Banks as Traders and Investors

Some may think that banks are mostly focused on things like deposits and loans, and this is certainly true of retail banking, who make most of their profit from taking in deposits and lending the money out to people who pay it back at a higher rate of interest than they pay to borrow it.

Retail banks certainly do buy and sell securities though, which consists of anything from short term paper to long term treasury bonds. Banks don’t just lend money out to people or commercial businesses, they lend it out to a variety of sources, including governments, and do so by way of purchasing and selling these debt instruments.

In addition to selling their deposit products, including things like term deposits and money market accounts, some banks also serve as retail broker to their clients, which also includes providing advisory services to them. This segment of banking is called wealth management and banks are certainly well focused on this area of service.

There’s also investment banking, and while retail banking is mostly focused on providing services not related to the securities industry, investment banks are solely focused upon securities. A lot of the things that investment banks are involved in aren’t well known to the public, although they do deal with individual clients as well as the security industry itself and many have a trading account with one of them.

In the U.S, for many years investment banks and retail banks have been kept separate, out of concerns of potential conflict of interest, as the interests of the bank and the interests of clients can sometimes be seen as competing. This is no longer the case and now banks are becoming more integrated as they are in other countries, with banks being now permitted to offer a full array of services.

Banks as Investments and as Investors

In a real sense, any money that you have in any sort of bank which you plan on keeping there for a length of time in order to accrue interest is invested, although we generally speak of investments as owning securities such as stocks or bonds.

It’s all investments though, and there are two main types, debt instruments and equity instruments. Money on deposit at a bank to earn interest is a debt instrument, because the money is owed to you by the bank, to be paid back later, much like a bond is. Buying a bank’s stock is an example of an equity instrument, where you own a portion of the bank which may be sold later.

So one may invest in a bank in either of these two fashions. Banks also invest, and in a sense their loans are investments, debt instruments, and they often will purchase other debt instruments in the marketplace.

Much of these debt instruments are used for liquidity purposes, to loan out money for a short duration, often shorter than loans to clients, in order to earn money from their assets but not have so much of it out there for longer periods. This helps banks have more money on hand to repay depositors, as well as providing a source of income for money not loaned out to clients.

Banks as Retail Financial Brokers

One may also open up a trading account at many banks, where the bank acts as in intermediary between the client and financial markets, placing trades for them as well as in some cases dispensing investment advice.

Many clients prefer self directed accounts, and banks will provide that to them if desired, anywhere up to the services of a full service financial brokerage, and even managing the entire investment account of clients.

The more involved the bank is, the higher the fees involved of course, as the bank needs to be compensated for the additional resources they commit as well as the value they add.

Banks compete with other financial firms, brokerage houses, for people’s business here, but banks are well positioned to take advantage of existing relationships with clients and seek to become a one stop shop for all of your financial needs, and offering brokerage services adds to the value here.

Banks as Market Makers

Brokerage firms, including banks that perform these services, trade securities, or provide the means by which they are traded, so they tend to hold a certain amount in hand at any one point

Due to the nature of financial trading, an intermediary is necessary for the free flow of trades, for instance if you want to buy 1000 shares but someone only has 500 shares to sell, you can’t do that directly, and even if the amounts match on both sides, someone has to bring the parties together.

Financial exchanges only provide the means to trade, they don’t participate in the trading, and the best way to think of this is the stock exchange providing the floor, with all of the people on the floor, the traders, being the intermediaries. Intermediaries also participate in electronic trading as well on the same basis.

So when you trade a security, you are trading with a financial intermediary, on both sides of the trade, both buying and selling it. These intermediaries are called market makers and some banks do make markets. In the case of a bank serving this role, you buy the shares from the bank, or sell it to the bank, and the bank has bought them on the market or will sell them on the market.

Since there is a risk involved here to the market maker, they need to be compensated, and market makers earn profit for themselves by disposing of the securities at a profit. This profit is reflected in the spreads between the bid and ask, and although these margins tend to be very small, market makers conduct a huge amount of transactions per day and can add up to a significant amount of a bank’s profits if they are heavily involved in providing this service.

Banks as Traders

Market making does consist of trading in a real sense, even though it’s primary role is to make financial markets more liquid and efficient, as well as providing a service to their trading clients, making trading faster and more reliable for them.

This is not what most people understand as trading, which is buying or selling a security and holding it for a certain amount of time in order to speculate on price changes.

Market making doesn’t really compete with individual investors the way that trading in competition with them would, but banks do this as well, and this is called proprietary trading.

Banks often will trade the assets of their clients, in which they have a duty to them to act in their best interests, but with proprietary trading, banks are using their own money and acting solely in their own interest.

With this being the case, there is the potential for conflicts of interest to emerge, where a bank may be seen as preferring their own interest to those of their clients, where they may be unable to preserve their obligation to their clients’ interests.

This is not lost upon bank regulators though, and is one of the reasons why retail and investment banking was kept separate in the U.S. for so long, and after this was permitted again, new legislation has emerged restricting proprietary trading in recent years.

Regulators do have the interests of individual investors at heart though and ensure that these interests are kept separate as much as reasonably possible, while not over restricting the activities of banks.

Other issues have emerged in recent times, such as banks not having to play by the same rules as other investors, such as being able to use money from the central bank to support their trading, or getting bailed out by the government when they make poor decisions, such as what happened with the mortgage backed securities debacle of a few years ago.

The Bottom Line

There’s no question that there needs to be a lot of regulation here to prevent such abuses, and every now and then regulations get eased too much and sometimes we get reminded why a certain degree of regulation is so important.

These bailouts also tend to raise the ire of the public and may result in a political response that may be harsher than actually required, which tends to hurt the profitability of banks, so it is in the banks’ own best interest to not overextend themselves with their involvement in securities holdings, such as the massive investment in these risky derivatives that we saw preceding the mortgage crisis.

While banks tend to be pretty conservative by nature, the way people have been compensated at investment banks has allowed some of them to throw the normal caution to the wind to a large degree, where everyone from the CEO on down becomes in a position to make a huge amount of bonus money on things that may benefit the bank in the short term but may add unacceptable risk in the long term.

This is no longer lost on shareholders like it once was, who ultimately call the shots, nor on regulators, so going forward we may expect more stability and control and be less likely to see a situation of this magnitude to occur again, at least until perhaps at some point in the distant future when we may forget the lessons learned from these things.