Regulation and Market Liquidity

The aftermath of the 2008-09 financial crisis witnessed one of the most active periods of regulatory intervention in U.S. financial history since the New Deal. Since then, considerable doubts have been raised on the negative welfare consequences of some of these regulations. One of the most controversial issue was bond market liquidity. Many expressed concerns that market liquidity in fixed-income markets had deteriorated because financial regulations such as the Volcker Rule and the Basel III banking regulation constrained banks’ ability to provide liquidity. In “Regulation and Market Liquidity, Management Science (May, 2019)”, Francesco Trebbi and Kairong Xiao empirically investigate this claim.

To answer this question, a common challenge faced by researchers is the unknown timing of regulatory impact. As vividly shown in their paper, post-crisis financial regulation was (and typically is) characterized by protracted rulemaking processes and complicated anticipatory responses or lagging reactions by sophisticated market participants. For instance, the Volcker Rule took almost four years to finalize through notice-and-comment rulemaking, with the deadline for a final rule being postponed several times and thousands of public comments presented to regulators. During the four years of regulatory process and before the rule finalization, different banks wound down their proprietary trading desks at different times. Conventional micro-econometric methods, which compare liquidity before and after a treatment date, are difficult to apply in this setting because it is unclear when regulation should have effects. The result of these methods could be sensitive to the assumption of the time around which the comparison is conducted and other arbitrary conditions necessary for identification (e.g. the selection of an appropriate control sample).

To address this challenge, the authors employ state-of-the-art time series econometric approaches based on large factor models to identify structural breaks in market liquidity and liquidity shortage. The most flexible of these empirical approaches do not require researchers to know the exact timing of regulatory impact and instead let the data to speak for themselves. The methodologies presented in the article are also able to detect sudden drops and changes in slow-moving trends of liquidity. The authors also prove that the tests have good statistical power in this application.

Against the popular claim that post-crisis regulation hurt liquidity, the authors find no systematic evidence of liquidity deterioration during periods of regulatory intervention across nineteen standard measures of market liquidity. Instead, breaks toward higher liquidity are often detected. These results qualify frequent informal discussion on the lack of evidence of large deterioration in market liquidity provision, a view shared by a growing group of market participants and policy makers. They are also relevant to the rigorous assessment of the welfare consequences of the Dodd–Frank Act and Basel III in terms of hindering the market-making capacity of large financial institutions, one of the main welfare costs observers ascribed to the recent regulatory surge.

Finally, the authors suggest one possible explanation for the resilient liquidity of corporate bonds: the entry of nonbank liquidity providers, such as mutual funds and ETFs. Because post-crisis regulations reduced the funding advantage of banks, nonbank entities found it profitable to enter the market. As more players compete to provide liquidity, the price of intermediacy may have gone down as a result. This shift in the structure of corporate bond markets appears to be still undergoing.

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Trebbi F and Xiao K (2019). Regulation and Market Liquidity. Management Science 65(5):1949–1968.