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United States Government Accountability Office:
GAO:
Report to Congressional Committees:
July 2011:
Proprietary Trading:
Regulators Will Need More Comprehensive Information to Fully Monitor
Compliance with New Restrictions When Implemented:
GAO-11-529:
GAO Highlights:
Highlights of GAO-11-529, a report to congressional committees.
Why GAO Did This Study:
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 less-liquid 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.
What GAO Found:
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.
What GAO Recommends:
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.
View [hyperlink, http://www.gao.gov/products/GAO-11-529] or key
components. For more information, contact Orice Williams Brown at
(202) 512-8678 or williamso@gao.gov.
[End of section]
Contents:
Letter:
Background:
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:
More Comprehensive Information Will Be Needed to Fully Monitor
Compliance with New Restrictions:
Conclusions:
Recommendation for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: Comments from the Board of Governors of the Federal
Reserve System:
Appendix III: Comments from the Commodity Futures Trading Commission:
Appendix IV: Comments from the Department of the Treasury:
Appendix V: Comments from the Federal Deposit Insurance Corporation:
Appendix VI: Comments from the Office of the Comptroller of the
Currency:
Appendix VII: Comments from the Securities and Exchange Commission:
Appendix VIII: GAO Contact and Staff Acknowledgments:
Figures:
Figure 1: Combined Revenues and Losses from Stand-Alone Proprietary
Trading at the Six Largest U.S. Bank Holding Companies, Third Quarter
2006 through Fourth Quarter 2010:
Figure 2: Revenues or Losses from Stand-Alone Proprietary Trading, All
Trading, and All Firmwide Activities at the Six Largest U.S. Bank
Holding Companies, Third Quarter 2006 to Fourth Quarter 2010:
Figure 3: Percentage of Firm-Quarters in Which Stand-Alone Proprietary
Trading and Total Trading Resulted in Revenues or Losses at the Six
Largest U.S. Bank Holding Companies, Third Quarter 2006 to Fourth
Quarter 2010:
Figure 4: Revenue per VaR, or "Risk-Adjusted Revenues," for Stand-
Alone Proprietary Trading and All Trading at the Six Largest U.S. Bank
Holding Companies, Third Quarter 2006 to Fourth Quarter 2010:
Figure 5: Combined Revenues or Losses from Investments in Hedge Funds
and Private Equity Funds at the Six Largest U.S. Bank Holding
Companies, Third Quarter 2006 through Fourth Quarter 2010:
Figure 6: Combined Revenues or Losses from Hedge and Private Equity
Fund Investments, and Total Revenues at the Six Largest U.S. Bank
Holding Companies, Third Quarter 2006 through Fourth Quarter 2010:
Figure 7: Change from Previous Quarter in Firmwide Net Income, and
Change from Previous Quarter in Revenues and Losses from All Trading,
Stand-Alone Proprietary Trading and Hedge Fund and Private Equity Fund
Investments for the Six Largest U.S. Bank Holding Companies, Fourth
Quarter 2006 through Fourth Quarter 2010:
Abbreviations:
CDO: collateralized debt obligation:
FDIC: Federal Deposit Insurance Corporation:
Federal Reserve: Board of Governors of the Federal Reserve System:
FSOC: Financial Stability Oversight Council:
OCC: Office of the Comptroller of the Currency:
SEC: Securities and Exchange Commission:
VaR: value-at-risk:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
July 13, 2011:
The Honorable Tim Johnson:
Chairman:
The Honorable Richard C. Shelby:
Ranking Member:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Spencer T. Bachus:
Chairman:
The Honorable Barney Frank:
Ranking Member:
Committee on Financial Services:
House of Representatives:
Section 619 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the act),[Footnote 1] 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.[Footnote 2] 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.[Footnote 3]
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.[Footnote 4] 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).[Footnote 5] 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.
Background:
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.[Footnote 6] 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).[Footnote 7] 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.[Footnote 8]
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.[Footnote
9] 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.[Footnote 10] 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.[Footnote 11]
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.
[Footnote 12] The study included specific recommendations for
regulators to monitor and supervise institutions for compliance.
[Footnote 13] 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.[Footnote 14] 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.[Footnote 15] 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.
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:
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.[Footnote 16] 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 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:
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.[Footnote 17] 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.[Footnote 18]
* 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),
[Footnote 19] 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.[Footnote
20] 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.
[Footnote 21] 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.[Footnote 22]
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.[Footnote 23] 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.
Although Stand-Alone Proprietary Trading Generally Produced Small
Revenues as a Percentage of Total Revenues, It Experienced Larger
Losses during the Financial Crisis:
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.[Footnote 24]
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.
[Footnote 25] 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.[Footnote 26] 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.[Footnote 27] 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.[Footnote 28] 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.
Figure 1: Combined Revenues and Losses from Stand-Alone Proprietary
Trading at the Six Largest U.S. Bank Holding Companies, Third Quarter
2006 through Fourth Quarter 2010:
[Refer to PDF for image: vertical bar graph]
Quarter: 2006 Q3;
Revenue/Loss: $533 million.
Quarter: 2006 Q4;
Revenue/Loss: $1.3 billion.
Quarter: 2007 Q1;
Revenue/Loss: $2.9 billion.
Quarter: 2007 Q2;
Revenue/Loss: $1.6 billion.
Quarter: 2007 Q3;
Revenue/Loss: -$649 million.
Quarter: 2007 Q4;
Revenue/Loss: -$7.6 billion.
Quarter: 2008 Q1;
Revenue/Loss: -$1.1 billion.
Quarter: 2008 Q2;
Revenue/Loss: $434 million.
Quarter: 2008 Q3;
Revenue/Loss: -$1.7 billion.
Quarter: 2008 Q4;
Revenue/Loss: -$4.8 billion.
Quarter: 2009 Q1;
Revenue/Loss: $572 million.
Quarter: 2009 Q2;
Revenue/Loss: $2.2 billion.
Quarter: 2009 Q3;
Revenue/Loss: $1.6 billion.
Quarter: 2009 Q4;
Revenue/Loss: $1.0 billion.
Quarter: 2010 Q1;
Revenue/Loss: $1.7 billion.
Quarter: 2010 Q2;
Revenue/Loss: $261 million.
Quarter: 2010 Q3;
Revenue/Loss: $1.1 billion.
Quarter: 2010 Q4;
Revenue/Loss: $552 million.
Sources: GAO analysis of data reported by six largest U.S. bank
holding companies.
Notes: Data shown here on stand-alone proprietary trading--which is
conducted at desks that are organized by a banking entity with the
specific purpose of trading a firm's own capital--does not include
other proprietary trading activities that may have taken place at the
institutions, depending on how the term is defined as part of the
rulemaking to implement Section 619 of the act. 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.
[End of figure]
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.[Footnote 29] 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 figure 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.
