Banking and Trading

49 Pages Posted: 1 Nov 2012

See all articles by Lev Ratnovski

Lev Ratnovski

International Monetary Fund; European Central Bank, Financial Research Division

Date Written: October 2012

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 rading, 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.

Keywords: Bank regulations, Banking, Capital, Commercial banks, Investment, Resource allocation, Bank regulation, proprietary trading, relationship banking, Volcker rule

JEL Classification: G21, G24, G28, G32

Suggested Citation

Ratnovski, Lev, Banking and Trading (October 2012). IMF Working Paper No. 12/238, Available at SSRN: https://ssrn.com/abstract=2169779

Lev Ratnovski (Contact Author)

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://ratnovski.googlepages.com

European Central Bank, Financial Research Division

Germany

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