Know Your Customer: Informed Trading by Banks

Abstract

This study analyzes information production and trading behavior of banks with lending relationships. We combine trade-by-trade supervisory data and credit-registry data to examine banks' proprietary trading in borrower stocks around a large number of corporate events. We find that relationship banks build up positive (negative) trading positions in the two weeks before events with positive (negative) news, even when these events are unscheduled, and unwind positions shortly after the event. This trading pattern is more pronounced when banks are likely to possess private information about their borrowers and cannot be explained by specialized expertise in certain industries or firms. The results suggest that banks' lending relationships inform their trading and underscore the potential for conflicts of interest in universal banking - a prominent concern in the regulatory debate for a long time. Our analysis also illustrates how combining large data sets can enhance the supervision of markets and financial institutions.

Keywords: Universal banks, bank regulation, big data, proprietary trading, Volcker Rule, insider trading, market supervision