Figure 2: Revenues or Losses from Stand-Alone Proprietary Trading, All
Trading, and All Firmwide Activities at the Six Largest U.S. Bank
Holding Companies, Third Quarter 2006 to Fourth Quarter 2010:
[Refer to PDF for image: vertical bar graph]
Quarter: 2006 Q3;
Revenues or losses from all bank holding company activities: $79.6
billion;
Revenues or losses from all trading activities: $13.8 billion;
Revenues or losses from stand-alone proprietary trading: $0.5 billion.
Quarter: 2006 Q4;
Revenues or losses from all bank holding company activities: $85.0
billion;
Revenues or losses from all trading activities: $15.7 billion;
Revenues or losses from stand-alone proprietary trading: $1.3 billion.
Quarter: 2007 Q1;
Revenues or losses from all bank holding company activities: $94.0
billion;
Revenues or losses from all trading activities: $23.1 billion;
Revenues or losses from stand-alone proprietary trading: $2.9 billion.
Quarter: 2007 Q2;
Revenues or losses from all bank holding company activities: $94.6
billion;
Revenues or losses from all trading activities: $20.5 billion;
Revenues or losses from stand-alone proprietary trading: $1.6 billion.
Quarter: 2007 Q3;
Revenues or losses from all bank holding company activities: $83.5
billion;
Revenues or losses from all trading activities: $13.5 billion;
Revenues or losses from stand-alone proprietary trading: -$0.6 billion.
Quarter: 2007 Q4;
Revenues or losses from all bank holding company activities: $55.8
billion;
Revenues or losses from all trading activities: -$11.5 billion;
Revenues or losses from stand-alone proprietary trading: -$7.6 billion.
Quarter: 2008 Q1;
Revenues or losses from all bank holding company activities: $73.3
billion;
Revenues or losses from all trading activities: $6.9 billion;
Revenues or losses from stand-alone proprietary trading: -$1.1 billion.
Quarter: 2008 Q2;
Revenues or losses from all bank holding company activities: $83.8
billion;
Revenues or losses from all trading activities: $12.7 billion;
Revenues or losses from stand-alone proprietary trading: $0.4 billion.
Quarter: 2008 Q3;
Revenues or losses from all bank holding company activities: $75.1
billion;
Revenues or losses from all trading activities: $8.4 billion;
Revenues or losses from stand-alone proprietary trading: -$1.7 billion.
Quarter: 2008 Q4;
Revenues or losses from all bank holding company activities: $47.3
billion;
Revenues or losses from all trading activities: -$6.0 billion;
Revenues or losses from stand-alone proprietary trading: -$4.8 billion.
Quarter: 2009 Q1;
Revenues or losses from all bank holding company activities: $118.9
billion;
Revenues or losses from all trading activities: $26.3 billion;
Revenues or losses from stand-alone proprietary trading: $0.6 billion.
Quarter: 2009 Q2;
Revenues or losses from all bank holding company activities: $130.5
billion;
Revenues or losses from all trading activities: $27.8 billion;
Revenues or losses from stand-alone proprietary trading: $2.2 billion.
Quarter: 2009 Q3;
Revenues or losses from all bank holding company activities: $116.6
billion;
Revenues or losses from all trading activities: $30.4 billion;
Revenues or losses from stand-alone proprietary trading: $1.6 billion.
Quarter: 2009 Q4;
Revenues or losses from all bank holding company activities: $93.0
billion;
Revenues or losses from all trading activities: $18.4 billion;
Revenues or losses from stand-alone proprietary trading: $1.0 billion.
Quarter: 2010 Q1;
Revenues or losses from all bank holding company activities: $128.6
billion;
Revenues or losses from all trading activities: $31.9 billion;
Revenues or losses from stand-alone proprietary trading: $1.7 billion.
Quarter: 2010 Q2;
Revenues or losses from all bank holding company activities: $114.8
billion;
Revenues or losses from all trading activities: $18.6 billion;
Revenues or losses from stand-alone proprietary trading: $0.3 billion.
Quarter: 2010 Q3;
Revenues or losses from all bank holding company activities: $108.0
billion;
Revenues or losses from all trading activities: $17.8 billion;
Revenues or losses from stand-alone proprietary trading: $1.1 billion.
Quarter: 2010 Q4;
Revenues or losses from all bank holding company activities: $105.1
billion;
Revenues or losses from all trading activities: $13.1 billion;
Revenues or losses from stand-alone proprietary trading: $0.6 billion.
Sources: GAO analysis of data reported by six largest U.S. bank
holding companies and publicly reported revenue data.
Note: Data shown here on stand-alone proprietary trading--which is
conducted at desks that are organized by a banking entity with the
specific purpose of trading a firm's own capital--does not include
other proprietary trading that may have taken place at the
institutions, depending on how the term is defined as part of the
rulemaking to implement Section 619 of the act.
[End of figure]
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.
Figure 3: Percentage of Firm-Quarters in Which Stand-Alone Proprietary
Trading and Total Trading Resulted in Revenues or Losses at the Six
Largest U.S. Bank Holding Companies, Third Quarter 2006 to Fourth
Quarter 2010:
[Refer to PDF for image: illustrated matrix]
Revenue in all trading/Loss in stand-alone proprietary trading:
Number of quarters: 17; 16%.
Revenue in all trading/Revenue in stand-alone proprietary trading:
Number of quarters: 77; 71%.
Loss in all trading/Loss in stand-alone proprietary trading:
Number of quarters: 9; 8%.
Loss in overall trading/Revenue in stand-alone proprietary trading
Number of quarters: 5; 5%.
Sources: GAO analysis of data reported by six largest U.S. bank
holding companies.
Note: Data shown here on stand-alone proprietary trading--which is
conducted at desks that are organized by a banking entity with the
specific purpose of trading a firm's own capital--does not include
other proprietary trading that may have taken place at the
institutions, depending on how the term is defined as part of the
rulemaking to implement Section 619 of the act.
[End of figure]
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.[Footnote 30] 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.[Footnote 31] 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.[Footnote 32] 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.
Figure 4: Revenue per VaR, or "Risk-Adjusted Revenues," for Stand-
Alone Proprietary Trading and All Trading at the Six Largest U.S. Bank
Holding Companies, Third Quarter 2006 to Fourth Quarter 2010:
[Refer to PDF for image: vertical bar graph]
Quarter: 2006 Q3;
Average of all trading revenues or losses, risk-adjusted: $32.6
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $6.1 billion.
Quarter: 2006 Q4;
Average of all trading revenues or losses, risk-adjusted: $33.3
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $6.8 billion.
Quarter: 2007 Q1;
Average of all trading revenues or losses, risk-adjusted: $40.5
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $10.7 billion.
Quarter: 2007 Q2;
Average of all trading revenues or losses, risk-adjusted: $35.1
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $7.9 billion.
Quarter: 2007 Q3;
Average of all trading revenues or losses, risk-adjusted: $17.9
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $3.0 billion.
Quarter: 2007 Q4;
Average of all trading revenues or losses, risk-adjusted: -$7.0
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $4.7 billion.
Quarter: 2008 Q1;
Average of all trading revenues or losses, risk-adjusted: $12.2
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $3.8 billion.
