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Opinion On Prohibiting Banks From Engaging In Proprietary Trading

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When a bank or firm invests in direct market using the organisation’s own capital and balance sheet to conduct financial transactions; in order to generate gain for itself instead of generating earnings through commission by trading on behalf of its clients is termed as proprietary trading. Usually banks or firms engage in such kind of practices to generate an extra return as they have a competitive advantage in regard to others.

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Often banks and financial institutions forms a proprietary trading desk for proprietary trading to be effective and also keep the institution’s clients in mind, which are normally secluded from other trading desks. This trading desk is responsible for a portion of the financial institution’s revenues unrelated to any client work and acts autonomously with no interference of what so ever nature.

These proprietary trading desks do function as a market maker too in many cases. There normally occurs a situation when a client wants to trade a large amount of a single security or trade a highly illiquid security and since, there are not many buyers or sellers for the particular type of trade, a proprietary trading desk will act as the buyer or seller, initiating the other side of the client trade. Which in turn helps in initiating a deal which otherwise would have failed.

There are three major benefits due to which any organisations involve themselves in proprietary trading. They are as follows:

  1. Increased profits: Whenever there is a trade carried out by a brokerage firm or an investment bank on behalf of its client in lieu they generate revenue in the form of fees and commissions, which can be both soft or hard, but that is a small percentage of the total amount of the investment made and the gains occurred out of that investment. On the other hand, in case of; proprietary trading a financial institution or a brokerage firm gets the 100% of the total gains occurred out of that particular trade or investment.
  2. Stocking of inventory: There are two major benefits of stocking the inventory or stockpile. Firstly; the institution can offer the speculative inventory to their clients at any given point which they might not have otherwise as and when needed. Secondly; when there is a crunch situation or to say, in a time when the market is down or at times when there is less liquidity in the market, it gets tough to purchase the securities from open market, in those times they have an option to use their stocked up inventory with them.
  3. Influence the market: Proprietary trading gives an edge to the financial institution or the brokerage firm over others by providing liquidity in the market on a specific security or a group of securities. This allows them to become an influential market maker.

There are few Risks too associated with proprietary trading, many brokerage firms or investment banks have closed down and a few had defaulted to their clients who have a proprietary trading desk. Brokers use algorithmic trading, insider information, trading strategies, etc., to enter into trades and make profits. Now, in such highly volatile and disruptive financial markets, anything can go wrong and in an instant a broker may end up losing millions in a matter of minutes despite adopting adequate risk management processes. It is always better to stay away from such practices as stocking of securities can anytime result in huge loses to the organizations and may end up in bringing the institution to such a position when they are left with no other option than to shut down their business operations permanently.

Impact on the banking industry of a ban on proprietary trading:

The total impact can be described in the four major parts, which are;

  1. Risk management
  2. Loan quality signaling in securitization
  3. Reduction in the value of financial services provided
  4. Impact on the business model of banks
  5. Effect on the co-evolution of Banks and Markets and the Ability of Businesses to Raise Capital

Risk Management: Banks have to manage a variety of risks. The most prominent among these are credit risk, interest rate risk, and liquidity risk. A bank would like to focus its loan origination activities in sectors where it has credit screening expertise because that is where it is most likely to be able to identify and screen out bad credit risks with the greatest precision. Because securitization creates tranches with different maturities, banks can also improve their management of interest rate risk by judiciously purchasing asset-backed securities (claims against pools of loans that are securitized). To effectively manage liquidity risk the major problem in banking is that loans are innately illiquid; they cannot be expeditiously sold without incurring a substantial loss in the form of a price discount relative to true value whereas deposits, especially demand deposits, represent liquid claims. By securitizing its illiquid loans, the bank immediately creates a portfolio of liquid claims that are traded in the capital market. Thus, securitization gives banks the opportunity to manage all three of their major risks.

Loan quality signaling in securitization:

In the event of securitization of pool of funds by a bank, there is a potential credibility problem. The bank has usually weaker incentives to devote resources to screening loan applicants and investing in the appropriate due diligence if it anticipates that these loans will be securitized than if it knows that the loans will be held on the bank’s books. The reason is that the bank bears a greater cost from making a bad loan if the loan stays on the bank’s books than if the loan is sold. Investors that purchase the asset-backed securities that are claims against the portfolio of securitized loans rationally anticipate these incentives and adjust the price accordingly. This can result in asset-backed claims selling at relatively low prices, which in turn would undo some of the lower-cost-of-financing benefit of securitization. One way to resolve the problem is through “signaling”. For example, a dealer selling a used or “pre-owned” car recognizes that potential buyers will have doubts about the quality of the car. A signal that can resolve these doubts would be a warranty provided by the dealer. The warranty would signal to a potential buyer that the dealer believes the car has high quality since the cost of providing the warranty is higher for a lower quality car. The securitization market also uses signaling, by keeping on its books some of the tranches of the loans it securitizes, a bank can signal to the market that it believes that the loans are of high quality.

