator to obtain data from the firms they are  responsible for that covers a sufficiently long enough period prior to the  implementation of the rules to fully ensure they have a sufficient baseline  of activity to understand and be able to better assess whether the firms  are changing their activities as required by the rules. Conversely, FSOC  could direct the Office of Financial Research, which was created within  the Department of the Treasury by the act to facilitate more robust and  sophisticated analysis of the financial system, to collect such information  and share it with regulators as authorized under the act.
section_title: Conclusions
paragraphs: The ability of financial institutions to conduct stand-alone proprietary  trading and investments in hedge funds and private equity funds had  advantages and disadvantages. While the activities produced a steady—if  small—revenue stream for the institutions, they also contributed to losses  during the financial crisis, which added to even greater losses from their  lending and securitization activities. The extent that proprietary trading  activities occur elsewhere in the firms remains unknown. Further, these  activities opened the door to potential conflicts of interest that in some  cases resulted in enforcement actions against some firms. While some  market participants expressed concerns that the restrictions on  proprietary trading activities could negatively affect U.S. financial  institutions and the economy by reducing banks’ ability to diversify their  income and compete with foreign institutions and reducing liquidity in  asset markets, the actual potential for such effects remain unclear.
While the regulators have started to take steps to improve their oversight,  the recent crisis revealed the challenges financial regulators face in  overseeing trading and investment activities at large financial institutions.  One challenge for regulators in implementing the act’s restrictions will be  to be mindful of possible unintended consequences. In addition,  regulators will face the challenge of identifying and monitoring permissible  activities that can create risks similar to those posed by proprietary  trading and fund investments. For example, we found that many of the  largest losses experienced by these firms were in activities such as  lending and underwriting. For these reasons, and because of the  uncertainty over whether some activities are or are not proprietary  trading, regulators can best ensure the overall safety of the U.S. financial  system by remaining vigilant about all activities that pose risks to large  financial institutions regardless of whether such activities fall under the  definitions of proprietary trading and hedge fund and private equity fund  investments that regulators develop as part of the required rulemaking.  However, implementing the restrictions, and in particular clarifying and  requiring monitoring to better ensure that only permissible activities occur,  will be difficult because of these and other challenges that must be  addressed. To date, the regulators have taken some positive steps to  ready themselves to prepare rules and supervise compliance with the  act’s restrictions. Completing a more in-depth review of activities that may  be covered by the act could provide information on the potential impact of  the restrictions, how firms are preparing for them, whether there are  efforts to evade the restrictions, and how to improve monitoring and  enforcement. Because the regulators—either individually or through the  Office of Financial Research—have yet to collect more complete  information on the number and nature of trading desks where proprietary  trading could be occurring, or firms’ hedge fund and private equity fund  investment activities, they risk not being able to most effectively  implement the restrictions.
section_title: Recommendation for Executive Action
paragraphs: In order to improve their ability to track and effectively implement the new  restrictions on proprietary trading and hedge fund and private equity fund  investments, we recommend that the Chairperson of FSOC direct the  Office of Financial Research, or work with the staffs of the Commodity  Futures Trading Commission, FDIC, Federal Reserve, OCC, and SEC, or  both, to collect and review more comprehensive information on the nature  and volume of activities that could potentially be covered by the act.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Department of the Treasury,  whose Secretary serves as the chairperson of FSOC; Commodity Futures  Trading Commission; FDIC; Federal Reserve; OCC; Office of Thrift  Supervision; SEC; and representatives of the six bank holding companies  from which we collected data. The Commodity Futures Trading  Commission, Department of the Treasury, FDIC, Federal Reserve, OCC,  and SEC provided written responses, which are reprinted in appendixes II  through VII. Some of the agencies and bank holding companies provided  technical comments that we incorporated as appropriate.
The letters from the Commodity Futures Trading Commission,  Department of the Treasury, FDIC, OCC, and SEC stated that the  agencies will consider our recommendation as part of their Section 619  rulemaking process. The Commodity Futures Trading Commission,  Department of the Treasury, FDIC, Federal Reserve, and OCC stated  that, as noted in the FSOC study, the collection of and analysis of  information about trading activities is an important part of understanding  trading activities and identifying prohibited proprietary trading. The  Department of the Treasury, FDIC, and OCC said that as part of this  process they would consider whether certain metrics or other data could  be collected during the conformance period.
The Department of the Treasury, FDIC, OCC, and SEC stated, as we did  in our report, that collecting information before the rule is finalized would  be difficult without more specificity about permissible activities and the  scope of coverage of certain types of fund investments. Although we  acknowledge the difficulties of identifying and collecting additional  information, gathering more comprehensive information on the nature of  and volume of trading at stand-alone proprietary-trading desks, as well as  where the firms may be conducting prohibited proprietary trading at  market-making desks or elsewhere in the firm, would assist the regulators  in implementing the act’s restrictions in various ways. Having such  information, including more complete data on the amounts of revenue and  VaR levels of these firms’ desks that may be conducting proprietary  trading now, would help regulators monitor the changes the bank holding  companies make and provide them with a baseline to help observe  whether the firms’ trading inventories and revenues change in the ways  expected once the act’s restrictions are in place. The agencies’ ongoing  supervision and regulation of these firms, which for some agencies  includes on-site examiners conducting ongoing monitoring, provides a  valuable mechanism for collecting such baseline information going  forward.
