Banking and Trading

Abstract

We study the interaction between relationship banking and short-term, scalable arm's length finance which we call trading. Relationship banking is not scalable, has high franchise value, is long-term oriented and low risk. Trading is transaction-based: scalable, with lower margins (capital constrained), short-term, and more prone to risk shifting. When a bank engages in trading, it can use its franchise value to expand the scale of trading. However there are two inefficiencies. We show that a bank may allocate too much capital to trading ex post, compromising the ability to build relationships ex ante. And a bank may use trading for risk shifting. Financial innovation and the deepening of financial markets have pushed much of arm's length finance into the realm of trading by improving the marketability of assets. While combining relationship banking and trading offers some benefits at a low scale of trading, the unbridled growth of trading opportunities is distortive. The analysis offers insights into bank business models and helps assess recent initiatives aimed at structural reforms in banking.