Know Your Customer: Relationship Lending and Bank Trading

Authors: Rainer Haselmann (Goethe), Christian Leuz (University of Chicago) and Sebastian Schreiber (Goethe)

Title: Know Your Customer: Relationship Lending and Bank Trading

Abstract: In this study, we analyze the trading behavior of banks with lending relationships. We combine detailed German data on banks' proprietary trading and market making with credit register information on their lending. Specifically, we examine how banks trade common stocks of their borrowers around important corporate events. We find that banks are more likely to trade ahead of events when they are firms' main lender, i.e., the relationship bank. We show that relationship banks build up positive (negative) trading positions in the two weeks before positive (negative) news events, which they unwind shortly after the event. This trading pattern is particularly pronounced for unscheduled earnings events, M&A transactions, and after borrower obtain new bank loans, i.e., in situations when management has private information and the event is difficult to anticipate without superior information. Our results highlight the potential for conflicts of interest in banking relationships, which has been a prominent concern in the regulatory debate.