Do Banks Trade Stocks on Information from Their Loan Desks?

In a recently published paper that I coauthored with Professors Linda Allen and Lin Peng of Baruch College, we provide evidence that lead arrangers of syndicated loans that are also market makers for the borrower's stock reuse information obtained in one market to benefit in the other market.

Our findings are somewhat discomforting, given that there is less than full clarity regarding the legality of reusing information and whether ethical walls are being violated.

While our paper does not address the issue of legality, our findings that information is being reused should be of interest to regulators and policymakers. The Volcker rule does not end the reuse of information that we have identified, as this reuse of information does not involve proprietary trading. Indeed, it may be that only separation between commercial and investment banking, such as required by the repealed Glass-Steagall Act, would eradicate the reuse of information.  

Another implication of our paper is that the impact of "super-informed" participants, such as lead arrangers that are also equity market makers, will depend on market structure, as super-informed participants can either improve or hurt market liquidity.

The lead arranger of a syndicated loan is typically a bank whose relationship with the borrower began well before the syndicated loan originated. The lead arranger remains heavily involved during the life of the loan – this bank tends to hold a large stake in the loan, monitors payments, and syndicates pieces of the loan to others.

A bank that is a lead arranger of a syndicated loan has the opportunity to learn quite a bit about the borrower. This information is potentially reusable by the bank in other contexts.

One setting in which a bank can benefit from information is when it acts as an equity market maker. Market makers face significant information challenges. After all, they face potentially well-informed traders whose information advantages can be costly to counterparties. Market makers can therefore benefit tremendously from any type of information advantage.

For example, a syndicated loan borrower is typically required to satisfy various covenants, such as a maximum debt to earnings covenant or minimum net worth covenant. To ensure that these covenants are satisfied, the borrower discloses private information to the loan syndicate. This private information can give an equity market maker an information advantage.

So lead arrangers are well informed, and equity market makers are information-hungry. This suggests that when banks are both lead arrangers and market makers for the borrower's stock they have an incentive to reuse the information they obtain as lead arrangers to benefit themselves as equity market makers.

Indeed, banks also have an incentive to use information obtained as equity market makers to benefit themselves in the loan market. The natural question to ask is whether information is being reused across equity and loan markets.

Our paper provides evidence that lead arrangers that are also market makers for the borrower's stock do reuse information. This finding is unsurprising, given the value of information. Intriguingly, we also find that the reuse of information makes it easier to trade in equity markets and more difficult to trade in the loan market.

In other words, equity markets become more liquid but loan markets become less liquid when lead arrangers are also market makers.

We looked at 384 loans, 22% of which have lead arrangers that are also market makers for the borrower's stock. We measured the ease of trading on equity and loan markets by extracting the bid-ask spread, a key measure of liquidity, for both the equity and loan markets. We found that equity bid-ask spreads decreased by 35% and loan bid-ask spreads increased by 21% when lead arrangers are also equity market makers.

We performed extensive testing to make sure that our results are driven by the lead arranger's role as equity market maker and not by other factors such as borrower size, loan size, the borrower's probability of default, and many other factors for which we control.

So why do equity markets become more liquid and loan markets become less liquid when lead arrangers are also market makers? To understand this phenomenon one must recognize that the impact of a super-informed participant will depend on the structure of the market in which this participant is active.

In the more-competitive equity markets, lead arrangers that are also equity market makers use their information advantage to tighten spreads, as being super-informed gives them the confidence to bid higher and ask lower prices for shares than other market makers.

In the less-competitive loan markets, the presence of a super-informed participant leads to defensively higher spreads, as market makers in the secondary market for syndicated loans warily bid lower prices and ask higher prices in the presence of a super-informed participant.

Policymakers should consider these effects when setting rules that restrict the reuse of information.

Aron Gottesman is an Associate Professor of Finance at the Lubin School of Business at Pace University and can be reached at agottesman@pace.edu.