We study the interaction between relationship banking and short-term arm’s length activities of banks, called trading. We show that a bank can use the franchise value of its relationships to expand the scale of trading, but may allocate too much capital to trading ex post, compromising its ability to build relationships ex ante. This effect is reinforced when trading is used for risk shifting. Overall, combining relationship banking and trading offers benefits under small-scale trading, but distortions may dominate when trading is unbridled. This suggests that trading by banks, while benign historically, might be distortive with deeper financial markets.

This paper studies the significant variation in the cross-section of standalone and systemic risk of large banks during the recent financial crisis to identify bank specific factors that determine risk. We find that systemic risk grows with bank size and is inversely related to bank capital, and this effect exists above and beyond the effect of bank size and capital on standalone bank risk. Our results contribute to the ongoing debate on the merits of imposing systemic risk-based capital requirements on banks.