GAO-11-529 Proprietary Trading: Regulators Will Need More ... Hedge Funds and Private Equity Funds...

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Transcript of GAO-11-529 Proprietary Trading: Regulators Will Need More ... Hedge Funds and Private Equity Funds...

  • PROPRIETARY TRADING

    Regulators Will Need More Comprehensive Information to Fully Monitor Compliance with New Restrictions When Implemented

    Report to Congressional Committees

    July 2011

    GAO-11-529

    United States Government Accountability Office

    GAO

  • United States Government Accountability Office

    Highlights of GAO-11-529, a report to congressional committees

    July 2011

    PROPRIETARY TRADING Regulators Will Need More Comprehensive Information to Fully Monitor Compliance with New Restrictions When Implemented

    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 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.

    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.

    View GAO-11-529 or key components. For more information, contact Orice Williams Brown at (202) 512-8678 or williamso@gao.gov.

    http://www.gao.gov/products/GAO-11-529� http://www.gao.gov/products/GAO-11-529�

  • Page i GAO-11-529 Proprietary Trading

    Letter 1

    Background 3 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 6

    More Comprehensive Information Will Be Needed to Fully Monitor Compliance with New Restrictions 30

    Conclusions 43 Recommendation for Executive Action 44 Agency Comments and Our Evaluation 44

    Appendix I Scope and Methodology 47

    Appendix II Comments from the Board of Governors of the Federal Reserve System 50

    Appendix III Comments from the Commodity Futures Trading Commission 51

    Appendix IV Comments from the Department of the Treasury 52

    Appendix V Comments from the Federal Deposit Insurance Corporation 53

    Appendix VI Comments from the Office of the Comptroller of the Currency 54

    Appendix VII Comments from the Securities and Exchange Commission 55

    Appendix VIII GAO Contact and Staff Acknowledgments 56

    Contents

  • Page ii GAO-11-529 Proprietary Trading

    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 15

    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 17

    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 18

    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 21

    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 22

    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 24

    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 25

  • Page iii GAO-11-529 Proprietary Trading

    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

    This is a work of the U.S. government and is not subject to copyright protection in the United States. The published product may be reproduced and distributed in its entirety without further permission from GAO. However, because this work may contain copyrighted images or other material, permission from the copyright holder may be necessary if you wish to reproduce this material separately.

  • Page 1 GAO-11-529 Proprietary Trading

    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 Ban