We show that banks’ risk exposure in one asset category affects how they report regulatory risk weights for another asset category. Specifically, banks report lower credit risk weights for their loan portfolio when they face higher risk exposure in their trading book. This relationship is especially strong for banks that have binding regulatory capital constraints. Our results suggest the existence of incentive spillovers across different risk categories. We relate this behavior to the discretion inherent in internal ratings-based models which these banks use to assess risk. These findings imply that supervision should include a comprehensive view of different bank risk dimensions.

We analyze the relation between market-based credit risk interconnectedness among banks during the crisis and the associated balance sheet linkages via funding and securities holdings. For identification, we use a proprietary dataset that has the funding positions of banks at the bank-to-bank level for 2006–2013 in conjunction with investments of banks at the security level and the credit register from Germany. We find asymmetries both cross-sectionally and over time: when banks face difficulties to raise funding, the interbank lending affects market-based bank interconnectedness. Moreover, banks with investments in securities related to troubled classes have a higher credit risk interconnectedness. Overall, our results suggest that market-based measures of interdependence can serve well as risk monitoring tools in the absence of disaggregated high-frequency bank fundamental data.

We analyze securities trading by banks during the crisis and the associated spillovers to the supply of credit. We use a proprietary data set that has the investments of banks at the security level for 2005–2012 in conjunction with the credit register from Germany. We find that—during the crisis—banks with higher trading expertise (trading banks) increase their investments in securities, especially in those that had a larger price drop, with the strongest impact in low-rated and long-term securities. Moreover, trading banks reduce their credit supply, and the credit crunch is binding at the firm level. All of the effects are more pronounced for trading banks with higher capital levels. Finally, banks use central bank liquidity and government subsidies like public recapitalization and implicit guarantees mainly to support trading of securities. Overall, our results suggest an externality arising from fire sales in securities markets on credit supply via the trading behavior of banks.