Tuesday, January 3, 2017

Fed Finds Serious Liquidity Flaw in the Volcker Rule

Industry experts and regulators have debated for some time now about the effects regulation may or may not be having on liquidity. Critics of tough new bank regulations claim that the increased regulatory requirements, such as the higher capital requirements and new liquidity standards have reduced liquidity and banks' market-making capacity. Regulators, on the other hand, have been skeptical and have called for evidence showing regulations negatively affecting liquidity. In a study published on December 22, 2106, the Fed itself has produced just such evidence.[1]  


Authors Jack Bao and Xing (Alex) Zhou of the Federal Reserve Board in collaboration with Maureen O’Hara of the Johnson Graduate School of Management at Cornell University focused their study specifically on the implementation of the Volcker Rule and its effect on bond market liquidity, particularly in times of market stress. Their striking conclusion will only add to the list of unanticipated adverse consequences arising from the rush to regulate banks after the financial crisis: 


"Our main finding is that the Volcker Rule has a deleterious effect on corporate bond liquidity and dealers subject to the Rule become less willing to provide liquidity during stress times. While dealers not affected by the Volcker Rule have stepped in to provide liquidity, we find that the net effect is a less liquid corporate bond market.”


What separates this study from others, is that the researchers were able to isolate the negative effect of the Volcker Rule from the noise of so many other variables affecting liquidity: "We also rule out that the effects are due to the implementation of Basel III in conjunction with CCAR requirements.”   They achieved this by focusing particularly on the implementation period as compared to the period just before implementation and also by splitting dealers by their exposure to Basel III.  That Bao, Zhou, and O’Hara were able to hold the implementation of the Volcker Rule as their primary variable, while controlling for others, makes the results of this study even more important as lawmakers consider whether to revise, rewrite, or repeal the Volcker Rule altogether. 


[1] Bao, Jack, Maureen O’Hara, and Alex Zhou (2016). “The Volcker Rule and Market-Making in Times of Stress,” Finance and Economics Discussion Series 2016-102. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2016.102.

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