Researchers claim that post-crisis regulatory overhaul has created a liquidity crisis.
Financial regulators witnessed some of the world’s most actively traded markets fall into a steep slump earlier this year. Despite the reforms instituted in the wake of the 2008 crisis, global bond trading fell sharply and remained well below expectations. Many analysts attributed this to a liquidity crunch that has the potential to cause another downturn.
This month, the Global Financial Markets Association and the Institute of International Finance commissioned a report on the state of liquidity in global bond markets. The report, authored by PricewaterhouseCoopers (PWC), claims that the regulatory overhaul that occurred after the financial crisis has been the main contributor to the decline in bond market trading. The authors claim that many global financial regulations, including the Dodd-Frank Wall Street Reform and Consumer Protection Act, the European Market Infrastructure Regulation, and the Basel Accords, among other new financial standards, threaten the future of international trading markets. The report’s authors urge regulators to perform a comprehensive review before any further regulations are implemented.
The authors identify five ways regulatory reforms have allegedly reduced liquidity—that is, the ability to make transactions with limited external costs and low price impact. According to the report, banks responded to the overhaul by seeking to make more efficient use of their capital by reducing the markets they serve and streamlining their operations. Consequently, banks raised the amount of capital they kept in reserve and issued fewer loans.
The authors claim also that the onslaught of post-crisis regulations diminished market-making activity (the process by which many people trade securities and manage risk in bond markets) across the globe by raising both the cost of capital and the cost of financing businesses.
Regulations are responsible, the authors argue, for a large shift in general trading patterns away from a platform that institutional investors and corporations traditionally use. These trades—commonly referred to as over-the-counter trades, because they do not depend on public exchanges—have shifted towards centralized clearing and electronic trading platforms. This shift, according to the report, has made liquidity harder to access for borrowers who do not use public exchanges as readily.
The report goes on to claim that regulations have reduced liquidity in short-term loan markets (known as repo markets). Regulations have also created an environment that artificially inflated the value of liquid assets themselves, leading to hoarding and increased demand, according to the report.
Liquidity is necessary for a functioning market because it facilitates the efficient distribution and allocation of resources, capital, and risk throughout the economy. When liquidity begins to dry up, capital becomes more expensive, the cost of executing business transactions rises, and the task of identifying value in the economy becomes more difficult for all. Prolonged periods of low liquidity can be especially problematic by leading to large sell-offs, a run on a bank, or a general unwillingness to engage in trading at all.
The authors of the PWC report call for a broad evaluation of the international financial regulatory framework and identify some considerations for review. They recommend improved market data collection, targeted in part at how regulations affect individual asset classes. They believe that all new regulatory rules should be designed to strike a balance between creating banking sector stability and maintaining liquidity in financial markets. Finally, they recommend a review designed to ensure internal consistency within the body of regulation that covers different rule areas and to confirm that international standards are uniform.
The Global Financial Markets Association and the Institute of International Finance, which commissioned the report, provide analysis and guidance on global market issues, including emerging markets, international banking, and global finance. They are among the many organizations that have attempted to provide standards and guidance this year to combat the slump in bond trading.
Last summer, the Financial Industry Regulatory Authority (Finra) called on a group of bank executives and asset managers to explore solutions to the liquidity crunch. The Basel Committee on Banking Supervision also finalized new criteria recently for “identifying simple, transparent, and comparable” securitizations to support investor confidence and boost trading activity.
Financial regulators often seek to find a balance between bank stability and market activity. As liquidity dries up, borrowers are forced to turn to alternative market-based finance providers that can pose higher risks. The PWC report warns that although global monetary policy has provided support for liquidity, regulators should be aware of “early warning signals” as governments roll back quantitative easing and begin to raise interest rates, which may lead to further economic downturns.
