The Focus on the Prohibition of Bank Proprietary Trading is Misplaced

The EU Commission’s proposal to prohibit proprietary trading activities of commercial banks will not achieve the regulatory objectives / Separation of trading activities within the existing banking organization is a superior solution

A prohibition of proprietary trading by banks, as envisaged in a legislative proposal of the EU Commission, is more problematic than previously thought. It is unlikely to reduce risk-taking by banks. Moreover, it will not diminish systemic risk or facilitate bank resolution. In contrast, such a prohibition could crowd out desired trading activities. These are the conclusions drawn in a recent SAFE White Paper by Jan Pieter Krahnen (Goethe University Frankfurt and Research Center SAFE), Felix Noth (University of Magdeburg, Halle Institute for Economic Research and SAFE) and Ulrich Schüwer (University of Mainz and SAFE). The authors argue that a superior solution to limit excessive trading risk in banks would be to separate all trading activities into a legally distinct broker dealer institution. This entity may be part of the same bank-holding company, but must be separately funded. Such a separation would limit cross-subsidies between banking and trading and diminish contagion risk while still allowing for synergies across banking and trading.

Comparing the approaches of Volcker, Vickers and Liikanen

The White Paper provides a comparison between different proposals for reforming the structure of the banking industry: the Volcker rule in the U.S., the Vickers report in the UK, and the Liikanen and EU Commission proposals for the EU. All proposals for bank structural reform aim to reduce the risks believed to emanate from bank trading activities. The focus of the paper is on one major element of these proposals: the particular approach as to how the prohibition or separation of securities trading activities, notably proprietary trading, from “classical” commercial banking activities is to be realized. The authors favor the separation of all trading activities into a legally distinct broker dealer institution, a solution which is related to the suggestions in the Vickers proposal for the UK and also those of the High Level Expert Group chaired by Erkki Liikanen for the EU.

For the implementation of all reform proposals, the challenge of classifying securities transactions as being either client business, treasury business, or proprietary trading is a key element. The authors warn that clear-cut dividing lines between these activities are difficult to observe and supervise because of the high complexity characterizing today’s bank business models. This renders a ban of just one of these activities difficult if not impossible. JP Morgan’s so-called “London Whale” of 2012 is a prime example for ambiguity as to whether a complex transaction is a hedge or a proprietary position. Thus, even with proprietary trading prohibition in place, high risk trades that put a bank’s own capital at risk are possible – provided the bank can camouflage these as plausible hedging or market making strategies.

Conversely, the prohibition of proprietary trades may have an important unintended consequence: banks may abstain from (beneficial) hedging or market making services, simply because they fear the supervisor may misclassify them as proprietary trades. Such misclassifications are more likely if the hedging or market making strategy is complex, thus inviting misinterpretations. The costs of reductions in beneficial trading may be significant, both for financial stability and for market liquidity.

Different dividing lines between prohibited and permitted trading

The structural reform projects currently discussed or implemented in the U.S., the UK, and the EU differ with respect to the range of services covered by the separation decree and with respect to how separation is to be implemented. The Volcker rule draws the ‘magic’ line dividing prohibited and permitted trading activities between proprietary and non-proprietary transactions. The Liikanen proposal, in contrast to Volcker, does not single out proprietary trading for special treatment, but instead requires that all trading business, be it proprietary or client-oriented, is either prepared for separation in a crisis situation (avenue 1) or principally separated from retail banking (avenue 2).

After considering the Liikanen proposal, the EU Commission, in January 2014, put forth a legislative proposal (Barnier proposal) which recommends an outright ban for proprietary trading for big banks in Europe. Other forms of trading, like market making activities as well as hedging transactions for the banks’ own accounts, remain allowed. The proposal does grant the responsible supervisor the power to require the separation of all trading if problems occur that potentially put the whole bank and the wider financial system at risk. The negotiations in the European Parliament on the Barnier proposal have reached a deadlock. There is a possibility that EU Commissioner Jonathan Hill will recall the legislative proposal at this stage.

For the UK, Sir John Vickers proposed a partial separation of UK retail banking services from global wholesale and investment banking services, the so-called “retail ring-fence”, which resulted in the “Financial Services (Banking Reform) bill” and is to be implemented by 2019. The idea behind this separation proposal is to limit public guarantees to ring-fenced banks, as those perform banking services thought to be vital for the economy. Concurrently, the proposal aims at reducing incentives of non-ring-fenced banks for excessive risk-taking. According to the Vickers approach, proprietary trading does not receive any special treatment; it may be practiced within core retail banking and outside of it.

Download White Paper "Structural Reforms in Banking: The Role of Trading"