Finally, the Department of the Treasury, FDIC, Federal Reserve, and  OCC noted that the relevant agencies (or in some letters “some or all of  the relevant agencies”) responsible for implementing and enforcing  Section 619 are in the best position to collect and review relevant  information on the nature and volume of activities that could be covered  by Section 619. Our recommendation provides the Chairperson of the  FSOC the flexibility to direct the Office of Financial Research, or work  with staff of the agencies, or both, to collect more comprehensive  information.
We are sending copies of this report to the appropriate congressional  committees; the Department of the Treasury, whose Secretary serves as  the chairperson of the FSOC; Commodity Futures Trading Commission;  FDIC; Federal Reserve; OCC; Office of Thrift Supervision; SEC; and  other interested parties. In addition, the report will be available at no  charge on GAO’s Web site at http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  me at (202) 512-8678 or williamso@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made major contributions to  this report are listed in appendix VIII.
section_title: Appendix I: Scope and Methodology
paragraphs: To describe what is known about the risks and conflicts of interest  associated with proprietary trading and hedge and private equity fund  investments, we collected and analyzed data and documents from, and  interviewed federal agency officials, financial institutions, economists,  researchers, and others. These included: the federal financial regulators,  including the Board of Governors of the Federal Reserve System (Federal  Reserve), the Office of the Comptroller of the Currency, the Securities  and Exchange Commission, the Federal Deposit Insurance Corporation,  and the Commodity Futures Trading Commission; the Financial Industry  Regulatory Authority, which is the self-regulatory organization that  oversees broker-dealers; industry associations; policy research  organizations; and consumer advocacy organizations. We conducted site  visits and teleconferences to interview senior management and observe  trading desks at the six largest U.S. bank holding companies as of  December 31, 2010, which accounted for 88 percent of the total trading  revenues reported by all bank holding companies as ranked by total  assets reported in bank regulatory filings. We also collected documents  from and interviewed representatives of foreign regulators and research  bodies about the U.S. restrictions and whether their countries were likely  to enact similar restrictions.
In addition, to describe the risks associated with proprietary trading and  investments in hedge and private equity funds, we reviewed and analyzed  data from the six bank holding companies. To obtain information about  the extent to which proprietary trading posed risks to these firms, we  attempted to gather information on stand-alone proprietary trading as well  as other proprietary trading that may be occurring within other trading  activities of the firms. We gathered information on stand-alone proprietary  trading, but determined that collecting information on other activities that  might constitute proprietary trading was not feasible because the firms did  not separately maintain records on such activities and because of the  uncertainty over the types of activities that will be considered proprietary  trading by the regulators upon completion of the required regulatory  rulemaking. From this, we obtained data from all firms covering both their  stand-alone proprietary and total trading activities, including quarterly  data on profits, losses, Value-at Risk (VaR) estimates, and how often  their losses exceeded their VaR estimates, for the time period from third  quarter 2006 to fourth quarter 2010, or 18 quarters. The bank holding  companies also provided us with data on those hedge and private equity  funds that they believed would be restricted by the Dodd-Frank Wall  Street Reform and Consumer Protection Act (the act). We asked firms to  self-identify any activities involving acquiring or retaining any equity,  partnership, or ownership interest in or sponsoring private equity funds,  as defined in Section 619 of the act. They provided quarterly data on  revenue from such activities, for the third quarter 2006 through the fourth  quarter 2010, or 18 quarters. We also analyzed selected public filing  information collected from the companies’ 10K and 10Q filings and  through SNL Financial, a company that aggregates public filing  information.
The data provided by firms was self-reported, and while we did not verify  every data element’s accuracy, we took steps to help ensure that the data  were complete and sufficiently reliable for our purposes. Specifically, we  checked the data for such things as missing data, outliers, and for internal  consistency. We also discussed the data provided with the companies  and made follow-up requests for data and explanations as necessary to  better ensure that we analyzed sufficiently complete and consistent  information across all firms. In addition, we discussed with the Federal  Reserve on-site examiners of the six bank holding companies the  reliability of the information systems used to generate the data the  companies reported to us, as well as the magnitude and ranges of that  data provided. Finally, we reviewed information from each bank holding  company about the reliability of their management information systems,  which contained the computer-generated data they provided. While we  determined that the data were sufficiently reliable for the purposes of this  report, we present these data in our report as representations made to us  by these six largest bank holding companies.
To describe how regulators oversee proprietary trading and hedge fund  and private equity fund investment activity, we analyzed selected  examination and other regulatory documents from and interviewed federal  financial regulators. We reviewed our past reports that addressed risks at  large institutions and how their regulators have overseen such risks. We  also reviewed the comments submitted to the Financial Stability Oversight  Council as part of its study required by Section 619 of the act. Finally, we  interviewed representatives of the six largest bank holding companies to  learn how they interacted with their regulators and discussed regulatory  oversight with researchers, financial industry representatives, consumer  advocacy organizations, and policy organizations.
We conducted this performance audit from August 2010 to July 2011 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix II: Comments from the Board of Governors of the Federal Reserve System
section_title: Appendix III: Comments from the Commodity Futures Trading Commission
section_title: Appendix IV: Comments from the Department of the Treasury
section_title: Appendix V: Comments from the Federal Deposit Insurance Corporation
section_title: Appendix VI: Comments from the Office of the Comptroller of the Currency
section_title: Appendix VII: Comments from the Securities and Exchange Commission
section_title: Appendix VIII: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
paragraphs: Orice Williams Brown, (202) 512-8678 or williamso@gao.gov.
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Cody Goebel, Assistant Director;  Rudy Chatlos; Randy Fasnacht; James Lager; Thomas McCool; Jon  Menaster; Marc Molino; David Rodriguez; Paul Thompson; and Winnie  Tsen made key contributions to this report.