NEW YORK (TheStreet) -- During the economic crisis, we saw an interesting pattern of activity among commercial banks. As prices of securities dramatically dropped, banks purchased the securities, looking to make profits when the prices later increased. This had an effect on lending, as banks used their capital to buy securities rather than make loans. This despite the banks taking billions at the time from the Federal Reserve in liquidity support.
Now, regulators around the world are debating whether banks should be allowed to trade in securities. In the U.S. we have the Volcker rule, which prevents banks from proprietary trading. In Europe, they have the Liikanen Report. But an important question in these discussions is what are the benefits and costs to not having banks trade securities?
Answering that question has been difficult due to a lack of comprehensive micro data at the security level on banks' trading activities. However, in a recent study, my colleagues and I were given access to a unique, proprietary dataset from the Bundesbank (the German central bank) that provides information on security-level holdings for all banks in Germany at a quarterly frequency for the period between 2005 and 2012.
So we were able to analyze whether, during a financial crisis, banks with higher trading expertise increase their investments in securities, especially in securities that had a larger price drop, to profit from the trading opportunities. Further, we examined how this impacts lending.
We found that commercial banks with higher trading expertise indeed increase their level of security investments as compared to other banks. In particular, trading banks tend to buy more of the securities that had a larger drop in price. Also, the investment in securities that had a larger drop in price is primarily concentrated in lower-rated and long-term securities. These effects are more pronounced for trading banks with higher capital levels.
You can see this play out after the failure of Lehman Brothers in September 2008 when there was a sharp drop in the price of the JP Morgan medium-term note. Around this time, German banks with higher trading expertise increased their holdings of this note. After the price rebounded back to 100 over the subsequent quarters, they reduced their holdings. In comparison, other banks did not increase their holdings around the Lehman crisis.
Looking at the issue of whether the level of bank capital matters for the supply of credit, we found that trading banks did decrease their supply of credit to nonfinancial firms during the crisis compared to other banks. There was a larger drop in credit supply by trading banks with a higher level of capital. In other words, during a time of crisis, securities trading by banks can crowd out lending.
However, at the same time, we also found that banks buy securities that had a larger drop in price. So to the extent that 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 policy makers 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 happen again so we need to be thoughtful about what happens in the future if banks are prohibited from trading in securities.