Post-crisis increases in the capital requirements of large bank-affiliated dealers have reduced the liquidity of financial markets. The Volcker Rule may also have contributed to a loss of market liquidity. The benefits of a safer financial system associated with higher capital requirements easily exceed the corresponding cost in market liquidity. Nevertheless, a better understanding of the effect of capital requirements could promote some improvements in practice and regulation. In this article, I review some of the evidence on changes in market liquidity and argue that one particular regulation, the leverage-ratio rule,2 has inefficiently distorted dealer incentives for market making and that its financial-stability benefits could be achieved more effectively with risk-weighted capital requirements.
Historically, large dealer banks have been robust providers of liquidity to investors, especially for block positions and for assets traded in over-the-counter (OTC) markets. Before the financial crisis, they maintained large market-making inventories that served the needs of investors seeking quick access to specific assets. Dealers were also ready to quickly make additional space on their balance sheets for clients who wished to liquidate their asset positions. Capital requirements, however, were too low. By absorbing so much risk relative to their capital, most major dealers were a menace to financial stability. When some of the largest U.S. dealers failed or had to be bailed out in 2008, legislators and regulators resolved to restore financial stability with significant increases in capital and liquidity requirements. These new rules reduced the socially inefficient incentives of large dealers, caused principally by being “too big to fail.”
The adverse effects on the liquidity of OTC markets caused by capital regulations and the Volcker Rule are partly offset by regulations that have improved OTC market competition.
Despite significant improvements in capitalization, the credit spreads that dealers now pay are much higher than their pre-crisis levels. The creditors of major dealers are now acutely aware that they will be forced to take significant losses when the dealer approaches insolvency, especially through targeted “bail-ins” at its administrative failure resolution.3 This has further reduced the incentives of dealers to build large balance sheets, because debt financing is more costly. Indeed, the market-making securities inventories of bank-affiliated dealers have dropped precipitously.
As another example of balance-sheet pressure, dealers recently began to charge their swap books with “funding value adjustments” that discourage dealer swap desks from entering positions that require significant financing of collateral or up-front payments.4 Dealers have also dramatically increased their use of financial-engineering methods, such as swap compression trading, that economize on the amount of balance sheet space needed to intermediate a given amount of swap trades. To further reduce their balance sheets, dealers have “fired” large numbers of their less-profitable prime-brokerage clients.
Nevertheless, bid-ask spreads have not become wider in all OTC markets. In the corporate bond market, bid-ask spreads have actually narrowed, even relative to their pre-crisis levels, according to numerous sources.5,6,7,8 On the other hand, these same studies show that dealers are not absorbing large block trades as readily and that corporate bond turnover has declined. Helwege and Wang (2016) show that issuers of “mega-bonds” have responded by reducing the sizes of their largest issues.9
When intermediating corporate bond trade requests, research shows10,11 that dealers are now more likely to offer “agency” or “riskless-principal” trades, which delay the execution of a client’s request to sell until the dealer can find a matching buyer.12 Again, this reduces the amount of balance sheet space required to handle a given amount of trades. In effect, dealers are relying more on inventory held on their clients’ balance sheets, and less on inventory that they hold themselves. Various empirical studies have also shown that market returns have become more sensitive to dealer capitalization and to the sizes of dealer market-making inventories.13 Some of these effects are probably not reactions to the Volcker Rule, which is less concerned with balance-sheet space than trading motives. As I have explained,14 the main impediment to liquidity associated with the Volcker Rule is the difficulty of separating legitimately exempted market making from speculative trading that isn’t intended to market markets. Nevertheless, empirical analysis suggests that the Volcker Rule has also reduced the liquidity of the U.S. corporate bond market.15
Effects on Market Liquidity
There has been some confusion about whether or why capital requirements should matter for market liquidity. If capital requirements do matter, would that be a violation of the Modigliani-Miller (MM) Theorem? The most relevant part of the MM Theorem states that the total market value of a firm’s assets does not depend on the firm’s capital structure. Even under its own assumptions, however, MM doesn’t speak to the incentives of a firm to add new positions to its balance sheet. Whenever a dealer adds a new market-making position, even at zero trading profit, the market value of the dealer’s equity can be affected by a change in the riskiness of the dealer’s balance sheet.
For example, adding a sufficiently risky position, even before considering any trading profit, can benefit a dealer’s shareholders at the expense of its creditors, because the limited liability of shareholders allows them to walk away from insolvency at no cost. This leaves creditors with a weaker claim. Jensen and Meckling (1976)16 used the term “asset substitution” to describe this method of exploiting the divergent interests of creditors and shareholders. Even if no single trade has a big impact, the incremental effects can add up subtly over time. Capital requirements reduce or block asset-substitution incentives.
Volumes of trade in Treasury repos have dropped precipitously, especially in the interdealer repo market.
Higher capital requirements also alter an important incentive known as “debt overhang.” Debt overhang implies that a trade with a positive mark-to-market dealer profit can sometimes imply a negative return for the dealer’s equity.17 If the trade requires enough new capital relative to the risk of the new position, it may improve the credit quality of the dealer’s debt and correspondingly reduce the equity market value associated with limited liability. An example of this is a pair of back-to-back swaps, fully hedging each other, but requiring the dealer to make a net positive up-front payment or post an additional amount of collateral.
For instance, a buy-side investor may enter a swap with a dealer that the dealer hedges in the interdealer market. Buy-side firms frequently post no collateral with the dealer, but the dealer is required to post collateral for the interdealer swap, whether to a central counterparty or (as required in the U.S. from late 2016, and in Europe beginning at some time in 2017) to another dealer. Financing additional collateral causes a dealer’s creditors to benefit from improved backing, at the expense of the dealer’s legacy shareholders.18 Even if, as is common in practice, the required up-front payment or collateral is funded with unsecured debt, the effective cost to the dealer’s shareholders is significant and equal to an amount known in industry practice as the funding value adjustment. The dealer should enter into such a trade only when it compensates its shareholders with a sufficiently large trading profit, obtained by widening its bid-offer spread. An analogous “capital value adjustment” is required to compensate shareholders for using up some of the dealer’s headroom (available slack) under its regulatory capital requirement. Market-making capital requirements have increased significantly with the Basel19 III “fundamental review of the trading book.”
The leverage-ratio rule is a parallel system of Basel-based capital requirements that are not sensitive to the riskiness of a bank’s assets. Under the U.S. supplementary leverage-ratio rule, for example, the largest U.S. broker dealers are subject to a 5% leverage ratio. This means that for every $100 million of additional assets, a dealer is required to have an additional $5 million of capital, regardless of the riskiness of the assets. Under this rule, for example, intermediating U.S. Treasury repos requires a lot of capital relative to the tiny risks involved, and thus improves the position of the dealer’s unsecured legacy creditors. So, with the imposition of the leverage-ratio rule, dealers should increase their bid-ask spreads on repo intermediation enough to overcome the debt-overhang cost to their shareholders. That is exactly what they have been doing. Since the imposition of the supplementary leverage ratio rule, bid-ask spreads in the U.S. Treasury repo market have increased from around 3 basis points to over 16 basis points (see Figure 1). As a consequence, volumes of trade in Treasury repos have dropped precipitously, especially in the interdealer repo market.20