Institutions in Global Financial Markets - Literature review Example

Finance and Accounting Executive Summary The following essay highlights the details regarding the ban of proprietary trading in the banks after the establishment of Volcker Rule. The Volcker rule stated that proprietary trading have developed a number of risks for the economy, which is vulnerable for its growth. The essay explains the details pertaining to benefits and risks of the trading to the banks. It also lays emphasis on the impact of the rule on the operation of the banks. Introduction Proprietary trading is a useful concept for the banks as it generate huge amount of revenue. The trading takes into consideration investments in private equity and hedge funds. It has the potential to draw revenue to banks and is even prone to losses. The global banking entities have carried out this trading in standalone desk; however, they also conduct these trading activities within other firms. The records of such activities are not maintained by banks and thus regulatory authorities have developed new regulations that restricted the stand alone activities in propitiatory trading. Proprietary trading has given rise to many general concerns specifically in the banks. In banks the trading has given rise to prudential concerns as any possibility of loss will be borne by the society. Several researches in the banking sector of Germany have indicated that presence of this kind of trading along with the client activities has created potential conflicts of interest related to banking standards. These issues are eventually addressed by the ring-fencing techniques undertaken by the banks (IIF Research Note, 2014; Proviti, 2013). Proprietary trading in a bank usually refers to the trading activities that give proprietary positioning to the same. This indicates the fact price movement in a particular market have huge impact on the bottom line of the bank. The banks acts virtually and the price movement in the market grow up to a capital position either by encountering profit or loss or even directly accumulates the capital under proprietary trading (Merkley and Levin, 2011). It is also defined as the risk associate with the capital of the bank. This capital is earned through different financial instruments in order to gain profit from the movements of the market. Such activities are predictive in nature as it runs a definite business with the main objective of profit making. Parliamentary Commission on Banking Standards came in to existence for examining the crisis in standards and culture existing in banks presently (HL, 2014; IIF Research Note, 2014; Proviti, 2013). The Commission was requested to evaluate the draft related to the Government’s legislative proposals for making structural change in banking sector of United Kingdom (UK). The main reason behind this evaluation is to ensure the security of bank against higher degree of isolation between investment and retail banking (Volcker, n.d.; IIF Research Note, 2014; Proviti, 2013). During the course of consideration of proposal, few evidences against risk associated with proprietary trading came into prominence from the report submitted by Paul Volcker, former Chairman of the US Federal Reserve. Following the report provided by Paul Volcker, on December 2013, 5 federal financial regulatory agencies had issued final legislation pertaining to proprietary trading after taking into consideration the mentioned report. The proposal given by Paul Volcker was known as Volcker Rule, which is mainly a provision in Consumer Protection Act of 2010 and Dodd-Frank Act Wall Street Reform that aims at prohibiting the banks to engage in proprietary trading of the financial instruments. The rule highlights the exemptions and prohibition of using proprietary trading n banks. It also takes into considering the reason behind ban of proprietary trading and an overview of requirements pertaining to compliance programs. The essay aims at elaborating the above mentioned details pertaining to proprietary trading and the effect of Volcker rule on national and foreign banks is critically analysed (IIF Research Note, 2014; Proviti, 2013). Main findings This part of the essay lays emphasis on the risks and benefits of proprietary trading in banks. The risks are explained with the help of Volcker rule as its explained why the proprietary trading was banned for the banks (Von, 1989; Nyquist, 1995). Benefits and risks of proprietary trading in banks The benefits of proprietary trading to the banks are discussed hence forth. The banks use the capital for their own purpose and generate profit out of it. There is also risk associated with the investment as market movements are unpredictable. The loss incurring from illiquid inventory is disconnected from the activities of the customer activity and thus it is called pure proprietary trading. For the banks, proprietary trading is also called casino banking (Augar, 2005). In this banking, the traders speculate the market conditions and use the capital of the banks, which is borrowed. They do this to make profit and there is no connection on behalf of the customers. Before the financial crisis came into being, many banks operating globally engaged themselves in different forms of proprietary trading, which indicated set up of internal hedge funds or dedicated units. The best known example of such proprietary trading was Principal Strategy’s groups of Goldman Sachs. However, the trading was reportedly banned after Volcker’s rule was passed. The bank reported that about 10% of the bank’s revenue has been shut down in response to Volcker rule (IIF Research Note, 2014; Proviti, 2013; Garvey and Murphy, 2004). Most of the United Kingdom (UK) based banks do not engage in this type of trading fully but they regard it as a small activity within their premises which brings in profit or loss. This activity is totally driven by client needs and the banking activities along with other activities that are associated with banks. As for example, Standard Chartered Bank does not maintain a proper proprietary trading desk for their profit (Van Rooij, 2011). It is worth mentioning that the several banks do not maintain proprietary trading desks for earning profit as they focus on these activities as the part of other activities. The main reason behind the banks taking part in proprietary trading is their poor capital condition in the economy. The banks have always regarded proprietary trading to be profitable and thus factored the cost of funds. However, they identified the fact that the proprietary trading could not compete with that of hedge funds, which are unconstrained by the political and regulatory pressure. However, proprietary trading has to follow certain rules and regulations that are introduced by the regulatory authorities to manage the trading activities (Van Rooij, 2011; Kregel, 2011). Apart from the above mentioned benefits of proprietary trading to the banks, there are risks too, which are associated with the trading activities and it is vulnerable for the operation of the banks. There are two types of risks for the banks: prudential and cultural (Mitchell, Pedersen and Pulvino, 2007). Prudential risks is associated with proprietary trading in way that it can add cost to the banks and endanger the operation of the same if the activity is not right. Paul Volcker in his report to President Obama depicted that addition of further level of risk to the inherent risks that are associated with the commercial bank function do not make any sense. This is also not acceptable that risks will arise from speculative activities, which are better suited for various areas of financial markets (Van Rooij, 2011; Fecth, 2013; Lusardi and Mitchell, 2007). HSBS highlighted the following areas, where risks are associated with proprietary trading: The ability of the supervisors and banks to evaluate the risks pertaining to this trading should be high. Majority of the risk is associated with the capital treatment of the banks. In this context right resources are required for absorbing the losses that occurs in the course of time. Another risk is associated with the unexpected losses that are attached to the trading activities, which may diminish the actual capital resources of the bank. These losses curtail the capability of the bank to support the economic activities. The magnitude of unexpected risk unsecure the creditors and they are restricted to withdraw funds until their identity is verified and determined by the cause o loss thereby causing the credit capacity to get curtailed (Van Rooij, 2011; Fecth, 2013; Lusardi and Mitchell, 2007). Proprietary trading was one of the main reasons for the financial crisis. According to UBS, the hedge fund of Dillon Read Capital Management have encountered a loss of $ 3 billion before the transaction were closed in 2007 (Haushalter and Lowry, 2011; Froot and Stein, 1998). However, it is difficult to point out the other losses associated with proprietary trading as majority of the banks does not record it as a separate account. Along with that the losses incurred by large trading companies, particularly by the investment banks of United States (US), is not lucid enough to the client activities. It was observed that, majority of the banks of US lost a significant volume of collateralized debt obligations (CDOs). CDO or structured securities along with bonds or mortgages added to the loss, which the banks undertook in order to segregate the different types of risks. The banks who were engaged in these trading portfolios have encountered proprietary risk (Haushalter and Lowry, 2011; Richardson, Smith and Walter, 2010). The cultural risks are discussed henceforth. Apart from prudential risk, Paul Volcker exclaimed that there are various cultural issues related to this type of trading. It is observed that cultural differences occur between the traders and banks that originate as a result of the compensation approaches. The remuneration and rewards of the banks are also affected by the trading (Fecth, 2013; Lusardi and Mitchell, 2007). Impact on banking industry of a ban on proprietary trading The following impacts are observed in the banking after the ban of proprietary trading: Reduction in profitability and revenues: Proprietary trading is regarded as a volatile investment for the past few years. The revenues are generated through ring-fenced proprietary trading desks and have contributed to 10% of the industrial revenue in 2009 (Fecth, 2013; Lusardi and Mitchell, 2007). The banks in US had to forcefully shut down the desks due to the ban of the same. However, there are few banks which are yet to take the step and change the profile of their business. The impact on the downstream capital of the banks is crucial as the customers were penalized on their investment (Fecth, 2013; Lusardi and Mitchell, 2007; Crotty, Epstein and Levina, 2010). Changes in operating models of the banks: The compliance regimes and overview of the regulators highlights the present business processes and trading practices, which are unsustainable for the proprietary trading as it is banned. The impact of the ban has affected the business models of the banks. However, the regulators have provided with two years of time, within which they have to leave the use of proprietary trading activities (Bhupathi, 2009). The regulators have also assigned the banks to work with other banks and refine the