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Banking and Trading

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  • Boot, Arnoud W A
  • Ratnovski, Lev

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9148.

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Date of creation: Sep 2012
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Handle: RePEc:cpr:ceprdp:9148

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Keywords: banking; capital regulation; scale restrictions; trading;

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References

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  1. Boot, Arnoud W A & Thakor, Anjan, 1997. "Can Relationship Banking Survive Competition?," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1592, C.E.P.R. Discussion Papers.
  2. Holmström, Bengt, 2011. "Inside and Outside Liquidity," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262015783, December.
  3. Shleifer, Andrei & Vishny, Robert W., 2010. "Unstable banking," Journal of Financial Economics, Elsevier, Elsevier, vol. 97(3), pages 306-318, September.
  4. John H. Boyd & Gianni De Nicolã, 2005. "The Theory of Bank Risk Taking and Competition Revisited," Journal of Finance, American Finance Association, American Finance Association, vol. 60(3), pages 1329-1343, 06.
  5. Jeremy C. Stein, 1995. "Internal Capital Markets and the Competition for Corporate Resources," NBER Working Papers 5101, National Bureau of Economic Research, Inc.
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  7. Morris, Charles & Hoenig, Thomas, 2011. "Restructuring the Banking System to Improve Safety and Soundness," MPRA Paper 47614, University Library of Munich, Germany, revised Dec 2012.
  8. Stewart C. Myers & Raghuram G. Rajan, 1998. "The Paradox of Liquidity," CRSP working papers 339, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  9. Raghuram Rajan & Henry Servaes & Luigi Zingales, . "The Cost of Diversity: The Diversification Discount and Inefficient Investment," CRSP working papers 463, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  10. Bhide, Amar, 1993. "The hidden costs of stock market liquidity," Journal of Financial Economics, Elsevier, Elsevier, vol. 34(1), pages 31-51, August.
  11. Huang, Rocco & Ratnovski, Lev, 2011. "The dark side of bank wholesale funding," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 20(2), pages 248-263, April.
  12. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(3), pages 401-19, June.
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Cited by:
  1. Alexander, Gordon J. & Baptista, Alexandre M. & Yan, Shu, 2014. "Bank regulation and international financial stability: A case against the 2006 Basel framework for controlling tail risk in trading books," Journal of International Money and Finance, Elsevier, Elsevier, vol. 43(C), pages 107-130.
  2. Paul Cavelaars & Jakob de Haan & Paul Hilbers & Bart Stellinga, 2013. "Challenges for financial sector supervision," DNB Occasional Studies, Netherlands Central Bank, Research Department 1106, Netherlands Central Bank, Research Department.
  3. Hryckiewicz, Aneta, 2014. "Originators, traders, neutrals, and traditioners – various banking business models across the globe. Does the business model matter for financial stability?," MPRA Paper 55118, University Library of Munich, Germany.
  4. Apergis, Nicholas, 2014. "The long-term role of non-traditional banking in profitability and risk profiles: Evidence from a panel of U.S. banking institutions," Journal of International Money and Finance, Elsevier, Elsevier, vol. 45(C), pages 61-73.

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