In the wake of the Global Financial Crisis of 2007-2009, the regulatory regime for banks and bank holding companies was tightened significantly. Tightening of the regime was appropriate, but some economists and some market participants expressed concerns that the new regime, while undoubtedly making banks safer, might adversely affect market liquidity and thereby pose risks to financial stability. They noted that this possibility was of particular relevance to the United States, where an exceptionally large share of credit needs is met in the bond and money markets. Evidence of impaired liquidity in the years following implementation of the post-crisis rules was not clear-cut, however, and any impairment could not be unambiguously attributed to banking regulation. Even if market liquidity had been impaired by banking regulation, some policymakers considered this a relatively small price to pay for a stronger banking system.
In March of this year, the COVID-19 crisis revealed that the price was far higher than most had imagined. Market liquidity evaporated under stress, not only in markets for corporate debt but also in the U.S. Treasury markets, which are ordinarily the most liquid of all markets. Moreover, market participants as well as the Federal Reserve[1] attributed the evaporation of market liquidity to the exhaustion of the capacity of banks to provide liquidity to markets after demands for liquidity from bank business customers and deposit inflows swelled bank balance sheets.
Market participants and analysts had seen trouble brewing prior to March, however. A similar episode in September 2019 saw banks and broker-dealers unable to intermediate to bridge a massive temporary mismatch between supply and demand in the Treasury repo market, driving repo rates sharply higher (see BPI blog posts here and here for further discussion).
These developments suggest the need for a broad review of how the bank regulatory regime affects market liquidity so as to conduct a meaningful cost-benefit analysis and identify appropriate adjustments. Some key questions come to mind: What price in terms of reduced market liquidity is being paid for certain elements of the bank regulatory regime? Does bank safety and soundness require that price to be paid? Or are there other equally effective means of ensuring bank resiliency that would not impair market liquidity and therefore would better promote the overarching goal of making the financial system as a whole more resilient?
Debates Prior to COVID-19
Before the ink was dry on the post-GFC bank regulatory regime, bankers and other market participants were expressing concerns that the new regime might be reducing liquidity in markets that historically had been dependent for liquidity on market-making by bank-affiliated securities dealers (especially after the demise of Lehman, Bear Stearns, and other major independent dealers.) Some policymakers clearly took these concerns seriously and evaluated evidence as to whether market liquidity had been impaired. For example, in a speech delivered in November 2016, Federal Reserve Vice Chair Stanley Fischer reviewed the evidence that was then available.[2] He noted a sharp decline in bank dealers’ inventories of securities and said that the decline might be due in part to new banking regulations. But he took comfort from the possibility that nonbank firms like hedge funds might make up for any diminished market-making by banks. In any event, evidence for changes in market liquidity did not point clearly to a reduction. Furthermore, he argued that any changes in market liquidity should be analyzed in the broader context of the overall safety of the financial system. In that broader context, he concluded that bank regulatory changes, even those that may have reduced market liquidity, had enhanced financial stability on balance. Vice Chair Fischer acknowledged that market participants were especially concerned about the potential for market liquidity to become less resilient under stress, when it is needed most, and that evidence regarding resilience under market stress was difficult to gather. He recommended continued monitoring and analysis of market liquidity.
Nevertheless, when discussing the tradeoffs between the costs and benefits of the regulations that could be contributing to market illiquidity, Vice Chair Fischer grouped together the various regulations contributing to the buildup in banks’ capital after the financial crisis, rather than considering the possibility of changes to components of the framework that would lessen the negative consequences for market liquidity.
However, thanks to recent regulation and supervisory changes, including higher capital requirements and stress tests, leverage at the largest intermediaries is much reduced relative to pre-crisis norms–and, as a result, vulnerabilities from potential fire sale risks are less significant. From this perspective, a small reduction in liquidity from regulatory changes–even if present, which is not obvious–may be a reasonable price to pay for greater safety.
In his speech, Vice Chair Fischer did not analyze the specific elements of the bank regulatory regime that some believed were impairing market liquidity, although he mentioned that among those regulations was the Supplemental Leverage Ratio (SLR). That regulation was first put in place in 2013 as part of Basel III. But its impact on market liquidity was magnified by the Board’s decision in 2014 to require US GSIBs to maintain a 2 percent capital buffer (the enhanced SLR or “eSLR”) on top of the internationally agreed 3 percent minimum requirement.[3] The transcript of that meeting documents a vigorous discussion of the definition of the SLR and of the calibration of the eSLR.[4]
With regard to the definition of the SLR, some Board members questioned whether commercial bank deposits at central banks (a/k/a “reserves”) should be included in the denominator, and staff also noted that the inclusion of reverse repos in the denominator could impair the liquidity of the repo markets. Staff argued that because the Federal Reserve planned to normalize – that is reduce – the size of its balance sheet, reserves held by banks would decline, making the inclusion of reserves in the denominator less consequential. Moreover, even though reserves held at the Fed were a riskless asset, exclusion of reserves from the SLR would be inconsistent with the concept of SLR, which was a non-risk-based capital measure. Regarding repo markets, the staff opined that banks would remain actively engaged in the repo markets, regardless of the costs imposed by inclusion of reverse repos in the SLR.