Quarter: 2008 Q2;
Average of all trading revenues or losses, risk-adjusted: $16.2
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $1.5 billion.
Quarter: 2008 Q3;
Average of all trading revenues or losses, risk-adjusted: $12.4
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: -$5.4 billion.
Quarter: 2008 Q4;
Average of all trading revenues or losses, risk-adjusted: -$4.0
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: -$5.3 billion.
Quarter: 2009 Q1;
Average of all trading revenues or losses, risk-adjusted: $19.3
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: -$1.1 billion.
Quarter: 2009 Q2;
Average of all trading revenues or losses, risk-adjusted: $24.1
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $8.3 billion.
Quarter: 2009 Q3;
Average of all trading revenues or losses, risk-adjusted: $30.4
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $6.6 billion.
Quarter: 2009 Q4;
Average of all trading revenues or losses, risk-adjusted: $18.5
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $7.6 billion.
Quarter: 2010 Q1;
Average of all trading revenues or losses, risk-adjusted: $35.6
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $11.4 billion.
Quarter: 2010 Q2;
Average of all trading revenues or losses, risk-adjusted: $24.1
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $1.6 billion.
Quarter: 2010 Q3;
Average of all trading revenues or losses, risk-adjusted: $23.9
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $8.0 billion.
Quarter: 2010 Q4;
Average of all trading revenues or losses, risk-adjusted: $19.7
billion;
Average of stand-alone proprietary trading revenue or losses, risk-
adjusted: $5.1 billion.
Sources: GAO analysis of data reported by six largest U.S. bank
holding companies.
Notes: Revenue for all trading includes revenue from stand-alone
proprietary trading. As noted earlier, VaR for all trading is usually
less than the sum of the individual VaRs (such as for stand-alone
proprietary trading) because of diversification effects across
portfolios--that is, the results of different or opposite movements
among assets that result from one group holding assets that tend to
move in the opposite direction of those held by other groups within a
firm. This may account for some of the difference between risk-
adjusted revenues for all trading and stand-alone proprietary trading.
Data shown here on stand-alone proprietary trading--which is conducted
at desks that are organized by a banking entity with the specific
purpose of trading a firm's own capital--does not include other
proprietary trading that may have taken place at the institutions,
depending on how the term is defined as part of the rulemaking to
implement Section 619 of the act.
[End of figure]
Although Investments in Hedge and Private Equity Funds Generally
Produced Small Revenues as a Percentage of Total Revenues, They
Experienced Some Larger Losses during the Financial Crisis:
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.[Footnote 33] 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.
Figure 5: Combined Revenues or Losses from Investments in Hedge Funds
and Private Equity Funds at the Six Largest U.S. Bank Holding
Companies, Third Quarter 2006 through Fourth Quarter 2010:
[Refer to PDF for image: vertical bar graph]
Quarter: 2006 Q3;
Revenue/Loss: $1.6 billion.
Quarter: 2006 Q4;
Revenue/Loss: $2.7 billion.
Quarter: 2007 Q1;
Revenue/Loss: $4.0 billion.
Quarter: 2007 Q2;
Revenue/Loss: $4.2 billion.
Quarter: 2007 Q3;
Revenue/Loss: $2.5 billion;
Quarter: 2007 Q4;
Revenue/Loss: $2.0 billion.
Quarter: 2008 Q1;
Revenue/Loss: -$323 million.
Quarter: 2008 Q2;
Revenue/Loss: $1.7 billion.
Quarter: 2008 Q3;
Revenue/Loss: -$805 million.
Quarter: 2008 Q4;
Revenue/Loss: -$7.0 billion.
Quarter: 2009 Q1;
Revenue/Loss: -$1.8 billion.
Quarter: 2009 Q2;
Revenue/Loss: $1.1 billion.
Quarter: 2009 Q3;
Revenue/Loss: $2.2 billion.
Quarter: 2009 Q4;
Revenue/Loss: $2.2 billion.
Quarter: 2010 Q1;
Revenue/Loss: $1.8 billion.
Quarter: 2010 Q2;
Revenue/Loss: $445 million.
Quarter: 2010 Q3;
Revenue/Loss: $2.3 billion.
Quarter: 2010 Q4;
Revenue/Loss: $3.0 billion.
Sources: GAO analysis of data reported by six largest U.S. bank
holding companies.
[End of figure]
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 figure 6). Revenues from these
investments represented between about 0.08 to 3.5 percent of these
bank holding companies' combined revenues during this period.
Figure 6: Combined Revenues or Losses from Hedge and Private Equity
Fund Investments, and Total Revenues at the Six Largest U.S. Bank
Holding Companies, Third Quarter 2006 through Fourth Quarter 2010:
[Refer to PDF for image: 2 vertical bar graphs]
Quarter: 2006 Q3;
Revenues or losses from all bank holding company activities: $79.6
billion;
Revenues or losses from hedge fund investments: $0.5 billion;
Revenues or losses from private equity fund investments: $1.2 billion.
Quarter: 2006 Q4;
Revenues or losses from all bank holding company activities: $85.0
billion;
Revenues or losses from hedge fund investments: $0.7 billion;
Revenues or losses from private equity fund investments: $1.9 billion.
Quarter: 2007 Q1;
Revenues or losses from all bank holding company activities: $94.0
billion;
Revenues or losses from hedge fund investments: $0.8 billion;
Revenues or losses from private equity fund investments: $3.1 billion.
Quarter: 2007 Q2;
Revenues or losses from all bank holding company activities: $94.6
billion;
Revenues or losses from hedge fund investments: $0.9 billion;
Revenues or losses from private equity fund investments: $3.3 billion.
Quarter: 2007 Q3;
Revenues or losses from all bank holding company activities: $83.5
billion;
Revenues or losses from hedge fund investments: $0.8 billion;
Revenues or losses from private equity fund investments: $1.7 billion.
Quarter: 2007 Q4;
Revenues or losses from all bank holding company activities: $55.8
billion;
Revenues or losses from hedge fund investments: $0.4 billion;
Revenues or losses from private equity fund investments: $1.7 billion.
Quarter: 2008 Q1;
Revenues or losses from all bank holding company activities: $73.3
billion;
Revenues or losses from hedge fund investments: -$0.04 billion;
Revenues or losses from private equity fund investments: -$0.3 billion.
Quarter: 2008 Q2;
Revenues or losses from all bank holding company activities: $83.8
billion;
Revenues or losses from hedge fund investments: $0.5 billion;
Revenues or losses from private equity fund investments: $1.3 billion.
Quarter: 2008 Q3;
Revenues or losses from all bank holding company activities: $75.1
billion;
Revenues or losses from hedge fund investments: -$0.4 billion;
Revenues or losses from private equity fund investments: -$0.4 billion.
Quarter: 2008 Q4;
Revenues or losses from all bank holding company activities: $47.3
billion;
Revenues or losses from hedge fund investments: -$1.0 billion;
Revenues or losses from private equity fund investments: -$6.0 billion.
