Friday, March 18, 2016

Is Liquidity Suffering from Too Much Regulation?

Fed Cautiously Admits Regulation May be Having Negative Effects on Liquidity


Author: David Schwartz J.D. CPA

In a March 7, 2016 speech at the Institute of International Bankers Annual Washington Conference in Washington, DC, Federal Reserve Governor Lael Brainard remarked that new regulations may be having inadvertent effects on market liquidity. Governor Brainard’s statement is notable because Fed officials and regulators have been careful to avoid that inference.

 

While describing the state of market liquidity as well as Fed and other regulators’ activities on liquidity, Brainard noted “the role of regulation as a possible contributor” to the reduction of liquidity in the fixed income markets.  However, Governor Brainard’s remark should not be taken as an admission by Fed officials that higher capital requirements and new liquidity standards are the sole or even a main contributor to reduced market liquidity.  Last year, Fed President and Chief Executive Officer William C. Dudley dismissed the idea as unsupported by the facts, even disputing the assertion that market liquidity has diminished materially.

 

"Some opponents of tougher bank regulation claim that the increased regulatory requirements, such as the higher capital requirements and new liquidity standards, that have been imposed on large financial institutions in the aftermath of the financial crisis have reduced these firms' market-making capacity. . . This is a noteworthy assertion and would have significant implications for regulatory policy if it were correct.  However, . . . I don't think the hypothesis is well-supported by the available evidence."

 

"The evidence to date that liquidity has diminished markedly is, at best, mixed.  Even if one were to interpret the evidence as indicating that liquidity has been reduced, it is not clear whether regulation is the primary driver, as other changes have played important roles as well.  Even if higher capital and new liquidity requirements were found to result in greater transaction costs, these costs would need to be assessed against the benefits of having a more robust and resilient financial system and a reduced risk of financial crises in the future."

 

Brainard’s remark about “the role of regulation as a possible contributor” to the reduction of liquidity should be read in context, however.  Brainard also noted that “it is difficult to disentangle the effects on liquidity of changes in technology and market structure and changes in broker-dealer risk-management practices in the wake of the crisis on the one hand and enhanced regulation on the other. . . .While the leverage ratio and other Dodd-Frank Act requirements likely are encouraging broker-dealers to be more rigorous about risk management in allocating balance sheet capacity to certain trading activities, the growing presence of proprietary firms using algorithmic trading in many of these markets, which predated the crisis, is also influencing trading dynamics in important ways.”   Brainard urged her audience to keep in mind the purpose of liquidity regulations, noting that “it is important to recognize that this regulation was designed to reduce the concentration of liquidity risk on the balance sheets of the large, interconnected banking organizations that proved to be a major amplifier of financial instability at the height of the crisis.”

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