Working Paper: CEPR ID: DP9148
Authors: Arnoud W. A. Boot; Lev Ratnovski
Abstract: We study the effects of a bank?s engagement in trading. Traditional banking is relationship-based: not scalable, long-term oriented, with high implicit capital, and low risk (thanks to the law of large numbers). Trading is transactions-based: scalable, short-term, capital constrained, and with the ability to generate risk from concentrated positions. When a bank engages in trading, it can use its ?spare? capital to profitably expand the scale of trading. However there are two inefficiencies. A bank may allocate too much capital to trading ex-post, compromising the incentives to build relationships ex-ante. And a bank may use trading for risk-shifting. Financial development augments the scalability of trading, which initially benefits conglomeration, but beyond some point inefficiencies dominate. The deepening of financial markets in recent decades leads trading in banks to become increasingly risky, so that problems in managing and regulating trading in banks will persist for the foreseeable future. The analysis has implications for capital regulation, subsidiarization, and scope and scale restrictions in banking.
Keywords: banking; capital regulation; scale restrictions; trading
JEL Codes: G21; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased trading (F19) | diminished capacity for relationship banking (G21) |
| time inconsistency (D15) | overallocation of capital to trading activities (G31) |
| overallocation of capital to trading activities (G31) | undermined long-term relationship banking franchise (F65) |
| risk-shifting (H22) | incentives for banks to engage in riskier trading strategies (G21) |
| increased trading (F19) | negative implications for relationship banking profitability (G21) |
| negative implications for relationship banking profitability (G21) | harm to the bank's stability (F65) |