Quarter: 2009 Q1;
Revenues or losses from all bank holding company activities: $118.9
billion;
Revenues or losses from hedge fund investments: $0.5 billion;
Revenues or losses from private equity fund investments: -$2.3 billion.
Quarter: 2009 Q2;
Revenues or losses from all bank holding company activities: $130.5
billion;
Revenues or losses from hedge fund investments: $0.9 billion;
Revenues or losses from private equity fund investments: $0.12 billion.
Quarter: 2009 Q3;
Revenues or losses from all bank holding company activities: $116.6
billion;
Revenues or losses from hedge fund investments: $1.0 billion;
Revenues or losses from private equity fund investments: $1.2 billion.
Quarter: 2009 Q4;
Revenues or losses from all bank holding company activities: $93.0
billion;
Revenues or losses from hedge fund investments: $0.9 billion;
Revenues or losses from private equity fund investments: $1.3 billion.
Quarter: 2010 Q1;
Revenues or losses from all bank holding company activities: $128.6
billion;
Revenues or losses from hedge fund investments: $0.6 billion;
Revenues or losses from private equity fund investments: $1.2 billion.
Quarter: 2010 Q2;
Revenues or losses from all bank holding company activities: $114.8
billion;
Revenues or losses from hedge fund investments: $0.09 billion;
Revenues or losses from private equity fund investments: $0.4 billion.
Quarter: 2010 Q3;
Revenues or losses from all bank holding company activities: $108.0
billion;
Revenues or losses from hedge fund investments: $0.5 billion;
Revenues or losses from private equity fund investments: $1.8 billion.
Quarter: 2010 Q4;
Revenues or losses from all bank holding company activities: $105.1
billion;
Revenues or losses from hedge fund investments: $0.7 billion;
Revenues or losses from private equity fund investments: $2.2 billion.
Sources: GAO analysis of data reported by six largest U.S. bank
holding companies and publicly reported revenue data.
Note: These results reflect the total dollar amount of revenue or loss
generated from capital invested. Therefore, the greater the
investment, the greater the potential amount of revenue or loss.
[End of figure]
Other Activities Affected These Firms' Overall Net Incomes More Than
Their Stand-Alone Proprietary Trading and Hedge and Private Equity
Fund Investments:
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.
Figure 7: Change from Previous Quarter in Firmwide Net Income, and
Change from Previous Quarter in Revenues and Losses from All Trading,
Stand-Alone Proprietary Trading and Hedge Fund and Private Equity Fund
Investments for the Six Largest U.S. Bank Holding Companies, Fourth
Quarter 2006 through Fourth Quarter 2010:
[Refer to PDF for image: vertical bar graph]
Quarter: 2006 Q4;
Change from previous quarter in net income from all bank holding
company activities: $2.7 billion;
Change from previous quarter in revenues and losses from all trading
activities: $1.9 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: $0.8 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: $1.0 billion.
Quarter: 2007 Q1;
Change from previous quarter in net income from all bank holding
company activities: $0.6 billion;
Change from previous quarter in revenues and losses from all trading
activities: $7.4 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: $1.6 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: $1.3 billion.
Quarter: 2007 Q2;
Change from previous quarter in net income from all bank holding
company activities: $0.3 billion;
Change from previous quarter in revenues and losses from all trading
activities: -$2.6 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: -$1.3 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: $0.2 billion.
Quarter: 2007 Q3;
Change from previous quarter in net income from all bank holding
company activities: -$7.7 billion;
Change from previous quarter in revenues and losses from all trading
activities: -$7.0 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: -$2.2 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: -$1.7 billion.
Quarter: 2007 Q4;
Change from previous quarter in net income from all bank holding
company activities: -$21.3 billion;
Change from previous quarter in revenues and losses from all trading
activities: -$24.9 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: -$7.0 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: -$0.5 billion.
Quarter: 2008 Q1;
Change from previous quarter in net income from all bank holding
company activities: $9.0;
Change from previous quarter in revenues and losses from all trading
activities: $18.3 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: $6.5 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: -$2.4 billion.
Quarter: 2008 Q2;
Change from previous quarter in net income from all bank holding
company activities: $4.3 billion;
Change from previous quarter in revenues and losses from all trading
activities: $5.9 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: $1.5 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: $2.0 billion.
Quarter: 2008 Q3;
Change from previous quarter in net income from all bank holding
company activities: -$5.2 billion;
Change from previous quarter in revenues and losses from all trading
activities: -$4.3 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: -$2.1 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: -$2.5 billion.
Quarter: 2008 Q4;
Change from previous quarter in net income from all bank holding
company activities: -$28.5 billion;
Change from previous quarter in revenues and losses from all trading
activities: -$14.4 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: -$3.1 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: -$6.2 billion.
Quarter: 2009 Q1;
Change from previous quarter in net income from all bank holding
company activities: $38.5 billion;
Change from previous quarter in revenues and losses from all trading
activities: $32.3 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: $5.3 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: $5.2 billion.
Quarter: 2009 Q2;
Change from previous quarter in net income from all bank holding
company activities: $4.2 billion;
Change from previous quarter in revenues and losses from all trading
activities: $1.5 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: $1.6 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: $2.9 billion.
Quarter: 2009 Q3;
Change from previous quarter in net income from all bank holding
company activities: -$6.8 billion;
Change from previous quarter in revenues and losses from all trading
activities: $2.5 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: -$0.6 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: $1.1 billion.
Quarter: 2009 Q4;
Change from previous quarter in net income from all bank holding
company activities: -$5.8 billion;
Change from previous quarter in revenues and losses from all trading
activities: -$12.0 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: -$0.5 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: -$13.5 billion.
Quarter: 2010 Q1;
Change from previous quarter in net income from all bank holding
company activities: $14.7 billion;
Change from previous quarter in revenues and losses from all trading
activities: $13.6 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: $0.7 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: -$0.4 billion.
Quarter: 2010 Q2;
Change from previous quarter in net income from all bank holding
company activities: -$2.7 billion;
Change from previous quarter in revenues and losses from all trading
activities: -$13.3 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: -$1.4 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: -$1.3 billion.
Quarter: 2010 Q3;
Change from previous quarter in net income from all bank holding
company activities: -$11.1 billion;
Change from previous quarter in revenues and losses from all trading
activities: -$0.8 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: $0.8 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: $1.9 billion.
Quarter: 2010 Q4;
Change from previous quarter in net income from all bank holding
company activities: $6.7 billion;
Change from previous quarter in revenues and losses from all trading
activities: -$4.8 billion;
Change from previous quarter in revenues and losses from stand-alone
proprietary trading: -$0.5 billion;
Change from previous quarter in revenues and losses from hedge fund
and private equity fund investments: $0.7 billion.
Sources: GAO analysis of data reported by six largest U.S. bank
holding companies and publicly reported net income and revenue data.
Note: Data shown here on stand-alone proprietary trading--which is
conducted at desks that are organized by a banking entity with the
specific purpose of trading a firm's own capital--does not include
other proprietary trading that may have taken place at the
institutions, depending on how the term is defined as part of the
rulemaking to implement Section 619 of the act.
