Sleeping with the Enemy: Should Investment Banks Be Allowed to Engage in Prop Trading?

Abstract

This paper investigates whether conflicts of interest exist between the research and proprietary trading departments of full-service investment banks. Using a data set of 11,590 analyst stock recommendations over the period 1999-2007, we find that in the period preceding the Global Research Analyst Settlement (GRAS) sanctioned banks traded ahead of their research reports. Results in the post-GRAS period indicate that sanctioned banks continue to trade ahead of their research reports as institutional ownership in the stock increases and as return volatility increases. The latter result holds only if they also intend to trade against their recommendations after their release. We also find that banks trade against their recommendations for affiliated stocks. Finally, we do not find that the recommendation revision is related to changes in holdings of other investment banks, alleviating concerns that the observed relation is related to common information available to both departments and not to information leakages. Overall, the evidence supports the recent concerns of regulators regarding conflicts of interest that can arise between bank proprietary trading and research departments, highlighting the need for stricter regulation; it is not yet clear whether the Volcker Rule will be successful in addressing this issue.

Keywords: investment banking, proprietary trading, stock recommendations, financial crisis, global settlement (GRAS), Volcker rule, Dodd-Frank Act

JEL Classification: G24, G28