Bank Regulatory Reforms and Institutional Equity Holdings

Abstract

This paper examines the effects of changes in bank regulatory environment on the risk, return, and liquidity characteristics of equity portfolios of U.S. bank holding companies between 1997 and 2016. Using a comprehensive sample of bank and hedge fund holdings data we examine the impact of the repeal of the Glass-Steagall Act, the introduction of the second and third Basel Capital Accords, and the implementation of the Dodd-Frank legislation on institutional portfolios. We document a significant increase in both the idiosyncratic volatility and illiquidity of banks' portfolios during the period of financial deregulation initiated by the formal removal of restrictions prohibiting banks from engaging in securities trading. In contrast, subsequent reforms of the bank capital requirements system and the prohibition of banks from proprietary trading activities lead to reductions in those metrics. Our results suggest that banks' restricted ability to engage in market-making can be offset by the activities of hedge funds, although the consequences of this substitution for long-term market stability remain unclear.