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Fed’s Dudley: Don’t Panic (Yet) About Market Liquidity

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There is some argument that the regulatory onslaught since the financial crisis has negatively affected market liquidity, causing higher liquidity costs and more illiquidity events.

Because of this, some commentators even say the regulatory burden should be rolled back.

Bill Dudley, president and CEO of the Federal Reserve Bank of New York, spoke to these concerns at a liquidity forum hosted by the Securities Industry and Financial Markets Association on Wednesday.

“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,” he said to the crowd gathered in New York.

In the aftermath of the financial crisis, new regulations – such as the Basel III bank capital framework and the Dodd-Frank Act – were implemented to strengthen the financial system and to limit the risk of a future financial crisis.

“As a result, so the argument goes, this is leading to less liquidity for trading securities, and to more illiquidity events in which the prices of financial assets move sharply and become temporarily unmoored from their fundamental valuations,” Dudley said. “The contention is that higher liquidity costs and more frequent illiquidity events will, over time, drive up the borrowing costs of households, businesses and the U.S. government; and that this is a substantial, largely unintended cost imposed by tougher regulation.”

Dudley isn’t necessarily in favor of a regulatory rollback. Rather, he calls for more research and data to determine exactly what kind of impact regulation has on market liquidity.

“We certainly don’t want to undermine the progress we have made in making the financial system more robust and resilient.  But if there are adjustments to regulation that could improve liquidity provision without increasing financial stability risks, we should be open to considering such changes,” he said. “I suspect, however, making this determination will require considerably more data, research and reflection before we reach any definitive conclusions.”

The problem with some of the recent data, according to Dudley, is it may not show the clearest picture on how regulation affects market liquidity.

“It is important to note that the [Federal Open Market Committee]‘s unconventional monetary policy may have affected recent measures of liquidity in ways that could make it more difficult to clearly discern any potential changes,” Dudley said. “To the extent that this may be the case, then a clearer picture on liquidity conditions may only emerge as monetary policy is normalized.”

During the forum, Ken Bentsen, president and CEO of SIFMA, noted a recent PwC analysis that looks at the state of market liquidity.

(SIFMA’s global affiliate, the Global Financial Markets Association, partnered with the Institute for International Finance to commission an independent PwC analysis on the state of market liquidity.)

The analysis, Bensten said, found that a combination of several factors – including banks reducing risk following the introduction of new regulatory frameworks – have contributed to a measurable reduction in financial market liquidity across various asset classes.

According to the PwC report, bank holdings of tradable assets have decreased by more than 40% between 2008 and 2015, and in the U.S., dealer inventory of corporate bonds has declined by almost 60% over the same period.

“The report does not call for a rollback of current regulation,” Bentsen said. “Rather, the key takeaway is that it would be helpful for policymakers to engage in greater study of how reforms to date are cumulatively impacting liquidity and consider that as they finalize initiatives such as the Fundamental Review of the Trading Book, [the EU's amended Markets in Financial Instruments Directive], [the net stable funding ratio] and [total loss-absorbing capactiy] to ensure they are properly calibrated and not counterproductive.”

— Check out Are We on the Verge of a Liquidity Crisis? on ThinkAdvisor.