As we reported in our January 3, 2017 post, a Fed staff report published in December 2016 found that the Volcker Rule was harming bond liquidity. Not a month later, a new Fed staff working paper[1] published this week found that regulations limiting banks’ balance sheets like the Supplementary Leverage Ratio have made repurchase agreements (repos) more expensive for dealers, and this in turn has had negative affects on on liquidity in the cash Treasury market. The authors note that it is well known that repos are widely used in cash market intermediation, especially for shorting. But, until now, it has not been clear how limiting dealer leverage would translate into lower liquidity. By modeling how dealers use repo to intermediate in the cash market, the authors, Yesol Huh and Sebastian Infante, have identified the direct linkage between repo markets and cash market liquidity.[2]
The repo market mobilizes cheaper and more abundant funding for financial intermediaries. However, the model dealers use involves engaging in various repos and reverse repos, which can substantially increase the size of a dealer’s balance sheet. New and higher regulatory restrictions on the amount of leverage a large bank holding company (BHC) can take limits dealers’ balance sheet size. As a result, financial institutions are finding it necessary to manage their balance sheet more closely and more aggressively. The authors model how this balance sheet “squeeze” reduces dealers’ incentives to intermediate large trades, and cap the number of client orders they fill, thus limiting market depth and harming liquidity.
Agressive balance sheet management may have been responsible for driving JP Morgan from the tri-party repo market leaving Bank of New York Mellon on its own in the tri-party settlement space. Other institutions have scaled back their repo significantly in order to manage their leverage. Repo is a strong driver of liquidity associated with government securities because it allows fast and efficient financing and short covering. And it is well known that trading volumes in bond markets are closely related to the outstanding amount of repos. By providing the linkage between repo markets and market liquidity, this new Fed working paper adds valuable support for the notion that regulation is driving down liquidity, and consequently potentially making markets more vulnerable to the next shock.
[1] Fed staff working papers Finance and Economics Discussion Series (FEDS) are not official pronouncements of the Board of Governors of the Federal Reserve Board. Rather, they are preliminary materials circulated to stimulate discussion and critical comment.
[2] Huh, Yesol, and Sebastian Infante (2017). “Bond Market Intermediation and the Role of Repo,” Finance and Economic Discussion Series 2017-003. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2017.003