07/13/2011 08:18 pm ET Updated Sep 12, 2011

GAO Report On Proprietary Trading Slammed By Senate Democrats As 'Misleading'

A new government report on banks' controversial practice of trading and investing for their own profit was condemned Wednesday by congressional Democrats who called the practice "woefully incomplete" and "misleading," adding that it failed to reckon with the risks to the broader financial system.

The Volcker Rule, which required banks to sell off their operations that engaged in this so-called proprietary trading, was one of the most contentious elements of financial regulatory reform last year. Proponents argued that the rule was necessary to prevent banks from profiting at the expense of their customers and, ultimately, American taxpayers who stepped in when their complex bets on mortgages went bad. Banks complained that the rule would hurt their profits, while at the same time arguing that the extent of such speculation was not big enough to pose a risk to the financial system. The Government Accountability Office was brought in as something of a referee, commissioned to conduct a study to assess the true extent of such trading practices and whether losses in that area can contribute to the instability of financial institutions.

The GAO report released Wednesday appeared to give ammunition to Wall Street by concluding that such trading only constitutes a small share of its revenue and, thus, does not present much of a risk to the financial system. Critics, including the primary authors of the provisions that limit such activity, countered that the study was flawed because it failed to grapple with the full extent of banks' trading. The report could lead to momentum against enforcing the Volcker rule.

Sens. Jeff Merkley (D-Ore.) and Carl Levin (D-Mich.) sent a strongly worded letter to the GAO, criticizing the auditor for not looking at the full scope of proprietary trading operations. The report was "woefully incomplete," said the pair because it only collected data from the six largest banks' stand-alone units, where only a fraction of such trading occurs, rather than from across all bank divisions.

In a statement, Merkley and Levin said:

The report reminds us of the story of a man who dropped his keys at night and then began looking for them under a nearby parking lot light, not because he dropped them there but because that was where the light was.

GAO missed this opportunity to help shine more light on the high-risk gambles that decimated millions of families and businesses and nearly destroyed our financial system.

In the report, the GAO admitted that its information was incomplete but explained that it was not possible to collect information across all bank divisions, since banks "did not separately maintain records on such activities."

The senators were also concerned that the report did not explain how proprietary trading losses pose risks to safety and soundness and contribute to major losses in bank capital. "While we are not surprised that, even with its limited review, the GAO concluded that proprietary trading is riskier than other activities, a complete study of proprietary trading would have been of much greater value to policy makers and regulators," they said.

The head of the GAO, Gene L. Dodaro, fired back, writing in a letter to the senators that he believes "this study fully carries out our responsibilities" under the Dodd-Frank requirement. He claimed that the study wasn't just limited to stand-alone proprietary trading desks but included "activities at market-making desks, activities related to lending and securitization, particularly of mortgage-related assets, and private equity fund and hedge fund investments." He admitted that the GAO could not collect data outside of the stand-alone desks because the firms have not historically kept separate records of such activities. But Dodaro said that the GAO "mitigated this limitation" by reviewing other documents such as the banks' public financial disclosures and bankruptcy documents.

Dodaro also claimed that the report provided extensive information on the risks from proprietary trading, adding that the GAO's work will be supplemented by upcoming studies by the Financial Stability Oversight Council and banking regulators.

The GAO report, which only focused on these stand-alone trading desks, found that from June 2006 to December 2010, such trading produced an overall loss of $221 million -- $15.6 billion in revenue and $15.8 billion in losses.

It also warned that the new regulation may be difficult to enforce since it will be challenging to "best ensure that firms do not take prohibited proprietary positions while conducting their permitted customer-trading activities."