[End of figure]
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.[Footnote 34] 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.[Footnote 35] 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.[Footnote 36] 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.
While Some Market Participants See the New Restrictions as Having
Negative Consequences, Information on Such Potential Outcomes Was
Limited:
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.[Footnote 37] 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.[Footnote 38] 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.
More Comprehensive Information Will Be Needed to Fully Monitor
Compliance with New Restrictions:
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.
Oversight Has Not Always Been Effective in Assessing the Adequacy of
Risk Management at the Largest U.S. Financial Institutions:
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.
[Footnote 39] 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.[Footnote
40]
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.
[Footnote 41] 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.
[Footnote 42] 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.[Footnote 43]
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.
[Footnote 44] 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.[Footnote 45]
The Financial Crisis Highlighted Weaknesses in Oversight and Spurred
Efforts to Better Identify Risks:
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.[Footnote 46] 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.[Footnote 47] 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.[Footnote 48] 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.[Footnote 49] 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.[Footnote 50] 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.[Footnote 51]
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.[Footnote 52] 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.[Footnote 53]
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.
Implementing the Restrictions on Proprietary Trading and Hedge and
Private Equity Fund Investments Poses Challenges:
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.[Footnote
54] 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.[Footnote 55] 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.[Footnote 56] 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.
Specifically:
* 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.[Footnote 57]
Conclusions:
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.
Recommendation for Executive Action:
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.
Agency Comments and Our Evaluation:
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 [hyperlink, 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.
Signed by:
Orice Williams Brown:
Managing Director:
Financial Markets and Community Investment:
[End of section]
Appendix I: Scope and Methodology:
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.[Footnote 58] 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.[Footnote 59] 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.
[End of section]
Appendix II: Comments from the Board of Governors of the Federal
Reserve System:
Board of Governors of The Federal Reserve System:
Scott G. Alvarez:
General Counsel:
Washington, D.C. 20551:
June 28, 2011:
Cody Goebel:
Assistant Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, NW:
Washington, D.C. 20548:
Dear Mr. Goebel:
The Board of Governors of the Federal Reserve System appreciates the
opportunity to respond to your draft study, GA0-11-529, in which you
recommend that, as part of implementing rules under section
619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(Dodd-Frank Act), the relevant regulatory agencies collect and review
comprehensive information on the nature and volume of activities that
could potentially be covered by section 619.
The Federal regulatory agencies charged with implementing section 619
are now in the process of developing proposed rules that are intended
to further define covered activities and recordkeeping and reporting
requirements. This proposal will give interested members of the
public, including affected banking entities, an opportunity to comment
on the definitions and scope of the rules proposed by the agencies.
We appreciate the GAO's support for the use of metrics in determining
compliance with section 619 — an approach recommended by the Financial
Stability Oversight Council (FSOC) in its initial report regarding
implementation of section 619. As noted in the recommendations set
forth in the study on the effective implementation of section 619
published in January 2011 by the FSOC, the collection and analysis of
information about trading activities is an important part of
understanding trading activities and identifying prohibited
proprietary trading. For this and other reasons, we believe that some
or all of the relevant agencies responsible for implementing and
enforcing section 619 would be in the best position to undertake
collection and review of information that is ultimately determined to
be appropriate to ensure compliance and enforcement of section 619.
We appreciate the opportunity to comment and look forward to continued
dialogue on this important topic.
Sincerely,
Signed by:
Scott G. Alvarez:
[End of section]
Appendix III: Comments from the Commodity Futures Trading Commission:
U.S. Commodity Futures Trading Commission:
Office of General Counsel
Three Lafayette Centre
21st Street, NW, Washington, DC 20581
Telephone: (202) 418-5120
Facsimile: (202) 418-5524
[hyperlink, http://www.cftc.gov]
June 30, 2011:
Cody Goebel:
Assistant Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, NW:
Washington, D.C. 20548:
Dear Mr. Goebel:
I appreciate the opportunity to respond to your draft study, GAO-11-
529, in which you recommend that, as part of implementing rules under
section 619, "the Chairperson of the FSOC direct the Office of
Financial Research, or work with the staffs of the CFTC, 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."
The Commodity Futures Trading Commission staff agrees with the
Financial Stability Oversight Council study recommendations, published
in January 2011, on the effective implementation of section 619, that
the collection and analysis of information about trading activities is
an important part of understanding trading activities and identifying
prohibited proprietary trading. As you know, CFTC staff, in
consultation with other regulatory agencies, is now in the process of
developing proposed rules that are intended to further define covered
activities and recordkeeping and reporting requirements. As part of
the rulemaking process, CFTC staff will consider the Government
Accountability Office's recommendation.
I look forward to continued dialogue on this important topic.
Sincerely,
Signed by:
Dan M. Berkowitz:
General Counsel:
[End of section]
Appendix IV: Comments from the Department of the Treasury:
Department Of The Treasury:
Washington, D.C. 20220:
June 28, 2011:
Cody Goebel:
Assistant Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, NW:
Washington, D.C. 20548:
Dear Mr. Goebel:
The Treasury Department and the Federal regulatory agencies charged
with implementing Section 619 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank Act), commonly referred to as the
Volcker Rule, appreciate the opportunity to respond to your draft
study, GA0-11-529, in which you recommend that, as part of
implementing rules under section 619, the relevant regulatory agencies
should collect and review more comprehensive information on the nature
and volume of activities that could potentially be covered by section
619.
As your study also notes, it is difficult currently to collect data on
the precise activities that will be subject to the regulations
promulgated under section 619, because the types and extent of those
activities will not be certain until the rule is finalized. The
agencies are now in the process of developing proposed rules that are
intended to further define covered activities and recordkeeping and
reporting requirements. The agencies will consider the GAO's
recommendation as part of this rulemaking process, such as considering
whether certain metrics or other data could be collected and reviewed
during the conformance period.
As noted in the recommendations set forth in the study on the
effective implementation of section 619 published in January 2011 by
the Financial Stability Oversight Council, the collection and analysis
of information about trading activities is an important part of
understanding trading activities and identifying prohibited
proprietary trading. For this and other reasons, we believe that some
or all of the relevant agencies responsible for implementing and
enforcing section 619 would be in the best position, subject to
resource constraints, to undertake any collection and review of the
information that we may ultimately determine is appropriate.
We appreciate the opportunity to comment and look forward to continued
dialogue on this important topic.
Sincerely,
Signed by:
Jeffrey A. Goldstein:
[End of section]
Appendix V: Comments from the Federal Deposit Insurance Corporation:
FDIC:
Federal Deposit Insurance Corporation:
Division of Risk Management Supervision:
550 17th Street NW:
Washington, D.C. 20429-9990:
June 29, 2011:
Cody Goebel:
Assistant Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, NW:
Washington, D.C. 20548:
Dear Mr. Goebel:
The Federal Deposit Insurance Corporation (FDIC) appreciates the
opportunity to respond to your draft study, Proprietary Trading:
Regulators Will Need More Comprehensive Information to Fully Monitor
Compliance with New Restrictions When Implemented (GA0-11-529), in
which you recommend that, as part of implementing rules under section
619, the relevant regulatory agencies should collect and review more
comprehensive information on the nature and volume of activities that
could potentially be covered by section 619.
