WASHINGTON — New York Federal Reserve Bank President William Dudley became one of the first regulators to explicitly acknowledge the possible link between new regulations and liquidity problems in the market.
Speaking before a financial markets conference sponsored by the Atlanta Fed in Fernandina Beach, Fla., Sunday evening, Dudley said that traditional metrics of liquidity may not suggest problems, but those metrics also do not tell the entire story of what is happening in those markets.
Broader trends — such as the reduced profitability and inventories of securities dealers — have likely weighed down liquidity in Treasuries markets and corporate bond markets because of various post-crisis regulations. That stagnation may suggest that the risk has shifted from dealers to asset managers, Dudley said, and regulators may not have fully accounted for that effect.
"Capital and liquidity requirements for the largest securities dealers—which have been raised significantly since the financial crisis—might have adversely impacted market liquidity," Dudley said. "These regulatory changes likely have affected the profitability of dealer intermediation activities and consequently the provision of market liquidity."
Dudley said that the supplemental leverage ratio — which requires the largest banks to hold additional capital to offset the leverage shown on their balance sheets — treats all assets the same, regardless of risk profile, which reduces the profitability and prevalence of Treasury repurchase agreements. As a result, it reduces liquidity in that market. Restrictions on proprietary trading of corporate bonds, meanwhile, have reduced the depth of those markets as well.
"It would be surprising if these declines in repo and corporate bond holdings did not have some consequence for market liquidity," Dudley said. "The stagnation in dealer assets might indicate that inventory risk has shifted from dealers to asset managers and other buy-side participants, reflecting a shift in market-making from a 'principal' to an 'agency' model."
Dudley's willingness to concede that post-crisis reforms may be affecting market liquidity — and to specify which reforms may be having which effects — marks a shift in his stance on the issue from last year.
In a speech in October, Dudley said that assertions that regulations were to blame for perceived illiquidity "is [not] well supported by the available evidence," while adding that "if there are adjustments to regulation that could improve liquidity provisions without increasing financial stability risks, we should be open to considering such changes."
Dudley maintained that even if rules were having market impacts — for instance on securities dealers — those effects should be considered in tandem with the improved market stability and resilience since the crisis. He also reiterated a longstanding refrain by other regulators that liquidity changes may also be caused by nonregulatory shifts in market structure, such as the advent of electronic and algorithmic trading or cyclical changes in market attitudes. For these reasons, more evidence is needed before regulators or their Congressional overseers settle on changes to the regulatory landscape.
"Even if one agrees with the position that market liquidity has diminished, concluding that tougher regulatory requirements are the most important factor would be premature at this stage," Dudley said. "The available evidence and common sense suggest that the changes in the regulatory regime are likely important, but we need to do considerably more work before we reach a definitive conclusion on their relative contribution."
But aside from market liquidity, Dudley said, there is also the matter of "funding liquidity" — that is, the ability of firms to fund their long-dated assets in the short term. During the crisis, many banks and nonbanks found themselves forced to sell assets at fire-sale prices when the market for short-term wholesale funding dried up, and post-crisis reforms include liquidity rules meant to ensure banks can withstand that kind of crunch. But nonbank securities firms are not subject to those rules and may pose a systemic risk should funding liquidity dry up again.
Dudley said that one policy that should be considered is expanding the Fed's discount window to include securities firms, because they serve a systemic function of providing market and funding liquidity and such authority could stave off a liquidity crunch without having the Fed resort to its emergency lending powers.
"If a securities firm were to lose access to funding, the remaining options available would be finding a means of replenishing the firm's capital, selling assets or selling all or part of the securities firm's operations," Dudley said. "While this might be manageable in the case of a firm-specific idiosyncratic shock, it might prove more difficult if a common shock was broadly hitting the securities industry. In this circumstance, the failure of one firm could increase the stress on other firms that were facing similar difficulties."