Wall Street and the Financial Crisis: Anatomy of a Financial Collapse


D. Preventing Investment Bank Abuses

Developments over the past two years offer a number of ways to address problems identified in the Goldman Sachs and Deutsche Bank case studies. The success of those alternatives will depend in large part upon how they are implemented, and the degree to which the market disruptions caused by the financial crisis convince investment banks to realign their use of structured finance products, curb their proprietary trading, and respect the interests of their clients. Success will also depend upon sensible implementation of the measures enacted into law by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).

The Dodd-Frank Act contains several measures that affect investment banking practices. Three key provisions involve proprietary investments, conflicts of interest, and a new study of permitted banking activities.

Proprietary Trading Restrictions. Commercial banks, their holding companies, and affiliates, including any investment banks, |2837| are prohibited by the Dodd-Frank Act from engaging in proprietary trading, subject to certain provisions allowing them to continue to serve clients and reduce risks. |2838| The proprietary trading ban will still allow banks, for example, to continue to engage in transactions as market makers for clients, hedge their risks, and maintain very limited investments in private funds they sponsor or manage for others. |2839|

The proprietary trading provision also addresses conflicts of interest and high risk activities. It explicitly bars any proprietary trading activity that "would involve or result in a material conflict of interest … between the banking entity and its clients, customers, or counterparties," or that would result "in a material exposure by the banking entity to high-risk assets or high-risk trading strategies." |2840| Those express limitations are intended to reduce not only the risk of proprietary trading losses, but also the conflicts of interest that arise when a bank-affiliated investment bank enters into an activity that allows it to profit at the expense of its clients.

Investment banks that have no bank affiliation are not subject to the law's proprietary trading prohibition. If, however, an investment bank is designated by the newly-created Financial Stability Oversight Council as a systemically critical firm, the Dodd-Frank Act would subject its proprietary trading to additional capital requirements and quantitative limits. Those restrictions are intended to ensure large investment banks have sufficient safeguards in place when engaging in risky proprietary activities to prevent them from damaging the U.S. financial system as a whole or necessitating a taxpayer bailout if they get into financial trouble.

Private Fund Restrictions. To ensure that the proprietary trading restrictions are effective, the Dodd-Frank Act prohibits banks and their affiliates, including any investment banks, from bailing out any private fund they advise or sponsor, including an affiliated hedge fund or private equity fund. |2841| This prohibition would apply, for example, to Deutsche Bank and its affiliated hedge fund, Winchester Capital, which made a large proprietary investment in mortgage related products. |2842| These restrictions would not apply to investment banks that are not affiliated with a bank. If, however, the investment bank is designated as a systemically critical firm, it would become subject to additional capital charges to account for the risk that it may end up bailing out a private fund. The private fund provision also addresses the issue of eliminating any unfair advantage that banks may have from being able to rely on the special privileges of being a bank to implicitly guarantee a private fund, and ensures that a federally insured bank will not be put at risk if an affiliated private fund suffers losses. |2843|

Conflict of Interest Prohibitions. In 2009, one well known investment adviser described the link between proprietary trading and conflicts of interest as follows:

    "Proprietary trading by banks has become by degrees over recent years an egregious conflict of interest with their clients. Most if not all banks that prop trade now gather information from their institutional clients and exploit it. In complete contrast, 30 years ago, Goldman Sachs, for example, would never, ever have traded against its clients. How quaint that scrupulousness now seems. Indeed, from, say, 1935 to 1980, any banker who suggested such behavior would have been fired as both unprincipled and a threat to the partners' money." |2844|

The Dodd-Frank Act contains two conflict of interest prohibitions to restore the ethical bar against investment banks and other financial institutions profiting at the expense of their clients. The first is a broad prohibition that applies in any circumstances in which a firm trades for its own account, as explained above. |2845| The second, in Section 621, imposes a specific, explicit prohibition on any firm that underwrites, sponsors, or acts as a placement agent for an asset backed security, including a synthetic asset backed security, from engaging in a transaction "that would involve or result in any material conflict of interest" with an investor in that security. |2846| Together, these two prohibitions, if well implemented, will protect market participants from the self-dealing that contributed to the financial crisis.

