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Banking and Trading

Author

Listed:
  • Mr. Arnoud W.A. Boot
  • Mr. Lev Ratnovski

Abstract

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.

Suggested Citation

  • Mr. Arnoud W.A. Boot & Mr. Lev Ratnovski, 2012. "Banking and Trading," IMF Working Papers 2012/238, International Monetary Fund.
    • Handle: RePEc:imf:imfwpa:2012/238
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    References listed on IDEAS

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    More about this item

    Keywords

    WP; credit line; risky trading; interest rate; relationship banking; trading activity; Bank regulation; proprietary trading; Volcker rule; trading strategy; trading opportunity; franchise value; Lines of credit; Moral hazard; Bank soundness; Credit; Europe;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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