Study Volcker Rule has negative impact on bond liquidity during market stress


January 04, 2017

In their working paper, titled "The Volcker Rule and Market-Making in Times of Stress," two Federal Reserve staff members and a Cornell University finance professor report the key findings of their study on the Volcker Rule’s impact on the liquidity of corporate bonds and dealer behavior. The working paper’s main finding is that the Volcker Rule has a "deleterious effect on corporate bond liquidity" because dealers subject to the Rule "become less willing to provide liquidity" during times of stress.

The working paper (2016-102) for the Finance and Economic Discussion Series conducted by the Divisions of Research & Statistics and Monetary Affairs of the Federal Reserve Board in Washington, D.C., was authored by Fed staff members Jack Bao and Alex Zhou and by Maureen O’Hara of the Johnson Graduate School of Management at Cornell University.

Findings, conclusions. For their study, the authors focused on "events where investment-grade bonds are downgraded to speculative grade to capture plausible events of forced selling."

Generally, the authors found that dealers regulated by the Volker Rule "have decreased their market-making activities while non-Volcker-affected dealers have stepped in to provide some additional liquidity." Moreover, "even Volcker-affected dealers that are not constrained by Basel III and CCAR regulations change their behavior, inconsistent with the effects being driven by these other regulations," the authors determined. The paper concludes that because "Volcker-affected dealers have been the main liquidity providers," the net effect is that corporate bonds "are less liquid during times of stress due to the Volcker Rule."

Center for Financial Stability. Commenting on the working paper in his Jan. 4, 2017, post for the Center for Financial Stability, Steven Lofchie states, "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."

Companies: Center for Financial Stability

MainStory: TopStory FederalReserveSystem FinancialStability SecuritiesDerivatives VolckerRule

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