Study of Banking Activities. Section 620 of the Dodd-Frank Act directs banking regulators to review what types of banking activities are currently allowed under federal and state law, submit a report to Congress and the Financial Stability Oversight Council on those activities, and offer recommendations to restrict activities that are inappropriate or may have a negative effect on the safety and soundness of a banking entity or the U.S. financial system. This study could evaluate, for example, the use of complex structured finance products that are difficult to understand, have little or no track record on performance, and encourage investors to bet on the failure rather than the success of financial instruments.

Structured Finance Guidance. In connection with provisions in the Dodd-Frank Act related to approval of new products and standards of business conduct, |2847| the banking agencies, SEC, and CFTC may update and strengthen existing guidance on new structured finance products. In 2004, after the collapse of the Enron Corporation, the banking regulators and SEC proposed joint guidance to prevent abusive structured finance transactions. |2848| This guidance, which was not finalized until January 2007, was issued in a much weaker form. |2849| The final guidance eliminated, for example, warnings against structured finance products that facilitate deceptive accounting, circumvention of regulatory or financial reporting requirements, or tax evasion, as well as detailed guidance on the roles that should be played by a financial institution's board of directors, senior management, and legal counsel in approving new products and on the documentation they should assemble.

To prevent investment bank abuses and protect the U.S. financial system from future financial crises, this Report makes the following recommendations.

1. Review Structured Finance Transactions. Federal regulators should review the RMBS, CDO, CDS, and ABX activities described in this Report to identify any violations of law and to examine ways to strengthen existing regulatory prohibitions against abusive practices involving structured finance products.

2. Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on proprietary trading under Section 619, any exceptions to that ban, such as for marketmaking or risk-mitigating hedging activities, should be strictly limited in the implementing regulations to activities that serve clients or reduce risk.

3. Design Strong Conflict of Interest Prohibitions. Regulators implementing the conflict of interest prohibitions in Sections 619 and 621 should consider the types of conflicts of interest in the Goldman Sachs case study, as identified in Chapter VI(C)(6) of this Report.

4. Study Bank Use of Structured Finance. Regulators conducting the banking activities study under Section 620 should consider the role of federally insured banks in designing, marketing, and investing in structured finance products with risks that cannot be reliably measured and naked credit default swaps or synthetic financial instruments.

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2837. Two of the largest U.S. investment banks, Goldman Sachs and Morgan Stanley, are currently structured as bank holding companies and so are subject to the ban on proprietary trading. [Back]

2838. Section 619 of the Dodd-Frank Act (creating a new §13(a) in the Banking Holding Company Act of 1956). [Back]

2839. Id. at §13(d)(1). [Back]

2840. Id. at §13(d)(2). [Back]

2841. Id. at §13(d)(1)(G) and (I); (d)(4); and (f). [Back]

2842. Id. See section discussing Deutsche Bank, above. [Back]

2843. Id. See, e.g., 6/12/2010 Cambridge Winter Center report, "Test Case on the Charles," (explaining how State Street Bank bailed out the funds it managed, but then itself needed several emergency taxpayer-backed programs). [Back]

2844. "Lesson Not Learned: On Redesigning Our Current Financial System," GMO Newsletter Special Topic, at 2 (10/2009), available at http://www.scribd.com/doc/21682547/Jeremy-Grantham. [Back]

2845. Section 621 of the Dodd-Frank Act (creating a new § 27B(a) in the Securities Act of 1933). [Back]

2846. Id. at § 621. [Back]

2847. Section 717 and Title IX of the Dodd-Frank Act. [Back]

2848. "Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities," 69 Fed. Reg. 97 (5/19/2004). [Back]

2849. "Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities," 72 Fed. Reg. 7 (1/11/2007) (issued by the Office of the Comptroller of the Currency; Office of Thrift Supervision; Federal Reserve System; Federal Deposit Insurance Corporation; and Securities and Exchange Commission). [Back]

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(7) Goldman's Proprietary Investments Contents

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