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. 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. However, the likelihood of such potential outcomes was unclear. 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. 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  the combined revenue over the period totaled $15.6 billion, the combined  losses totaled $15.8 billion. 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. 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. 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. 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. Federal financial regulators have also taken steps to prevent what they  consider conflicts of interest associated with trading and investment  activities. However, implementing the act’s restrictions to  fully ensure that such risks no longer exist at the firms raises new  challenges for the regulators. While examiners have collected some information on certain trading and  fund activities, they have yet to collect comprehensive information. 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. 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. 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  also reviewed the comments submitted to the Financial Stability Oversight  Council as part of its study required by Section 619 of the act.
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 lessliquid assets. Regulators must implement these restrictions by October 2011. As required by Section 989 of the act, GAO reviewed (1) what is known about the risks associated with such activities and the potential effects of the restrictions and (2) how regulators oversee such activities. To conduct this work, GAO reviewed the trading and fund investment activities of the largest U.S. bank holding companies and collected selected data on their profits, losses, and risk measures. GAO also reviewed regulators' examinations and other materials related to the oversight of the largest bank holding companies.

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. 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.