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MIT Sloan study shows link between securities trading by banks and credit supply

CAMBRIDGE, Mass., March 30, 2015 – In the wake of the financial crisis, there has been considerable debate about securities trading by banks. A common argument is that during the crisis, banks’ securities trading activities led to a reduction in credit supply. However, others maintain that without such trading, there would have been a significant reduction in liquidity in the securities market. A new paper coauthored by MIT Sloan School of Management Prof. Rajkamal Iyer shows a significant link between securities trading by banks and credit supply during the crisis.

“Regulators around the world are debating whether banks should be allowed to trade in securities,” says Iyer. “In the U.S. we’ve had the Volcker rule in effect to impose restrictions on banks’ trading activities, and Europe has the Liikanen Report. But there has been little empirical analysis on the costs and benefits of these restrictions.”

The main constraint to research has been the lack of comprehensive micro data at the security level on banks’ trading activities. In Iyer’s study, he used 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.

The key question addressed in the study is whether, during a crisis, banks with higher trading expertise will increase their investments in securities, especially in securities that had a larger price drop, to profit from the trading opportunities? And if so, how will this impact lending?

Iyer and his colleagues found that commercial banks with higher trading expertise 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. Further, 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.

He points to Lehman Brothers as an example. After the failure of Lehman Brothers in September 2008, 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, they found that trading banks indeed decrease their supply of credit to nonfinancial firms during a crisis compared to other banks. They saw a larger drop in credit supply by trading banks with a higher level of capital.

“As for the debate about whether banks should engage in securities trading, our study shows that during a time of crisis, securities trading by banks can crowd out lending. However, at the same time, we also find that banks buy securities that had a larger drop in price,” he says. “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.”

Iyer says these are “important findings,” as policy makers around the world frame regulations regarding the securities trading activities that banks can engage in. He notes that 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,” he adds.

Prof. Iyer is coauthor of “Securities Trading by Banks and Credit Supply:   Micro-Evidence.” To read the full version, please visit: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2570763

For more information about Prof. Iyer, please visit: http://mitsloan.mit.edu/faculty/detail.php?in_spseqno=41358

The MIT Sloan School of Management is where smart, independent leaders come together to solve problems, create new organizations, and improve the world. Learn more at mitsloan.mit.edu.