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 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 Dodd-Frank Act, GAO reviewed:
- what is known about the risks associated with such activities and the potential effects of the restrictions, and
- how regulators oversee such activities.
GAO concluded 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. Further, GAO believes 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, GAO believes the actual potential for such effects remain unclear.
GAO believes one challenge for regulators in implementing the Dodd-Frank 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, the GAO found that many of the largest losses experienced by these institutions 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, GAO believes 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. GAO believes because the regulators 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.
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