Banks as Regulated Traders

46 Pages Posted: 11 Feb 2019 Last revised: 21 Feb 2019

See all articles by Antonio Falato

Antonio Falato

Board of Governors of the Federal Reserve System

Diana Iercosan

Board of Governors of the Federal Reserve System

Filip Zikes

Board of Governors of the Federal Reserve System

Date Written: 2019-02-07

Abstract

This paper uses detailed high-frequency regulatory data to evaluate whether trading increases or decreases systemic risk in the U.S. banking sector. We estimate the sensitivity of weekly bank trading net profits to a variety of aggregate risk factors, which include equities, fixed-income, derivatives, foreign exchange, and commodities. We find that U.S. banks had large trading exposures to equity market risk before the introduction of the Volcker Rule in 2014 and that they curtailed these exposures afterwards. Pre-rule equity risk exposures were large across the board of the main asset classes, including fixed-income. There is also evidence of smaller exposures to credit and currency risk. We corroborate the main finding on equity risk with a quasi-natural experiment that exploits the phased-in introduction of reporting requirements to refine identification, and an optimal changepoint regression that estimates time-varying exposures to address rebalancing. A stress-test calibration indicates that the Volcker Rule was an effective financial-stability regulation, as even a 5% drop in stock market returns would have led to material aggregate trading losses for banks in the pre-Volcker period, as large as about 3% (1.5%) of sector-wide market risk weighted assets (tier 1 capital).

Keywords: Bank trading, Regulation, Risk exposures, Systemic risk

JEL Classification: G38, G32, G21

Suggested Citation

Falato, Antonio and Iercosan, Diana and Zikes, Filip, Banks as Regulated Traders (2019-02-07). FEDS Working Paper No. 2019-005. Available at SSRN: https://ssrn.com/abstract=3331457 or http://dx.doi.org/10.17016/FEDS.2019.005

Antonio Falato (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th & C. St., N.W.
Washington, DC 20551
United States

Diana Iercosan

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Filip Zikes

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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