The role of securities trading by banks has assumed significant importance in the modern financial system (Langfield and Pagano 2014). Commercial banks today hold a significant amount of securities in their asset portfolio (20% in US and 19% in Germany). Recently, initiatives like the Volcker rule in the US or the Liikanen report and the Vickers Report in the EU and UK, respectively, aim at ring-fencing ‘traditional’ loan banking activities from securities trading. One reason for these types of reforms, as Federal Reserve Governor Jeremy Stein (2013) explains, is that banks may invest in securities during a crisis, because the increased volatility and potential fire sales imply an increased expected return from securities trading, which could lead to reallocation of funds by banks from lending to security investments in secondary markets (Diamond and Rajan 2011, Shleifer and Vishny 2010).
Buy securities on the way down – sell on the way up
In a recent study, we (Abbassi et al. 2015) analyse the security and credit registers in Germany, where we can observe individual security holdings for each bank every quarter and also individual loans to firms. We show that – in the crisis – banks with higher trading expertise increase the level of their security investments as compared to other banks, especially for securities that have fallen in price.1 Figure 1 provides an example for this pattern, using the investments of German banks in a seven-year floating-rate JP Morgan medium-term note. Subfigure (a) shows the price development of the note and (b) reflects the total holdings of that security. After the failure of Lehman Brothers in September 2008, when the price of the bond decreases, banks in Germany with higher trading expertise start increasing their holdings of the JP Morgan note. When prices revert and increase to 100 over the subsequent quarters, there is a decrease of the associated holdings. Note that this does not happen for other banks.
Figure 1a. Market price of a seven-year JP Morgan floating rate note
Figure 1b. Security holding
Notes: Subfigure (a) shows the monthly price development of the seven-year JP Morgan Chase & Co. medium-term note that runs from 2007 through 2012. Subfigure (b) depicts the euro-denominated holdings (in euro millions) of this security by banks with (higher) trading expertise (black solid line) and without trading expertise (gray dashed line). The first vertical line refers to the start of financial crisis in 2007:Q3, and the second vertical line denotes 2009:Q4, the end of the crisis in Germany.
This is just an example, but systematic evidence shows a similar picture when analysing all the investments of banks. Banks with trading expertise increase substantially more their overall security investments in crisis times as compared to other banks (Figure 2). Moreover, the effects are strongest for investments in securities that previously had a larger drop in price and are primarily concentrated in lower-rated and long-term securities. Finally, we find that trading-expertise banks with higher (not lower) capital levels engage more in these trading activities.
Figure 2. Security holdings
Notes: This figure presents the evolution of total security holdings as a fraction of total assets (normalised to 2007:Q2). The black solid line refers to `Trading banks' and the gray dashed line represents `Non-trading banks'. We classify a bank as a `Trading bank' (higher trading expertise) when it has membership to the largest fixed income platform in Germany (Eurex Exchange). The first vertical line refers to the start of financial crisis in 2007:Q3, and the second vertical line denotes 2009:Q4, the end of the crisis in Germany.
Put the money where your mouth is
These trading activities in secondary markets are ex-ante risky (securities that previously fall in price, especially low rated and long-term), which is mainly why banks with high capital can afford to take on these ex-ante risky strategies. Moreover, the realised (ex-post) returns in the middle of the crisis are on average 12% for these banks with trading expertise that buy securities whose prices decrease in the previous period, whereas the typical loan interest rate to the real sector is around 5%. Therefore, given the investment activities of trading-expertise banks, we also study the potential effects on the supply of credit. We find that trading banks decrease their lending to non-financial corporations during the crisis as compared to other banks. Comparing the lending behaviour of different banks to the same firm during the same quarter, we find a larger drop in credit supply by trading banks, especially those that are better capitalised. Firms cannot completely undo this decrease in credit supply by borrowing from other banks. These findings suggest that trading activities of banks crowd out lending (Stein 2013).
Raison d’être for stricter regulation?
While restricting banks from trading in securities could possibly prevent reduction in credit supply, it is important to remember that at the same time, these banks buy securities that had a larger drop in price. Moreover, this behaviour is more prevalent for banks with higher (not lower) capital levels. Therefore, to the extent that these banks are large players in these markets, the results suggest that restrictions on securities trading by banks could affect the liquidity of these markets.
These are important findings, as policymakers around the world frame regulations regarding securities trading activities that banks can engage in. Policymakers should carefully weigh the costs and benefits when implementing securities trading regulations on banks. Financial crises will occur again, so we need to be thoughtful about what may happen in the future if banks are restricted from trading in financial securities.
Disclaimer: The views expressed here are those of the authors and do not necessarily represent those of the Deutsche Bundesbank or the Eurosystem.
Abbassi, P, R Iyer, J L Peydró and F R Tous (2015) “Securities trading by banks and credit supply: micro-evidence”, CEPR Discussion Papers 10480.
Diamond, D W and R G Rajan (2011) “Fear of fire sales, illiquidity seeking, and credit freezes”, Quarterly Journal of Economics, 126(2): 557-591.
Langfield, S and M Pagano (2014) “Bank bias in Europe: Effects on systemic risk and growth”, Working paper.
Shleifer, A and R W Vishny (2010) “Unstable banking”, Journal of Financial Economics, 97(3): 306-318.
Stein, J C (2013) “The Fire-sales problem and securities financing transactions”, Speech by Governor Jeremy C. Stein at the Federal Reserve Bank of New York during the Workshop on Fire sales as a driver of systemic risk in Triparty Repo and other secured funding markets, New York, October 4.
1 Higher trading expertise is proxied by direct membership to the main trading platform in Germany, i.e. Eurex Exchange.