Is Proprietary Trading Detrimental to Retail Investors?

Banks – particularly universal banks – should be well suited to provide guidance to their retail investors in their investment decisions as they have more and better resources to collect and process information than do individual investors. However, as a result of having proprietary trading and retail banking under the same roof, conflicts of interest between banks and their retail customers might arise. In a paper that is forthcoming in the Journal of Finance Andreas Hackethal and his co-authors Falko Fecht (Frankfurt School of Finance and Management) and Yigitcan Karabulut (Rotterdam School of Management) provide strong evidence that banks sold underperforming stocks from their proprietary trading holdings into the portfolios of their retail customers. They also show that the stock portfolio performance of customers of banks with proprietary trading was significantly worse than that of customers of banks without proprietary trading desks.

The study is based on a unique dataset provided by Deutsche Bundesbank that comprises the individual stock investments of 102 German banks and those of its retail customers for the period from 2005 to 2009. The security holdings of banks in the dataset comprise security positions from proprietary trading, market making and strategic investments. The final data sample represents nearly 63% of the stock investments made by all monetary financial institutions in Germany during the observation period.

Banks sell, retail customers buy

The authors first examine the relationship between the stock investments of banks and those of their retail customers at the individual security level and find that, when a bank sells a given stock from its proprietary trading portfolio, its retail customers tend to buy the same stock in that period. The direction of stock flows between bank and customer portfolios is negative only when banks sell stocks but not when they buy stocks. Further tests also confirm that this finding is not a mere artifact of banks’ market-making activities or retail investors’ herding behavior and that it is robust to changes in empirical specifications, variable definitions, sampling restrictions and econometric methods.

Next, the authors analyze whether the observed behavior of banks has any negative implications for the portfolio performance of their retail customers. First, they show that retail customers experience trading losses from those transactions in which they purchase stocks that their banks sell from their proprietary trading portfolio. Second, they find that stocks directly sold by banks to their customers not only significantly underperform stocks that are either held or purchased by banks, but also underperform retail customers’ other stock investments in their portfolios.

Conflict of interest between proprietary trading and retail banking

These results suggest a potential conflict of interest between the proprietary trading activities and retail banking divisions. To address the possibility that any practice of pushing underperforming stocks into retail client portfolios is overcompensated by superior overall investment advice the authors compare the stock portfolio performance of customers of banks with proprietary trading units with that of customers of banks without proprietary trading units. Considering several performance indicators, they find that client stock portfolios at banks with proprietary trading desks significantly underperform client portfolios at other banks.

Overall, the results reveal a potential conflict of interest from combining proprietary trading and retail banking under one roof, which seems to negatively affect the portfolio performance of retail investors.

Fecht, F., Hackethal, A. and Y. Karabulut (2017), "Is Proprietary Trading Detrimental to Retail Investors?", forthcoming in the Journal of Finance.