As your study also notes, it is difficult currently to collect data on
the precise activities that will be subject to the regulations
promulgated under section 619, because the types and extent of those
activities will not be certain until the rule is finalized. The
agencies are now in the process of developing proposed rules that are
intended to further define covered activities and recordkeeping and
reporting requirements. The agencies will consider the GAO's
recommendation as part of this rulemaking process, such as considering
whether certain metrics or other data could be collected and reviewed
during the conformance period.
As noted in the recommendations set forth in the study on the
effective implementation of section 619 published in January 2011 by
the Financial Stability Oversight Council, the collection and analysis
of information about trading activities is an important part of
understanding trading activities and identifying prohibited
proprietary trading. For this and other reasons, we believe that 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.
We appreciate the opportunity to comment and look forward to continued
dialogue on this important topic.
Sincerely,
Signed by:
Sandra L. Thompson:
Director:
[End of section]
Appendix VI: Comments from the Office of the Comptroller of the
Currency:
Comptroller of the Currency:
Administrator of National Banks:
Washington, DC20219:
June 28,2011:
Ms. Once Williams Brown:
Managing Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548:
Dear Ms. Brown:
The Office of the Comptroller of the Currency, one of the Federal
regulatory agencies charged with implementing section 619 of the Dodd-
Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act),
commonly referred to as the Volcker Rule, appreciates the opportunity
to respond to your draft study, GAO-117529, in which you recommend
that, as part of implementing rules under section 619, the relevant
regulatory agencies should collect and review more comprehensive
information on the nature and volume of activities that could
potentially be covered by section 619.
As your study also notes, it is difficult currently to collect data on
the precise activities that will be subject to the regulations
promulgated under section 619, because the types and extent of those
activities will not be certain until the rule is finalized. The
agencies are now in the process of developing proposed rules that are
intended to further define covered activities and recordkeeping and
reporting requirements The agencies will consider the GAO's
recommendation as part of this rulemaking process, in particular, in
connection with whether certain metrics or other data could be
collected and reviewed during the conformance period.
As noted in the recommendations set forth in the study on the
effective implementation of section 619 published in January 2011 by
the Financial Stability Oversight Council, the collection and analysis
of information about trading activities is an important part of
understanding trading activities and identifying prohibited
proprietary trading. For this and other reasons, we believe that the
relevant agencies responsible for implementing and enforcing section
619 would be in the best position to undertake any collection and
review of the information that we may ultimately determine is
appropriate.
We appreciate the opportunity to comment and look forward to continued
dialogue on this important topic.
Sincerely,
Signed by:
John Walsh:
Acting Comptroller of the Currency:
[End of section]
Appendix VII: Comments from the Securities and Exchange Commission:
United States Securities And Exchange Commission:
Division Of Trading And Markets:
Washington, DC 20549
June 30, 2011:
Cody Goebel:
Assistant Director:
Financial Markets and Community Investment:
U.S. Government Accountability Office:
441 G Street, NW:
Washington, D.C. 20548:
Dear Mr. Goebel:
Commission staff appreciates the opportunity to respond to your draft
study, GA0-11-529, in which you recommend that, as part of
implementing rules under section 619, the "Chairperson of the FSOC
direct the Office of Financial Research, or work with the staffs of
the CFTC, 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."
As your study notes, it is difficult currently to collect data on the
precise activities that will be subject to the regulations promulgated
under section 619, because the types and extent of those activities
will not be certain until the rule is finalized. As you know,
Commission staff, in consultation with the other relevant regulatory
agencies, is currently in the process of developing proposed rules
that are intended to further define covered activities and
recordkeeping and reporting requirements. As part of this rulemaking
process, Commission staff will consider the GAO's recommendations.
We appreciate the opportunity to comment and look forward to continued
dialogue on this important topic.
Sincerely,
Signed by:
Robert Cook:
Director:
Division of Trading and Markets:
[End of section]
Appendix VIII: GAO Contact and Staff Acknowledgments:
GAO Contact:
Orice Williams Brown, (202) 512-8678 or williamso@gao.gov.
Staff Acknowledgments:
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.
[End of section]
Footnotes:
[1] Pub. L. No 111-203 § 619 (which amended the Bank Holding Company
Act of 1956), 124 Stat. 1376, 1620-31 (2010), adding 12 U.S.C. § 1851.
As discussed later in this report, Section 619 of the act requires the
federal banking agencies, the Securities and Exchange Commission, and
the Commodity Futures Trading Commission to promulgate rules
implementing the prohibition. 12 U.S.C. § 1851(b).
[2] Section 619 specifically defines the terms "proprietary trading,"
"hedge fund," and "private equity fund." 12 U.S.C. § 1851(h). We
provide abbreviated definitions of these terms for the purpose of
readability, but readers should refer to the act and our background
section for more specific information. Depending on how the regulators
implement the act, some activities that match our abbreviated
definitions could be permitted, and some that fall outside it may be
restricted.
[3] This report describes the provisions of Section 619 generally as
restrictions rather than prohibitions--similar to the act itself--
because Section 619 sets forth a list of permitted activities to which
the prohibitions generally do not apply. See 12 U.S.C. § 1851(a), (d).
[4] Section 989 of the act requires that we conduct a study regarding
the risks and conflicts associated with proprietary trading. To carry
out this study we considered stand-alone proprietary trading as well
as proprietary trading that may occur in relation to market-making or
other activities at financial institutions. For the purposes of this
report, stand-alone proprietary trading refers to trading at stand-
alone proprietary-trading desks, which are those organized by a
banking entity with the specific purpose of conducting trading using
the firm's own capital. We generally did not include merchant banking
activities or other long-term principal investments, although we
discuss debate about whether such activities should be restricted.
Section 620 of the act requires the appropriate federal banking
agencies to jointly study and prepare a report on the activities that
a banking entity may engage in under federal and state law and the
risks presented by or associated with such activities.
[5] The bank holding companies were Bank of America Corporation;
Citigroup Inc.; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.;
Morgan Stanley; and Wells Fargo & Company. The Goldman Sachs Group,
Inc., and Morgan Stanley became holding companies in September 2008.
[6] 12 U.S.C. § 1851(h)(1). The term "insured depository institution"
excludes institutions that function solely in a trust or fiduciary
capacity and satisfy other conditions. Under section 8 of the
International Banking Act of 1978, any foreign bank with a branch,
agency, or commercial lending company subsidiary in the United States,
and any company that indirectly controls such foreign bank, is treated
as a bank holding company. 12 U.S.C. § 3105.
[7] 12 U.S.C. § 1851(h)(4), (6). The definition of a trading account
also includes "any such other accounts" as determined by the
appropriate federal banking agencies, the Securities and Exchange
Commission, and the Commodity Futures Trading Commission, and set
forth in a rule.
