In the last two years, investment banks have returned to proprietary trading – attempting to compensate for a dearth of underwriting and advisory business, and doing so with conspicuous success. Now, there are signs that commercial banks, too, are softening their attitude to prop trading – but there are differing explanations for the trend.

“We believe there has been an across-the-board increase in prop trading – for investment and commercial banks,” says Tanya Azarchs, an analyst with Standard & Poor’s (S&P) in New York. Azarchs says that prop trading never really went away, even among commercial banks, although they professed to shun it after the market turmoil of 1998. But recent years have seen it regaining popularity.

Not everyone sees it quite that way. The head of market risk at one large North American bank claims that there has been a genuine gulf between commercial and investment banks in their attitude to prop trading: “A lot of banks have substantially scaled back their market risk, but others – principally the US securities firms – have moved in the opposite direction and seem to have done quite well out of it.”

Like others, he cites Citigroup's 1998 decision to “scale back” its proprietary trading activity as a turning point. In fact, says S&P’s Azarchs, the business was effectively liquidated. “Citi’s investment banking unit, Salomon Smith Barney, housed a prop trading business that was effectively a big hedge fund – almost on the same scale as LTCM," she contends, "but Sandy Weill demonstrated an absolute intolerance for that form of risk and ordered it to be run down.”

At the time, Weill’s decision seemed emblematic of the industry’s new-found distaste for the earnings volatility and occasional spectacular losses that were thought of as the unavoidable consequence of proprietary trading. But times have changed.

Last month, reports claimed that Citi was bulking its proprietary trading business back up. Then, this week, HSBC said that proprietary risk-taking is set to increase next year – with expectations for a roughly 50% increase in prop trading profits. S&P’s Azarchs expects other commercial banks to follow suit.

“It is interesting,” says the market risk manager. He claims to have seen no evidence of a recent increase in prop trading among commercial banks, but admits that the announcements from Citi and HSBC “may mark the beginning of a new approach”.

If so, why the change of heart? The most obvious rationale is the one used to explain Citi’s announcement: the banks want a slice of the bumper trading profits that the investment banks have been earning. Commercial banks may be envious of the profits earned at Goldman Sachs, JP Morgan Chase, and the other banks that have displayed an appetite for market risk.

One London-based banking analyst says that HSBC has seen “trading opportunities out there and decided to re-deploy its capital to take advantage.” The market risk head speculates along similar lines: “It may be that Citi is looking at Goldman Sachs and thinking “did we shoot ourselves in the foot by exiting the prop trading business?””

A spokesman for HSBC denies that the increase in proprietary risk taking – mentioned by Sir John Bond, the bank’s chairman, on Tuesday while outlining the strategic plan for HSBC’s investment banking business – has anything to do with the recent success at other banks. Rather, he claims, it is a necessary consequence of HSBC’s desire to expand its global customer trading business.

“We are not setting up a prop desk. There is no target for prop trading,” he says. “As part of the expansion of our trading business, we take positions and provide liquidity to customers – so, as activity increases, there would be an increase in what we call “dealing profits” – which are profits from proprietary risk-taking.” That sounds like spin designed to avoid prop trading’s usual associations – of big gains and big losses, of reckless bets and unruly traders – but that's a charge that HSBC denies, and the market risk head offers some support.

“There’s some merit in that kind of argument - most institutions do some positioning and some trading in support of their customer business. That’s relatively easy to tease out from within the institution – but it can be difficult to see from outside," he says. "Obviously, some banks also go out and look for trading opportunities without any illusions about supporting customer activity.” HSBC's spokesman is adamant that his bank does not fall into this latter category.

There are other reasons that an increase in proprietary trading might make strategic sense, says S&P’s Azarchs. She notes that many banks are now seeing a significant reduction in credit risk as business conditions improve and charge-offs decline. From a portfolio basis, as one source of earnings volatility decreases, there might be room to take on more elsewhere.

After all, if aggregate levels of risk fall too far, potential returns should decline as well.  “Banks could be asking “how much volatility can I stomach?” As part of a strategic review, you might decide that losing credit volatility means some can be added through the market, in a controlled way,” she says.

Declining margins in high volume trading businesses may also be pushing some banks to take more market risk, she suggests. “In the past, that type of trading used to provide the ballast of the trading income, but spreads are narrowing and one could see the move to prop trading as a last-ditch effort to maintain the profitability of the trading business.”

©2010 Sungard. All rights reserved. Legal Information

Home | About Ambit ERisk | Solutions | Collateral | Contact Us | Search
Risk Reports Case Studies RMA Ambit ERisk Whitepaper Economic Capital Training And Workshop Events	About Ambit ERisk Solutions Collateral