programs of compliance. Nevertheless, ultimate effect is substantial as hedging along with risk management methods are re-evaluated, re-organized and the business models are re-tuned (Fecth, 2013; Lusardi and Mitchell, 2007; ). Reshaping business: The rule has raised the cost of the banks that are associated with the proprietary trading businesses. The institutions that have moderately lowered their trading profits have decided to economize in order to avoid shutting down of the US trading desks or related business entirely (Shefrin and Statman, 2000). Replacement of activities away from the trading books of bank: The balance of activities, which takes place in banks and non-banks, is likely to modify significantly because of the Volcker prop trading ban. The dealers who are unrelated to the banks have a new competitive advantage with respect to the choice of strategies associated with trading and opportunities for building new trading talents. Moreover, the regulators have the significant option to use provisions of Volcker on systemically non-banks. Presently, the non-bank trading businesses had achieved enough growth by level of magnitude even before that when outcomes are real threats. Furthermore, proprietary trading ban have contributed for increasing the incentives of Basel 3 capital that is charged to move the risk-taking of the bank from trading books to banking book (Mehran and Stulz, 2007; Fecth, 2013; Lusardi and Mitchell, 2007). Conclusion/ Recommendation It can be concluded that the Volcker rule have made significant changes in the operation of the banks as it have banned one of the most important investment of the banks. The banks have lost huge amount of money and few banks are yet to obey the rule as they have been provided time by the regulators. Hence, it can be recommended that Volcker’s rule is proposed for the betterment of the economic activities. Reference List 1. Augar, P., 2005. The greed merchants: How the Investment banks played the free market game. London: Allen Lane. 2. Bhupathi, T., 2009. Technologys Latest Market Manipulator-High Frequency Trading: The Strategies, Tools, Risks and Responses. NCJL & Tech., 11, p. 377. 3. Crotty, J., Epstein, G. and Levina, I., 2010. Proprietary Trading is a Bigger Deal than Many Bankers and Pundits Claim. SAFER Policy Brief, 20(2), p. 18. 4. Fecth, F., 2013. Is proprietary trading detrimental to retail investors? [pdf] n.p. Available at: < http://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&frm=1&source=web&cd=1&cad=rja&uact=8&ved=0CBwQFjAA&url=http%3A%2F%2Fonline.wsj.com%2Fpublic%2Fresources%2Fdocuments%2FVolcker_Rule_Essay_2-13-12.pdf&ei=UBwAVJmhN5HluQSju4D4Aw&usg=AFQjCNFxOjIK0jQN0zmF4GmNyihnH0Q-qw&bvm=bv.74115972,d.dGc > [Accessed 28 August 2014]. 5. Froot, K. A. and Stein, J. C., 1998. Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach. Journal of Financial Economics, 47(1), pp. 55-82. 6. Garvey, R. and Murphy, A., 2004. Are professional traders too slow to realize their losses? Financial Analysts Journal, pp. 35-43. 7. Haushalter, D. And Lowry, M., 2011. When do banks listen to their analysts? Evidence from mergers and acquisitions. Review of Financial Studies, 24(2), pp. 321–357 8. HL, 2014. Proprietary trading. [pdf] n.p. Available at: < http://www.publications.parliament.uk/pa/jt201213/jtselect/jtpcbs/138/138.pdf > [Accessed 28 August 2014]. 9. IIF Research Note, 2014. Volkers Rule Approved. [online] Available at: < https://www.google.co.in/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&cad=rja&uact=8&ved=0CCIQFjAB&url=http%3A%2F%2Fwww.iif.com%2Fcem201402_4.pdf&ei=3P_-U5P0Cc2XuATs64DoDA&usg=AFQjCNGtRQS4Y551hmMDufk-fRKmy-hYAg&bvm=bv.74035653,d.c2E > [Accessed 28 August 2014]. 10. Kregel, J., 2011. Will restricting proprietary trading and stricter derivatives regulation make the US financial system more stable? PSL Quarterly Review, 64(258). 11. Lusardi, A. and Mitchell, O. S., 2007. Baby boomer retirement security: The roles of planning, financialliteracy, and housing wealth. Journal of Monetary Economics, 54, pp. 205–224. 12. Mehran, H. and Stulz, R. M., 2007. The economics of conflicts of interest in financial institutions. Journal of Financial Economics, 85(2), pp. 267 – 296. 13. Merkley, J. and Levin, C., 2011. Dodd-Frank Act Restrictions on Proprietary Trading and Conflicts of Interest: New Tools to Address Evolving Threat. Journal on Legislation, 48, p. 55. 14. Mitchell, M., Pedersen, L. H. and Pulvino, T., 2007. Slow moving capital. New York: National Bureau of Economic Research. 15. Nyquist, P., 1995. Failure to Engage: The Regulation of Proprietary Trading Systems. Yale Law & Policy Review, pp. 281-337. 16. Proviti, 2013. The Volcker Rule: The end of Proprietary Trading? [pdf] n.p. Available at: < http://www.protiviti.co.in/en-US/Documents/Regulatory-Reports/General-Business/FSI-Flash-Report-Volcker-Rule-101311-Protiviti.pdf > [Accessed 28 August 2014]. 17. Richardson, M., Smith, R. and Walter, I., 2010. Large banks and the Volcker rule. Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance, pp. 181-212. 18. Shefrin, H. and Statman, M., 2000. Behavioral portfolio theory. Journal of Financial and Quantitative Analysis, 35(02), pp. 127–151 19. Van Rooij, M. A., 2011. Financial literacy and stock market participation. Journal of Financial Economics, 101, pp. 449–472. 20. Volcker, P., no date. Commentary On The Restrictions On Proprietary Trading By Insured Depositary Institutions. [pdf] n.p. Available at: < http://www.debevoise.com/publications/pdf/TheVolckerRuleAnInDepthQAabouttheProprietaryTradingProvisions.pdf > [Accessed 28 August 2014]. 21. Von, E., 1989. Cooperation between rivals: informal know-how trading. Netherlands: Springer. Read More