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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
Banks as Regulated Traders
Antonio Falato
Diana A. Iercosan
Filip Zikes
Abstract

This paper uses detailed high-frequency regulatory data to evaluate whether trading increases or decreases systemic risk in the U.S. banking sector. We estimate the sensitivity of weekly bank trading net profits to a variety of aggregate risk factors, which include equities, fixed-income, derivatives, foreign exchange, and commodities. We find that U.S. banks had large trading exposures to equity market risk before the introduction of the Volcker Rule in 2014 and that they curtailed these exposures afterwards. Pre-rule equity risk exposures were large across the board of the main asset classes, including fixed-income. There is also evidence of smaller exposures to credit and currency risk. We corroborate the main finding on equity risk with a quasi-natural experiment that exploits the phased-in introduction of reporting requirements to refine identification, and an optimal changepoint regression that estimates time-varying exposures to address rebalancing. A stress-test calibration indicates that the Volcker Rule was an effective financial-stability regulation, as even a 5% drop in stock market returns would have led to material aggregate trading losses for banks in the pre-Volcker period, as large as about 3% (1.5%) of sector-wide market risk weighted assets (tier 1 capital).


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Antonio Falato & Diana A. Iercosan & Filip Zikes, Banks as Regulated Traders, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2019-005, 07 Feb 2019.
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Keywords: Bank trading ; Regulation ; Risk exposures ; Systemic risk
DOI: 10.17016/FEDS.2019.005
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