WASHINGTON — Policymakers need to closely study whether new regulations are hampering liquidity in the fixed-income market, a prominent banker and regulators said Monday.
"Pre-crisis, there was too much market liquidity and too little safety and soundness and then the question is where we are today and how are we looking at these new policies and their implications for market liquidity," Sandie O'Connor, chief of regulatory affairs at JPMorgan Chase, said at the National Association of Business Economist annual policy conference on Monday.
O'Connor noted there is "no single metric that is a full descriptor" of liquidity, which she said is multidimensional and could be measured in several different ways. However, she said banks and regulators are in uncharted waters with a number of structural, economic and participant changes in the market, not to mention unprecedented monetary policy actions.
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"I think we need to be very cognizant of the environment," O'Connor said.
The Federal Reserve Board has already finalized one rule that requires big banks to hold enough high-quality liquid assets on their balance sheets to ensure they could survive a short-term crisis and is working on another proposal focused on long-term liquidity needs. Regulators have also required derivatives to be cleared through clearing houses, a move that is sopping up liquidity.
The result is a market where many of the major players are buying and holding similar securities.
"With regard to the U.S. Treasury market, expectations for liquidity remain unchanged because the reality is you are holding those types of securities so that when the time comes you can convert them into cash and you can achieve the fundamental value," O'Connor said. "Therein, I think, is a really important question that we need to focus on: Can the marketplace deliver the liquidity that will be required …in a marketplace that has more homogenous position-taking and investors that are holding them exactly for liquidity purposes?"
Speaking at a separate event on Monday sponsored by the Institute of International Bankers, Fed Gov. Lael Brainard acknowledged that regulation could be a "possible contributor" to changes in market behavior and availability of liquidity in stress scenarios. But she pointed out that the purpose of regulatory reform was to spread liquidity risk away from the largest and most systemically important institutions — an effect that appears to have already been realized.
"It is important to recognize that this regulation was designed to reduce the concentration of liquidity risk on the balance sheets of the large, interconnected banking organizations that proved to be a major amplifier of financial instability at the height of the crisis," Brainard said.
O'Connor emphasized the importance of regulatory reforms, saying "rolling back regulation" was not a silver bullet to the liquidity issue. Rather, she said, there are likely opportunities to improve efficiencies by reducing duplicative regulatory requirements or increase consistency between different regulatory regimes.
Another change is likely the behavior of broker-dealers, whose traditional role in markets has been to "catch a falling knife" — that is, in a moment of market volatility, they will step in and buy, holding those assets until the market recovers and they can sell those positions.
But Andreas Lehnert, deputy director at the office of financial stability policy and research at the Fed, who was speaking alongside O'Connor, said it's unlikely broker-dealers will still fulfill that role.
"This idea that there is a dealer community that is willing to step in when prices are falling rapidly or somehow getting totally out of whack … it is probably safe to say that the dealer community was never interested in the business of catching the proverbial falling knife," Lehnert said.
O'Connor agreed. "The broker-dealer community won't catch the falling knife, but once it has fallen, it will pick it up," she said.