Reduction in the Value of Financial Services Provided by Banks:

Banks provide a variety of services to their customers, some of which may be adversely affected by the Volcker Rule. The following figure shows the wide variety of services that investment banks, for example, provide:

A bank’s knowledge of financial markets enables it to provide services that add value to its customers. This knowledge is gained in a variety of ways, one of which is market making. Market making involves a network, the larger the number of trades that the bank is involved in as a market maker, the more it learns about market conditions and the more valuable a member of the network it becomes. This knowledge then not only enhances its effectiveness as a market maker, but also increases the value it provides across a wide range of services, such as those shown in Figure. This knowledge has been referred to as the “cross-sectional reusability of information. Ban on proprietary trading that limit the role of banks as market makers also diminish the amount of information that banks can gather about market conditions and lowers the value of the services that they provide to their customers.

Impact on the business model of banks:

Banks have evolved as a business model over the past few decades that involve providing a diversified set of financial services that include commercial and investment banking, including securities underwriting and market making. This evolution of the banking business model occurred not because of changes in regulation but because of the inexorable march of market forces. The dynamics of the financial services industry made it economically beneficial for banks to expand their business model to provide a diversified set of financial services, this evolving business model provided numerous economic advantages as follows:

More Efficient Use of Liquidity: Keeping more liquid assets, like cash, on the balance sheet is one way for banks to manage liquidity risk. Volcker Rule that causes banks to retrench from market making will reduce the efficiency of the bank’s liquidity risk management. Banks are likely to respond by keeping more liquidity on the balance sheet. Which will increase the bank’s cost of providing various services, and the higher cost will likely be passed on to the bank’s customers.

More Efficient Use of Capital: Like liquidity, capital also presents banks with a tradeoff. On the one hand, keeping more capital increases the overall safety of the bank. On the other hand, capital is costly for the bank. Thus, banks will attempt to optimize their use of capital. Using logic similar to that for liquidity, we can see that banks will be able to use capital more efficiently when they engage in more activities. The economic consequences of the Volcker rule to the extent that allowing banks to operate with the diversified financial services model leads to a more efficient use of capital, it may prove to be easier for regulators to obtain the cooperation of banks in endorsing higher capital requirements.

Higher Quality of Services Provided to Customers: A bank with a more diversified set of financial services as its business model will end up gathering more information about market conditions than a bank that does not provide as diversified a set of services. This was discussed earlier as a benefit of cross-sectional information reusability, which increases the value of the services the bank provides to its customers.

More Profitable and Safer Banks: A business model of providing more diversified financial services can generate more profits for banks and make them safer. However, there is another dimension to this from the standpoint of the bank’s business model. When the bank’s activities are artificially curtailed by regulatory proscriptions, the bank is not only forced to retrench from a potentially profitable activity, but also may be compelled to alter its business model. The reason is that retrenching from one activity causes a decline in valuable customer-specific and market information the bank gathers. Because of cross-sectional information reusability, this diminishes the value of other activities.

Effect on the Co-evolution of Banks and Markets and the Ability of Businesses to Raise Capital:

The view in academic research has been that commercial banks compete with the capital market for business. A bank loan and commercial paper are often close substitutes for high-credit-quality borrowers. Mutual funds are close substitutes for bank deposits, and grew in prominence when Regulation Q ceilings on deposit interests became binding during the high-interest-rate period of the 1980s. However, that besides competing, banks and markets also complements each other and coevolves. When financial markets are better developed, banks are able to finance themselves with equity capital at lower cost, which enables them to expand their scope of lending by extending credit to riskier borrowers. This facilitates the development of banking. Similarly, when banks become more effective in screening borrowers, they are able to ensure that only borrowers above a certain quality threshold are able to go public and have their security issuances underwritten. This benefits the capital market. This analysis suggests that when banks have access to a broader range of activities like private equity, hedge funds, market making, the co-evolution of banks and markets is facilitated. That is, the impact of positive developments in the capital market on the development of banks and the impact of positive developments in banking on the development of the capital market are both elevated. This suggests the disturbing possibility that denying banks the opportunity to invest in hedge funds, private equity, and the like will artificially constrain the co-evolution of both banks and markets.

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