Regulators Note Disappearance of Liquidity in Markets

In a blog post titled “Regulators, Finally Getting a Clue,” University of Houston finance professor Craig Pirrong discussed the disappearance of liquidity in the bond and stock markets. 

According to Mr. Pirrong, global regulators are “concerned, and apparently mystified,” by this phenomenon and worry “that banks are scaling back costly market making functions” that could leave investors stranded. Mr. Pirrong quotes IOSCO Secretary General David Wright as saying that there has been a “Houdini” disappearance of market makers in general and that “it’s partly caused by some regulation.” 

According to Mr. Pirrong, between the impending Volcker Rule and more stringent capital rules and limitations on off-exchange dealing in stocks, regulators have increased restrictions on market-making activities. It is therefore obvious, he said, that liquidity would dry up. Additionally, Mr. Pirrong stated that regulators are “finally coming to recognize the unintended consequences of their actions”; by attempting to make the system less risky, they have created new risks.

Lofchie Comment:  As Professor Pirrong suggests, the negative consequences from the new capital rules were and should have been obvious. Indeed, note my commentary (below) from August 13 regarding a speech given by the President of the Federal Reserve Bank of Boston Eric S. Rosengren.  Simply put, regulators should not be surprised when burdensome rules imposed on the financial industry flow through to the “real economy.”

August 13 Excerpt: 

Mr. Rosengren states that an increase in capital requirements would result in a reduction of the profitability of broker-dealers (or bank holding companies). He does not make explicit the consequences of that. Any reduction in profitability (meaning any increase in expenses) will inevitably reduce the level of activity and increase the cost that others (such as market participants) must pay to justify the expense of the activity. If Mr. Rosengren’s concern is that broker-dealers are not reliable providers of liquidity to the credit markets, then it is hard to see how increasing their capital requirements improves liquidity in those markets. Rather, his proposal should result in a material reduction of liquidity in the credit markets, which (in theory) should result in a material increase in corporate borrowing costs. . . .

Higher capital charges advocated by Mr. Rosengren are already coming into effect, which will have the (negative) consequence of reducing liquidity in the credit markets. Recent reports demonstrate that broker-dealers are beginning to withdraw significant amounts of money from the lending markets as a result of the more punitive capital regulations imposed by the bank regulators (who have authority over the capital held by the holding companies that own the broker-dealers).

See: Regulators, Finally Getting a Clue” by Craig Pirrong.