The Board of Governors of the Federal Reserve System staff members and a Cornell University finance professor examined the impact of the Volcker Rule on corporate bond illiquidity and dealer behavior during times of market stress. In a recent working paper, the authors concluded that the rule creates a less liquid market for corporate bonds because the dealers that are covered by it become "less willing" to offer liquidity during such times.

The economists focused on the downgrading of investment-grade corporate bonds due to the increased risk of "forced selling." They reported that:

  • when compared to a control group of BB-rated bonds, downgraded bonds exhibited a "larger price impact of trading";
  • the larger price impact grew after the implementation of the Volcker Rule;
  • bond market illiquidity during "stress periods is now approaching levels see[n] during the financial crisis"; and
  • dealers covered by the Volcker Rule have decreased their involvement in dealer-customer trades and are "less willing to commit capital."

The authors concluded that the effect of the rule on dealers has been pronounced:

Overall, our results show that the Volcker Rule has had a real effect on dealer behavior, with significant effects only on those dealers affected by the Volcker Rule and not all bond dealers.

The working paper is an academic study drafted as part of the Finance and Economics Discussion Series, Division of Research & Statistics and Monetary Affairs of the Federal Reserve Board in Washington.

Commentary / Steven Lofchie

The consensus among both buy- and sell-side market participants is that there has been a decline in liquidity. One would expect liquidity to decline as a result of the Volcker Rule for a number of reasons. For one thing, it is difficult for a bank to demonstrate to regulators that its trading activities are permissible market-making and not impermissible proprietary trading. As a result, banking organizations are likelier to withdraw from the market than to risk regulatory repercussions. It would be surprising if the Volcker Rule did not diminish liquidity.

For the past several years, banking regulators refused to acknowledge the likelihood of the Volcker Rule's negative effect on liquidity. To bolster their refusal, regulators have reiterated that the bid-ask spread in highly rated bonds has stayed the same or declined, even as they pointedly ignored the fact that the size of trades has decreased and disregarded the impact of diminished liquidity on bonds that are less highly rated. (See FDIC Chair Gruenberg Asserts That Post-Crisis Reforms Strengthen the Financial System.)

As the authors of the paper observed, the fact that the Volcker Rule resulted in diminished liquidity does not mean that the Volcker Rule is a failure, per se, or that its consequences are negative overall. What it does mean is that the rule has demonstrably and materially negative consequences. The important question is this: do the benefits of the Volcker Rule outweigh its disadvantages?

Unfortunately, that question is not answered by this study, nor has it been debated by the regulators. Those who have an interest in defending the rule cannot be trusted to address the issue fairly and have refused to admit any downside thus far. (Compare, e.g., Comptroller Curry Asserts That Post-Crisis Financial System Is Stronger and Regulators Examine Current Developments in U.S. Treasury Markets (with Delta Strategy Group Summary) with CFTC Commissioner Giancarlo Calls for "Clear-Eyed Attention" to Market Challenges.)

The failure of regulators to concede potential issues with various rulemaking decisions would be problematic enough if it were confined to the Volcker Rule. Sadly, it is not. That same failure derails regulators' discussions of mandatory central clearing. What could make the problem even worse is the possibility that the downsides of the new rules may compound each other; i.e., both the Volcker Rule and mandatory central clearing requirements have material negative effects on liquidity (albeit for different reasons: Volcker, because it discourages market-making; central clearing, because it drains cash and liquid assets from the system, as Houston University Finance Professor Craig Pirrong argues in a recent Streetwise Professor  blog entry), thus making the markets far more prone to share downward breaks.

This is not to say that the new rules are all bad; it is to say that they may be bad in toto or in part, and that their negative consequences must be acknowledged.

May the new year allow these issues to be seen with new eyes.

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