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. 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. 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.