[8] 12 U.S.C. § 1851(d)(1).
[9] 12 U.S.C. § 1851(b)(2).
[10] See Pub. L. No. 111-203 §§ 311, 312.
[11] The Office of Thrift Supervision will continue to be the
appropriate federal banking agency for federal savings associations
and FDIC-insured state-chartered savings associations until July 21,
2011.
[12] This council was created by the act to identify and coordinate
responses to emerging risks to the financial system. It is chaired by
the Secretary of the Treasury and comprised of voting representatives
from the Federal Reserve, OCC, SEC, FDIC, the Commodity Futures
Trading Commission, the Consumer Financial Protection Bureau, the
Federal Housing Finance Agency, the National Credit Union
Administration, and an independent member with insurance expertise. It
also includes nonvoting representatives of the Office of Financial
Research; the Federal Insurance Office; and state banking, securities,
and insurance regulators.
[13] Financial Stability Oversight Council, Study & Recommendations on
Prohibitions on Proprietary Trading & Certain Relationships with Hedge
Funds and Private Equity Funds (Washington, D.C., Jan. 18, 2011).
[14] 76 Fed. Reg. 8265 (Feb. 14, 2011); see 12 U.S.C. § 1851(c)(6).
The section provides a 2-year conformance period, subject to
extension, during which a banking entity can wind down, sell, or
otherwise conform its activities, investments, and relationships to
the proprietary trading restrictions.
[15] 12 U.S.C. § 1851(b)(2).
[16] These securities entitle their holders to a portion of the cash
flows from a group of mortgages.
[17] Market making is known generally as quoting both a buy and a sell
price in a financial instrument hoping to make a profit on a bid-offer
spread, although no single definition of market-making exists in law
or regulation.
[18] Another form of liquidity risk that financial institutions face
arises if they cannot obtain adequate short-term funding to finance
their operations.
[19] CDOs are securities backed by a pool of bonds, loans, or other
debt obligations.
[20] Front running is prohibited by the Financial Industry Regulatory
Authority (FINRA), which is the self-regulatory organization for
broker-dealers. See FINRA Rule 2010, FINRA Regulation IM 2110-3.
[21] SEC File No. 3-14204 (Jan. 25, 2011). According to the order,
although the proprietary traders at this firm did not have direct
access to the computer system the market makers used to execute
customer orders, by virtue of being located on the broker-dealer's
equity trading floor they could see customer order information on the
market makers' computer screens and hear market makers discuss
customer orders. Moreover, according to the order, the broker-dealer
encouraged its market makers to generate and share "trading ideas"
with the proprietary traders, promising higher bonuses to market
makers whose ideas were profitable.
[22] See, e.g., section 15(g) of the Securities Exchange Act of 1934,
15 U.S.C. § 78o(g), which requires registered brokers and dealers to
maintain and enforce written policies and procedures reasonably
designed to prevent the misuse of material, nonpublic information.
[23] We did not examine the adequacy of bank holding company controls
in place to prevent and mitigate conflicts of interest related to
proprietary trading and hedge fund and private equity investments as
part of the scope of this report.
[24] The scope of this report is limited to trading at banking
entities, and all of the data analysis in the report specifically
focuses on the six largest bank holding companies as of December 31,
2010. Outside of banking entities as defined in the act, other
financial institutions also conduct proprietary trading and make
investments in hedge funds and private equity funds, including other
hedge funds, broker-dealers, pension funds, insurance companies, and
others. Under Section 619, a nonbank financial company supervised by
the Federal Reserve that engages in proprietary trading or invests in
hedge funds and private equity funds will be subject to additional
capital requirements and quantitative limits that the Board
establishes by rule. 12 U.S.C. § 1851(a)(2).
[25] This analysis is based on trading revenue data in item 5c on Form
Y9-C Schedule HI for each firm, as well as OCC's Quarterly Report on
Bank Trading and Derivatives Activities for the Fourth Quarter of
2010, which compiled this data for all bank holding companies. Because
of how trading revenue and other items are reported on Form Y9-C, the
data may not match the trading revenue data discussed below that was
self-reported by the six bank holding companies. For example, trading
revenue on the Form Y9-C does not include interest income on trading
assets, which is reported separately.
[26] Some of the trading that took place within the firms' self-
reported stand-alone proprietary-trading desks might not be subject to
prohibition under the proprietary trading restrictions that regulators
will finalize as part of their rulemaking, such as trading in
government securities.
[27] As noted above, for the purposes of this report, stand-alone
proprietary-trading desks are those desks that are organized by a
banking entity with the specific purpose of trading a firm's own
capital. In a limited number of instances, bank holding companies
identified stand-alone proprietary-trading desk activity for which
they were unable to provide revenue data. For example, one firm
separately tracked revenue at one of their stand-alone proprietary-
trading desks for some but not all of the quarters. In these
instances, we verified that the missing data would not significantly
affect our findings.
[28] Trading revenues and losses reflect the total amount of money
made or lost from trading activities, and combined revenues or losses
reflect the sum of such figures across the six firms.
[29] While our report is primarily based on the analysis of the data
of all six bank holding companies and our statistics and figures
largely present combined results, we do present some data on single
firms or ranges or values across the six firms as appropriate.
[30] We calculated revenue-to-VaR figures by dividing the total
revenue at a firm or one of its trading desks by the corresponding
average daily VaR for that firm or trading desk for a particular
quarter, and then taking the average of these figures across multiple
stand-alone proprietary-trading desks, quarters, and firms, as
appropriate. Not all of the firms were able to provide complete VaR
data, but we determined that no single firm was responsible for a
significant portion of the missing data, and that corresponding
revenue and loss data were relatively small. Specifically, three of
the six firms could not provide complete information on VaR for all of
their stand-alone proprietary-trading desks, representing 12 percent
of the cases in which firms provided individual firm-quarter-desk
revenue or loss data. This 12 percent of excluded VaR data
corresponded to $867 million dollars of revenue and $981 million in
losses.
[31] Because the six firms do not all use the same 95 or 99 percent
confidence interval, the data do not address the implications of the
frequency of VaR breaks at each individual firm. Not all of the firms
were able to provide complete VaR break data, but we determined that
no single firm was responsible for a significant portion of the
missing data, and that corresponding revenue and loss data were
relatively small. Specifically, three of the six firms could not
provide complete VaR break data for all of their stand-alone
proprietary-trading desks, representing 21 percent of the cases in
which firms provided individual firm-quarter-desk revenue or loss
data. This 21 percent of excluded VaR data corresponded to $2.1
billion in revenue and $1.4 billion in losses.
[32] Our calculation of a single firm's VaR breaks for proprietary
trading during one quarter--used to compare it to that for all trading-
-was an estimate based on taking the average number of breaks across
its proprietary-trading desks for that quarter.
[33] Hedge fund and private equity revenue data included carried
interest, which is the share of fund profits that is paid to the
managers of the fund, and other management fee revenue. One of the six
bank holding companies was unable to provide complete data on its
hedge fund revenues. Based on our analysis of data the firm provided,
including data on the amount of capital it invested in hedge funds
over the time period, its revenue in this area appears insignificant
compared with the other bank holding companies.
