Proprietary trading: evidence from the crisis

Francesc R. Tous, Puriya Abbassi, Rajkamal Iyer, José-Luis Peydró.

What are the consequences of proprietary trading? Banks typically hold and trade a significant amount of securities, and during the financial crisis, many of these securities suffered strong price declines. How did banks react? This is precisely what we investigate for the case of Germany in a recently published paper. We find that some banks increased their investments in securities, especially for those securities that suffered price drops. This strategy delivered high returns; but at the same time, these banks pulled back on lending to the real economy, since during the financial crisis they could not easily raise new (long-term) funding. Our findings suggest that proprietary trading during a crisis can lead to less lending to the real sector.

The activity of trading securities by banks was subject to strong criticism during the financial crisis. In the UK, the Parliamentary Commission on Banking Standards published a report three years ago demanding more powers for the PRA to tackle banks’ proprietary trading. Structural reform bans proprietary trading in the ring-fenced entity, with the objective of protecting the continuity of core banking services. There are several concerns about banks’ trading activities: for instance, banks can take on large risky bets using implicit and explicit government support—deposit insurance, liquidity from the central bank, or explicit public guarantees—threatening their ability to continue offering core banking services. There is another concern: during a crisis, banks might find it more profitable to invest in securities than to lend to the non-financial sector, since the former may offer better returns given temporary price distortions. This could create a credit crunch, although at the same time it could help maintain a correct functioning of securities markets by eliminating such price distortions.

This discussion has also been the subject of recent academic work. However, the debate has mainly been on the theoretical front since data limitations have prevented a proper identification of such effects. Some examples of this work include Diamond and Rajan (2011) and Shleifer and Vishny (2010). These papers show that banks might restrict lending and hoard liquidity in order to invest in securities that distressed institutions may need to sell.

In our paper, we explore how banks behaved during the financial crisis in the securities and lending markets. We use the confidential securities and credit registers from the Deutsche Bundesbank. The securities register has information on banks’ holdings of individual securities. This allows us to know how much of a specific security, issued by a specific issuer, German banks held at the end of each quarter, from the end of 2005 until the end of 2012. Using granular data is fundamental for policy making, as the One Bank Research Agenda Discussion Paper highlights; for instance, in the case of securities trading, bank-level data (i.e., observing only the total amount that banks invest in securities) would not allow us to understand which type of securities different banks buy and sell: it is not the same to have a bank investing in German bunds compared to have a bank investing in BBB 10-year corporate bonds that have fallen in price. Moreover, without granular data one cannot distinguish between changes in holdings driven by bank behaviour from changes in holdings driven by issuers’ behaviour. It is only by comparing how much different banks buy (and sell) of the same security at the same time that we can identify differentiated trading behaviour. And for this we need granular data.

Our main hypothesis is that banks with higher trading expertise (we call them “trading banks”) take advantage of the volatility in securities markets by increasing their investment and reducing, as a consequence, their lending to the real economy. We identify trading banks as those which are members of the Eurex Exchange, the largest fixed-income trading platform in Germany. Our results show that trading banks increased their overall exposure to securities during the crisis. As mentioned before, the granularity of the data allows us to compare how much two banks with different trading expertise (a trading and a non-trading bank) buy of the same security during the same quarter. The results, hence, are not driven by changes in the supply of securities, such as shocks to the issuers.

A very clear way to illustrate our results is by using the example of a single security. The left panel in Figure 1 shows the price of a 7-year floating rate note issued by JP Morgan: the price fell considerably, especially after Lehman failed, and then recovered in 2009. The dotted vertical lines show the start and the end of the financial crisis. The right panel compares the evolution of the holdings of this particular note by trading and non-trading banks. Trading banks increased their holdings of the JP Morgan note at the same time that the price was collapsing, and then reduced them when the price recovered. There is an additional piece of information in the chart: trading banks did not buy this security from non-trading banks; they bought it from non-bank institutions. In other words, the banking sector as a whole, mainly through trading banks, absorbed a lot of risk from the securities market during the crisis.

Figure 1. JP Morgan floating rate note

Figure 1

Our research shows that this was not the exception, but the rule: trading banks bought on average twice as much as non-trading banks. This higher investment was concentrated in those securities that suffered a stronger price drop. Importantly, we consistently observe that stronger trading banks, both in terms of capital and in terms of profits, bought even more securities.  Moreover, we also find that banks receiving public support, for instance central bank liquidity and implicit guarantees, bought more securities: trading banks that borrowed more from the central bank invested even more in securities; and we also observe that Landesbanks, which have implicit guarantees since they are owned by the federal states, bought more securities than non-trading banks; nevertheless, Landesbanks’ behaviour did not depend on balance sheet strength, consistent with the idea that banks drew on public subsidies (in this case, implicit support) to engage in trading.

But did it pay off? We calculate the return from buying securities when prices are falling in several different ways. Regardless of how we compute returns, the result is the same: annual returns were around 15 – 20% especially after Lehman failed. This compares to an average return on lending of 5%. Hence, the strategy of purchasing securities in a falling market was indeed very profitable, as long as one could withstand the volatility for some quarters.

What does this mean for lending? We make use of the German credit register to answer this question. The granularity of the data allows us to control for credit demand and hence focus only on credit supply. We find that, during the crisis, banks with trading expertise decreased lending to non-financial firms; among trading banks, those with stronger capital positions decreased lending even more. Public support measures, such as the funding received from the central bank, were not used to continue lending to the real economy. Importantly, we observe that firms were not able to substitute the reduction in credit supply by borrowing from non-trading banks or issuing debt. This result is crucial and suggests the existence of a negative externality arising from the securities markets that affects the real economy.

What are the policy implications of our results? We show that banks increased purchases of securities at the expense of lending to the real economy during the financial crisis. This result could suggest that banning banks from engaging in these activities would be beneficial for the real economy, especially during a crisis. But a crucial point of our results is the fact that the banks that engage in these activities are precisely those with stronger balance sheets. Our results are not consistent with a story of risk shifting and gambling for resurrection, where very weak banks would invest in very risky securities hoping that the market recovers. And hence, a natural question arises: absent these banks, who would have absorbed the risk in the securities market, and what would have been the consequences for issuance and the real economy if securities prices had fallen further? Failing to consider this issue could have dangerous and unintended consequences in the future.

Francesc R. Tous works in the Bank’s Policy Strategy and Implementation Division, Puriya Abbassi works at Deutsche Bundesbank, Rajkamal Iyer works at MIT Sloan School of Management and José-Luis Peydró works at Universitat Pompeu Fabra and is a Senior Houblon-Norman fellow at the Bank of England.

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Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

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