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Banking and Trading

  • Arnoud W.A. Boot
  • Lev Ratnovski

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, shortterm, 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 profitablity 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 deepending of the 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 International Monetary Fund in its series IMF Working Papers with number 12/238.

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Length: 48
Date of creation: 02 Oct 2012
Date of revision:
Handle: RePEc:imf:imfwpa:12/238
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  1. John H. Boyd & Gianni De Nicolã, 2005. "The Theory of Bank Risk Taking and Competition Revisited," Journal of Finance, American Finance Association, vol. 60(3), pages 1329-1343, 06.
  2. 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.
  3. Boot, Arnoud W A & Thakor, Anjan, 1997. "Can Relationship Banking Survive Competition?," CEPR Discussion Papers 1592, C.E.P.R. Discussion Papers.
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  11. Holmström, Bengt, 2013. "Inside and Outside Liquidity," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262518536, June.
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  13. Acharya, Viral V. & Cooley, Thomas & Richardson, Matthew & Walter, Ingo, 2010. "Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–2009," Foundations and Trends(R) in Finance, now publishers, vol. 4(4), pages 247-325, April.
  14. Thomas M. Hoenig & Charles S. Morris, 2013. "Restructuring the Banking System to Improve Safety and Soundness," World Scientific Book Chapters, in: The Social Value of the Financial Sector Too Big to Fail or Just Too Big?, chapter 21, pages 401-425 World Scientific Publishing Co. Pte. Ltd..
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