[34] A leveraged loan is one made to a company or other entity that
already holds a considerable amount of debt, usually increasing the
amount of risk and corresponding loan cost.
[35] In re Lehman Brothers Holdings Inc., Case No. 08-13555 (Bankr
S.D.N.Y), Report of Anton R. Valukas, Examiner, (Mar. 11, 2010).
[36] U.S. Senate Permanent Subcommittee on Investigations, Committee
on Homeland Security and Governmental Affairs, Wall Street and the
Financial Crisis: Anatomy of the Financial Collapse, Majority and
Minority Staff Report (Washington, D.C., Apr. 13, 2011).
[37] JPMorganChase, Global Investment Banks: Regulatory Arbitrage I:
Tougher than expected Volcker rules undiscounted - OW Euro IBs (Jan.
12, 2011), and J.P.Morgan Cazenove, Global Investment Banks:
Regulatory Arbitrage Series: OW European over US IBs (Mar. 8, 2011).
[38] Oliver Wyman, The Volcker Rule: Considerations for Implementation
of Proprietary Trading Regulations (Washington, D.C., January 2011).
[39] Other financial regulatory agencies and self-regulatory agencies
also contribute to the oversight of trading and investment activities
at large U.S. bank and thrift holding companies. These include FDIC,
which oversees state-chartered banks that are not members of the
Federal Reserve System and state-chartered thrifts; and the Commodity
Futures Trading Commission, which oversees futures commission
merchants. State regulators also oversee state-chartered institutions.
In addition, the Financial Industry Regulatory Authority is the self-
regulatory organization that oversees trading by broker-dealers.
[40] For more information about risk management at large financial
institutions, see GAO, Review of Regulators' Oversight of Risk
Management Systems at a Limited Number of Large, Complex Financial
Institutions, [hyperlink, http://www.gao.gov/products/GAO-09-499T]
(Washington, D.C.: Mar. 18, 2009).
[41] In 2008, we reported on efforts that regulators had made to
assess bank holding companies' exposures to external hedge funds. As
noted in that report, regulators had not specifically monitored hedge
fund activities on an ongoing basis, but had increased their reviews
of policies and procedures to mitigate counterparty credit risk at
large institutions. For example, the Federal Reserve conducted reviews
between 2004 and 2007 of credit risk management practices that
involved hedge fund-related activities at several large banks. The
Federal Reserve concluded that the banks generally had strengthened
practices for managing risk exposures to hedge funds but could further
enhance firmwide risk management systems and practices. These
practices included expanded stress testing, which measures the
potential impact of various scenarios or market movements on an asset,
counterparty exposure, or the value of a firm's portfolio. See GAO,
Hedge Funds: Regulators and Market Participants Are Taking Steps to
Strengthen Market Discipline, but Continued Attention Is Needed, GAO-
08-200 (Washington, D.C.: Jan. 24, 2008.)
[42] SEC Release No. 34-58775 (Oct. 14, 2008). For a more detailed
discussion of SEC guidance regarding market making, see FSOC report at
28-29.
[43] 15 U.S.C. 78o(g), formerly subsection 15(f), redesignated by Pub.
L. No. 111-203 § 929X(c).
[44] [hyperlink, http://www.gao.gov/products/GAO-09-499T].
[45] GAO, Financial Market Regulation: Agencies Engaged in
Consolidated Supervision Can Strengthen Performance Measurement and
Collaboration, [hyperlink, http://www.gao.gov/products/GAO-07-154]
(Washington, D.C.: Mar. 15, 2007).
[46] GAO, Financial Regulation: A Framework for Crafting and Assessing
Proposals to Modernize the Outdated U.S. Financial Regulatory System,
[hyperlink, http://www.gao.gov/products/GAO-09-216] (Washington, D.C.:
Jan. 8, 2009).
[47] See, Chairman of the Securities and Exchange Commission Mary L.
Schapiro, Testimony Concerning the Lehman Brothers Examiner's Report,
Before the House Financial Services Committee (Apr. 20, 2010).
[48] AIG was a savings and loan holding company regulated by the
Office of Thrift Supervision because of its control of a savings
association.
[49] Super-senior tranches were the securities within a CDO that were
assigned higher credit ratings and presumed to present lower risks.
[50] The Basel Committee on Banking Supervision, established in 1974,
is an international body of banking supervisors that sets standards on
capital adequacy, among other things. The committee announced the
Basel III details on September 12, 2010. Over the next several years,
the U.S. will develop rules to implement Basel III to apply to U.S.
financial institutions.
[51] Tier 1 risk-based capital is considered core capital--the most
stable and readily available for supporting a bank's operations and
includes elements such as common stock and noncumulative perpetual
preferred stock.
[52] Pub. L. No. 111-203 § 171.
[53] Under Section 604 of the act, the scope of the Federal Reserve's
supervisory authority with respect to bank holding companies and their
nonbank subsidiaries was expanded, effective July 21, 2011. Pub. L.
No. 111-203 § 604 (amendments to section 5(c) of the Bank Holding
Company Act of 1956, 12 U.S.C. § 1844(c)). The act provides similar
authority for nonbank financial companies supervised by the Board and
provides for recommendations of supervisory standards by the FSOC.
Pub. L. No. 110-203 §§ 161, 162, 115.
[54] For more information, see Financial Stability Oversight Council,
Study & Recommendations on Prohibitions on Proprietary Trading &
Certain Relationships with Hedge Funds and Private Equity Funds, 22-25.
[55] 12 U.S.C. § 1851(h)(2). The Investment Company Act exemptions
apply to private funds owned by not more than one hundred persons that
do not make a public offering and private funds owned exclusively by
qualified purchasers that do not make a public offering. 15 U.S.C. §
80a-3(c)(1), (7).
[56] The rules are to be promulgated "not later than 9 months after
completion" of the FSOC study. 12 U.S.C. § 1851(b)(2).
[57] See Pub. L. No. 111-203 § 112(a)(2)(A).
[58] Section 989 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act requires that we conduct a study regarding the risks
and conflicts associated with proprietary trading in financial
products or entities. To carry out this study we considered stand-
alone proprietary trading as well as proprietary trading that may
occur in relation to market-making or other activities at financial
institutions. For the purposes of this report, stand-alone proprietary
trading refers to trading at stand-alone proprietary-trading desks,
which are those organized by a banking entity with the specific
purpose of trading a firm's own capital. We generally did not include
merchant banking activities or other long-term principal investments,
although we discuss debate about whether such activities should be
restricted. Section 620 of the act requires the appropriate federal
banking agencies to jointly study and prepare a report on the
activities that a banking entity may in engage in under federal and
state law and the risks presented by or associated with such
activities.
[59] These reports are the Consolidated Financial Statements for Bank
Holding Companies (Y-9C). We conducted on-site visits for five of the
six bank holding companies and conducted telephone interviews with the
sixth.
[End of section]
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