Banking and Trading

We study the interaction between banking and trading businesses within a uni-versal bank. Traditional banking is relationship-based: not scalable, long-term oriented, with high implicit capital, and low risk (thanks to the law of large num-bers). Trading is transactions-based: scalable, short-term, capital constrained, and with the ability to generate extreme risk from concentrated positions. A merger be-tween banking and trading enables using the ‘spare ’ capital of the relationship bank to profitably expand the scale of trading. However it generates two inefficiencies. Universal banks may allocate too much capital to trading ex-post, compromising the incentives to build relationships ex-ante. And universal banks may use trad-ing for risk-shifting, compromising bank stability. Financial development augments the scalability of trading, which initially benefits conglomeration, but beyond some point inefficiencies dominate. The deepening of financial markets in recent decades suggest that conglomeration faces severe head winds such that problems in man-aging and regulating universal banks will persist for the foreseeable future. The analysis has implications for capital regulation, subsidiarization, and scope and scale restrictions in banking. ∗Contact