Banking and Trading

IMF Working Papers, October 2, 2012

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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 profitably expand the scale of trading.
Two inefficiencies arise when banks engage in trading:
- A bank may allocate too much capital to trading ex-post, compromising the incentives to build relationships ex-ante.
- 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.

Trading increases scalability but introduces concentrated-position risks absent in relationship-based banking.
Use of ‘spare’ capital for trading can expand trading activity profitably but can distort capital allocation between trading and relationship banking.
Two principal inefficiencies:
- Excessive ex-post capital allocation to trading reduces ex-ante relationship-building incentives.
- Trading can be employed as a mechanism for risk-shifting by banks.
Financial development has a nonlinear effect:
- Early-stage development favors conglomeration due to increased trading scalability.
- Beyond a certain point, market deepening accentuates trading-related inefficiencies and systemic risk.
The trend of deeper financial markets in recent decades implies persistent challenges in managing and regulating trading within banks.

Capital regulation: implications stem from the interaction between relationship banking implicit capital and trading capital demands.
Subsidiarization: organizational structure choices (e.g., subsidiarization) may mitigate or exacerbate trading-related risks.
Scope and scale restrictions in banking: limiting the scope or scale of bank trading activities can address the identified inefficiencies and risk-shifting incentives.

Subject: Bank soundness, Banking, Credit, Financial crises, Financial institutions, Financial sector policy and analysis, Lines of credit, Money, Moral hazard, Tax incentives
Keywords: Bank regulation, Bank soundness, Credit, credit line, Europe, franchise value, interest rate, Lines of credit, Moral hazard, proprietary trading, relationship banking, risky trading, trading activity, trading opportunity, trading strategy, Volcker rule, WP

Source: IMF Working Paper "Banking and Trading" by Arnoud W.A. Boot and Lev Ratnovski, October 2, 2012.

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