Regulators are now considering revisions to the Volcker Rule after more than four years of experience post-implementation.
Some commentators have reasoned that there is no evidence the Volcker Rule has affected “market liquidity” and, as a result, there is no pressing need to revisit the rule. There are three good reasons to disagree with this view:
1.) Financial markets – and corporate debt markets in particular – have undergone significant structural changes since the financial crisis;
2.) There is mounting evidence that regulation – and the Volcker Rule in particular – is impairing corporate bond liquidity; and
3.) Regardless of the effect of the Volcker Rule on market liquidity, the rule is cumbersome and complex. Regulators can make it more efficient and less burdensome while staying faithful to the statutory requirement to ban banks from engaging in proprietary trading and limiting the unintended consequences on traditional banking activities that encourage capital formation and growth.
As a result, revising certain aspects of the Volcker Rule could reduce the unnecessary burdens and costs associated with implementing and complying with the rule. In addition, in light of the findings of recent research, revising the Volcker Rule could also improve market liquidity. Improved liquidity would benefit households and businesses that rely on banks to facilitate their needs to adjust their investment portfolios at reasonable cost so that more of their investments can be used to fund the things they care about.
Financial markets – and corporate debt markets in particular – have undergone significant structural changes since the financial crisis.
Who are the owners of corporate bonds and how do they acquire them? Corporate bonds are owned by investment funds, households, and businesses for savings and investment purposes. These end users rely on market intermediaries or “dealers” to buy and sell these securities. To facilitate customer buy-and-sell orders, dealers hold an inventory of corporate bonds in much the same way that auto dealers hold an inventory of cars for sale. When customers buy cars, some leave the lot; when customers sell cars—say, as a trade-in—cars enter the lot. A dealer, any dealer, has to manage inventory to facilitate customer demands.
Dealer bond inventories fell considerably during the financial crisis and have never recovered, while bond holdings of investment funds have risen markedly during the same time period, as shown in Figure 1. Smaller dealer inventories mean that dealers may be less willing and able to accept increases in inventory to facilitate customer trades. Moreover, the relative growth in corporate bond holdings by investment funds suggests that dealers could be even more challenged to accommodate a significant increase in trading demands by these funds were that to occur.
This significant change in market structure has occurred during an economic expansion with strong financial markets. It remains unclear whether dealers will be able to accommodate significant buy-and- sell orders from corporate bond investors in the event of a future spike in demand for trading that could occur during a period of economic weakness. In the context of the previous car dealer analogy, it is as if car dealers have had the size of their lot reduced—say to comply with a new zoning law—which would limit their ability to serve customers in the event that there is a significant increase in the demand to buy-and-sell cars. While it is impossible to know for sure what the future will bring, what is certain is that the structure of the bond market has changed in important ways that should be recognized and carefully considered.
There is mounting evidence that regulation – and the Volcker Rule in particular – is impairing corporate bond liquidity.
The term “liquidity” generally refers to the ease and cost at which investors can engage in buy and sell transactions. A market is more liquid if it is easier and less costly to trade. Markets with lower trading costs benefit investors because fewer resources are spent in the process of establishing and adjusting an investment portfolio. These lower transactions costs are analogous to lower fees on mutual funds. Lower fees and costs mean investors keep more of their own money, which they can then use to serve their investment needs such as funding retirements.
Corporate bond liquidity is difficult to measure precisely given the number of economic factors that affect these transactions, but a stream of recent research suggests that bond market liquidity has deteriorated since the financial crisis and the onset of heightened financial regulation. Specifically, Anderson and Stulz (2017) find that liquidity is worse post-crisis when market volatility is high. Bao et. al. (2016) argue that bond liquidity during periods of stress has worsened post-crisis as a result of the Volcker Rule. Importantly, these findings suggest that market liquidity is most affected at those times when market liquidity is most valuable: during periods of financial stress when trading demand spikes.
Research also suggests that dealers are less willing to take and hold corporate bond inventory from customers post-crisis. Figure 2 shows the decline in overnight dealer inventory as measured by Bessembinder et al. (2017). The figure shows a measure of dealer inventory held overnight by dealers as a result of customer trades. This inventory is a measure of how much customer demand a dealer is willing to absorb to facilitate customer trades. Dealers that are willing to hold larger inventories can facilitate more trades for their customers. The figure clearly shows that dealers held greater inventories to facilitate customer trades before the crisis and that dealer inventories have steadily declined. As these inventories decline, dealers are likely to be more challenged to facilitate buy-and-sell orders, which ultimately makes it more difficult for customers to adjust their investment portfolios as desired.
Moreover, the authors make two points about the decline in dealer inventories supporting the view that bank regulation is affecting dealer inventory behavior and market liquidity. First, they show that the identified decline in inventory is concentrated among bank-affiliated dealers, which suggests that heightened bank regulation – such as the Volcker Rule – is playing a role and that the deterioration is not just a result of broader market-wide changes. Second, they show that these declines are often largest during the “Volcker period,” which they date as April 2014-October 2016 (the end of their sample). These findings suggest that regulation – and the Volcker Rule in particular – is contributing to the decline in market liquidity.
Finally, other researchers such as Choi and Huh (2017) and Schultz (2017) also find evidence of deteriorating market liquidity, either in terms of increased costs of trading – especially when customers want to sell quickly and demand liquidity – or reduced dealer capacity to take bonds into inventory to facilitate customer trades. Moreover, all of the research papers described here suggest that certain aspects of the Volcker Rule – such as detailed metrics reporting – may be a cause for their findings.
Has the Volcker Rule really affected market liquidity and does that really matter for whether the Volcker Rule should be revised?
While the data do not provide exact clarity as to the causes of reduced liquidity, it is fair to presume that the new regulatory architecture is a contributing factor. Whether the Volcker Rule has a clear and discernible impact on market liquidity will always be shrouded in some degree of uncertainty because markets are complex and the world is ever-changing. At the same time, it is the case that some recent research finds that corporate bond liquidity has deteriorated and that this deterioration may be due to the effect of the Volcker Rule and other regulations.
This observed decline in market liquidity should not be considered a narrow “dealer problem.” Rather, it is important to understand that dealers provide liquidity in order to facilitate customer demands. Ultimately, policies that impair market liquidity increase costs and reduce services for households and businesses that rely on dealers to provide them with access to capital markets.
At the same time, however, we do not need to agree that the Volcker Rule is affecting market liquidity to agree that it should be revised. While measuring market liquidity is difficult, measuring the costs of implementing and complying with the Volcker Rule is a good deal easier. The past few years of experience with the rule strongly suggest that it is overly complex, vague, and interpreted differently by different regulators. Uncertainty about how the rule will be implemented and enforced creates an environment in which dealers may be unwilling to facilitate customer demands. A clearer and more transparent rule that supports customer facilitation would make it easier for dealers to assume inventory risk on behalf of their clients.
A number of commenters, including the U.S. Treasury Department, have proposed commonsense suggestions to revise the Volcker Rule that would reduce the costs of compliance without sacrificing the statutory mandate to ban proprietary trading. A regulation – any regulation – that is inefficient and unnecessarily costly can and should be improved regardless of its market impact. This is simply a matter of good government and is a laudable goal in its own right.
 The Volcker Rule was finalized in December 2013 by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Commodity Futures Trading Commission, and the Securities and Exchange Commission.