Sleeping with the enemy: should investment banks be allowed to engage in prop trading?

Abstract

In the midst of the controversy regarding the consequences of the Volcker Rule, we examine whether conflicts of interest exist between the research and proprietary (prop) trading departments of investment banks. Consistent with the existence of a prop trading incentive, our results suggest that banks trade both ahead of and against their upgrades and downgrades for stocks not affiliated with the investment banking department and with small institutional interest. Our results are robust to a vast array of validation and sensitivity analyses, alleviating concerns that they are driven by unobserved factors. Our analysis also suggests that the global settlement, which targeted the investment banking incentive, has accentuated the prop trading incentive. Similarly, our results do not suggest that the financial crisis and the recent attention of regulators to conflicts of interest arising from prop trading have had any success in curtailing the prop trading incentive.