why do commercial banks have lots of money for trading#hearsay

Reason: a commercial bank makes money by lending to (credit worthy) borrowers but ROI of this traditional business model is modest. They get much better ROI from security trading.

Reason: a commercial bank often has excess liquidity. Out of $1b deposit, banks are regulated to lend out perhaps 75% (or 90% — known as LTD ratio) but must keep some 25% of the $1b in liquid cash. If the bank keeps 25.5%, then the .5% is excess liquidity. Note a bank can’t treat (total deposit minus total loan) as excess liquidity. Bank is regulated to keep some liquid cash to satisfy depositor withdrawals.

By default, the excess liquidity cash sits there earning 0 return. Security trading is one way to get some return.

Reason: a commercial bank often has FX risk to hedge. I think FX/derivative trading is one way to hedge. Bank must allocate some capital to the trading desk. Regulators would approve such capital allocation as it’s needed to reduce systemic risk and strengthen stability.

Reason: a commercial bank often has large enterprise customers who need tailor-made financial solutions. (I feel many mainstream derivative products originated in big bank’s structuring desks addressing the needs of big corporates.) When the corporate enters a derivative contract with the bank, the bank must hedge its risk by trading suitable securities on the open market. Bank must allocate some capital to the trading desk.

Reason: many banks started trading using it’s own excess liquidity. Then they realize ROI is sweet, so they started borrowing from other banks purely for security trading. This is another source of trading capital.


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