This past week German Policy regulators put a foothold on the degree on which banks are able to prop trade.
According the Associated Press, German officials headed by Finance Minister Wolfgang Schaeuble will require investment banks whose trading activities are over €100 Billion a year or 20% of their balance sheet, to separate those transactions from its commercial banking sector. In other words, this will disallow banks from using commercial banking funds to perform prop trading activity, as well as limiting the amount of risk they are able to take. The consequence of those that defy the latter regulations will be up to 5 years in prison.
Taking a step back, proprietary trading, also known as “Prop Trading”, is a type of investment done by banks where they use their own funds to purchase stocks and bonds with the hopes of selling them at a higher price and gain from the capital appreciation.
Why would German officials regulate Investment banks from performing these types of transactions?
From a real world point of view an example of prop trading would be the following:
A dealer of water wells brings a seller and a buyer together. From the transaction he pockets a percentage, just like an investment bank does in the assistance of buying and selling stocks and bonds. But sometimes a dealer might make the decision to stock on water wells instead of depending on a seller for a transaction to occur. That way the dealer pockets the whole transaction and not only a percentage of the deal. In other words he ceases to be a middleman and becomes the actual seller.
The higher risk this dealer will incur is that 1) there must be a demand for his water wells, and 2) the price for those water wells must increase. If the price for water wells drops and demand ceases to exist, then the dealer’s wells have lesser value than when he purchased them, he is left with a useless inventory, and most likely this will lead him to go out of business.
Now, when a dealer goes out of business it is not a big deal, but when that dealer is a bank then the effects could ripple throughout the economy putting the financial system in jeopardy.
Moving from a water well dealer to a bank like Wells Fargo, these banks are being regulated on the amount of stocks and bonds they are able to keep in inventory so the effects of a possible depreciation in prices and decrease in demand for their inventory of stocks and bonds will not have a devastating effect that would find governments bailing out banks using tax payer money.
By: Luis Alfonzo Chacin
