Conflicts of Interest in Universal Banks

Abstract: We analyze the conflict of interest that arises when universal banks engage in proprietary trading of borrower stocks. This conflict has been a prominent concern in the regulatory debates for a long time. We combine trade-by-trade supervisory data with credit registry information in Germany. Our findings reveal that lending relationships inform banks’ proprietary trading. To separate bank expertise and trading based on private information from lending relationships, we study bank prop trading around corporate events. We show that banks execute net purchases (sales) in borrower stocks weeks before positive (negative) news events, even when these events are unscheduled and surprising to the rest of the market. We link this trading pattern to situations when banks should possess private borrower information and rule out that it is explained by specialized expertise. We also find evidence consistent with information flows through banks’ centralized risk management as well as that banks’ alter their trading patterns once they acquire private information, consistent with shrouding of informed trading. Our evidence highlights the importance of conflicts in universal banking.

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