Conflicts of Interest in Banks: Evidence from Proprietary Trading

We analyze the conflict of interest that arises when universal banks engage in proprietary trading of borrower stocks, which has been a prominent concern in the regulatory debates for a long time. We combine trade-by-trade supervisory data with credit registry information in Germany. Our findings reveal that lending relationships inform banks' prop trading. To separate bank expertise and private information from lending as explanations, we study prop trading around corporate events. We show that banks execute purchases (sales) in borrower stocks in the weeks before positive (negative) news events, even when these events are unscheduled and surprising to the market. We link this trading pattern to situations when banks possess private borrower information, and rule out that it is explained by specialized expertise. We also find evidence consistent with information flows through banks' centralized risk management, that banks alter trading patterns once they acquire private information, consistent with shrouding of informed trading, and that OTC counter-parties price-protect against relationship banks. Our evidence highlights the difficulty of avoiding conflicts in universal banking.