Securities activities by commercial banking firms' Section 20 subsidiaries: risk, return and diversification benefits

This paper studies the implications of securities activities on bank safety and soundness by comparing the ex-post returns between banking firms' Section 20 subsidiaries -- subsidiaries that were authorized by the Federal Reserve to conduct bank-ineligible securities activities -- and their commercial bank affiliates. I found that securities subsidiaries that are primary dealers of government securities, their higher risk partially comes from their higher leverage, whereas for those that are not primary dealers, despite having lower leverage, they tend to be riskier than their bank affiliates partly because of their aggressive trading behavior. Nevertheless, securities subsidiaries appear to provide diversification benefits to bank holding companies, as evidenced by the low return correlation between bank subsidiaries and securities subsidiaries. Within the class of securities activities, I found that securities trading tends to be more profitable and riskier than banking activities. Trading activities engaged by primary dealer securities subsidiaries tend to provide strong diversification benefits to banking activities, reducing the banking organization's overall risk. For non-primary dealers, due to their aggressive trading behavior, their trading activities were found to increase the firm's total risk. On the other hand, securities underwriting is found to be riskier, and in the case of non-primary dealers also less profitable, than banking activities. Nevertheless, its return exhibits low correlation with banking return and trading return, suggesting that securities underwriting provides potential diversification benefits to both banking and trading activities.