Two U.S. regulators said that tougher rules to strengthen the nation’s financial system had not impaired the functioning of the bond market, and even if liquidity may have been affected for some types of securities, this was balanced by the benefit of safer banks.
“Some reduction in market liquidity is a cost worth paying in helping to make the overall financial system significantly safer,” Federal Reserve Governor Jerome Powell told subcommittees of the Senate Banking Committee on Thursday during an appearance with U.S. Treasury Counselor Antonio Weiss.
Bankers have blamed the post-crisis Dodd-Frank financial reforms of 2010 for contributing to sudden bouts of bond market volatility by raising the regulatory costs of doing business, which they say have made the markets less liquid.
Liquidity in financial markets refers in part to the ease with which investors can buy and sell securities without substantially moving prices. Some bankers, including JPMorgan & Co.’s Chief Executive Officer Jamie Dimon, have warned that the next financial crisis could be exacerbated by a shortage of U.S. Treasuries.
Powell said regulation aimed at making banks safer imposed since the financial crisis of 2008-09, and greater risk-aversion by banks involved in market-making, may both have contributed to lower liquidity in bond markets, particularly the market for U.S. Treasury securities.
However, it’s important “not to overemphasize any effects of regulation,” Powell said. “Banks have independently re-calibrated their own approaches to risk and scaled back their market-making activities. Dealers significantly reduced their fixed-income portfolios beginning in 2009, well ahead of most post-crisis changes in regulation.”
Research from the New York Fed in October found that sudden spikes of illiquidity have increased in the U.S. Treasury market, making it more challenging for investors trading government securities during times of stress.
“It may be that liquidity has deteriorated only in certain market segments,” Powell said Thursday. “It may also be that, even if liquidity is adequate in normal conditions, it has become more fragile, or prone to disappearing under stress.”
At the same hearing, Weiss said that while the primary bond market was functioning “exceptionally well” since the financial crisis, episodes of volatility mean the government needs to watch to see whether or not they’re isolated incidents.
“Financial reform has strengthened the core of our financial system, increasing confidence in volatile times,” he said. “But inevitably the tests will become more difficult, and neither market participants nor policy makers can afford to become complacent.”
— Check out A ‘Big Short’ Lesson About Bond Liquidity on ThinkAdvisor.