Description

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.

More publications in this series: Working Papers

More publications by: Arnoud W A Boot ; Lev Ratnovski