With regard to calibration of the buffer requirement for the SLR (the enhanced SLR or eSLR), some Board members expressed concerns that the calibration of the eSLR buffer at 2 percent would mean that the SLR would too often be the binding capital requirement rather than a backstop to the risk-based capital requirements, as intended. But staff assured them that banks had relatively easy actions that they could take to make the SLR less binding. In addition, one Board member noted that plans were in train to increase buffer requirements for the risk-based capital ratios, which would help ensure that the SLR remained a backstop and the risk-based requirements the binding constraint.
As described below, key assumptions underlying the calibration of the eSLR had proven false prior to March 2020: the Fed dramatically increased, not decreased, the size of its balance sheet; banks significantly decreased their participation in repo markets; and the leverage component of the Fed’s annual stress test had become the most binding capital constraint.
Repo Markets Flash a Warning Sign in September 2019
Even prior to the current crisis, sentiment appeared to have shifted toward a broader recognition that bank regulation had reduced liquidity in financial markets. On September 16, 2019 the simultaneity of corporate tax day and Treasury securities settlement resulted in a massive shortfall of the supply of Treasury securities financing relative to the demand for that financing. By the end of the day, repo rates, which had been running a bit over 2 percent, jumped to as high as 9 percent, and money markets remained unsettled for a week.
One of the key questions raised by the September episode was why banks did not redeploy their reserve balances toward providing repo financing, automatically addressing the mismatch in the supply and demand for repo financing. Banks at the time had $1.4 trillion in reserve balances. In response to a Senior Financial Officer Survey conducted the previous month, banks had just reported that the lowest level of reserve balances with which they were comfortable was $652 billion. The official sector recognized, albeit somewhat begrudgingly, that financial regulations had inhibited the redeployment and so contributed to the severe episode of illiquidity in Treasury repo markets. For example, Vice Chair for Supervision Randal Quarles stated before Congress on December 4, 2019:
– [T]here were a complex set of factors that contributed to those events in September. Not all of them were related to our regulatory framework, but I do think that as we have considered what were the driving factors in the disruptions in the repo market in September we have identified some areas where our existing supervision of their regulatory framework, less the calibration or structure of the framework itself, may have created some incentives that were contributors.
A survey of senior financial officers that the Fed conducted in November 2019 to determine the causes of the mid-September turmoil did not find that supervisory expectations, guidance, or regulations were important determinants of banks’ demand for reserves, but that’s probably because the Fed did not include those possible reasons as potential responses to its questions on the surveys. In response to a BPI survey conducted in January 2020, many banks judged that supervision and regulation were “important” or “very important” as reasons for their reserve demand including Reg YY liquidity monitoring, the LCR, examiner expectations about the composition of liquidity buffers, and resolution liquidity requirements. (See “Missing Answers to a Recent Fed Survey.”)
Market Liquidity Under Stress: The Covid-19 Crisis Delivers the Evidence
In March of this year, the COVID-19 pandemic rocked financial markets in the United States and abroad and provided unambiguous evidence regarding the resilience of market liquidity under stress. It demonstrated that under stress market liquidity could evaporate, not only in markets that were not terribly liquid in good times, like the corporate bond and asset-backed security (ABS) markets, but even in what ordinarily are the most liquid markets in the world, the markets for U.S. Treasury securities.
The Fed’s May 2020 Financial Stability Report summarizes the breakdown in Treasury and agency MBS markets in March this way:
As a more adverse outlook for the economy associated with the COVID-19 pandemic prompted investors to move rapidly toward cash and shorter-term government securities, trading conditions in the markets for Treasury securities and agency mortgage-backed securities (MBS) started to experience strains.[5]
“Strains” is an understatement with respect to the effects on market liquidity. The two most commonly cited measures of market liquidity – market depth and bid-offer spread – both worsened by a factor of 10.[6] The Treasury Borrowing Advisory Committee (TBAC) stated that “The widespread, heightened investor demand for cash resulted in acute demand for dealer balance sheet capacity, contributing to wider bid-ask spreads, on-the-run/off-the-run spreads, and declining market depth.”
On March 16, when Vikram Rao, the head bond trader of Capital Group, asked executives that he knew at many of the big banks why they weren’t trading:
[T]hey had the same refrain: There was no room to buy bonds and other assets and still remain in compliance with tougher guidelines imposed by regulators after the previous financial crisis. In other words, capital rules intended to make the financial system safer were, at least in this instance, draining liquidity from the markets. One senior bank executive leveled with him: ‘We can’t bid on anything that adds to the balance sheet right now.’[7]
A global financial market meltdown was avoided only by the Fed purchasing massive amounts of Treasury securities and Agency MBS, including $1 trillion in Treasury securities purchased in just 3 weeks. As the Fed’s assets increased, so too did its liabilities, including in particular reserve balances, nearly all of which must be held by banks. As discussed below, because those reserves put downward pressure on banks’ leverage ratios, they added further to balance sheet pressures.
While catastrophe was avoided in March through extraordinary Federal Reserve actions, such actions could become increasingly necessary. Dealer balance sheets have declined as outstanding Treasury securities have grown. In 2007, the total amount of outstanding marketable Treasury securities were less than 2.5 times dealer inventories; currently outstandings are more than 8 times inventories, and that ratio will no doubt rise further due to the projected further rapid growth in Federal borrowing. As noted by Duffie (2020):
In short, the size of the Treasury market may have outgrown the capacity of dealers to safely intermediate the market on their own balance sheets, raising questions about the safe-haven status of U.S. Treasuries and concerns over the cost to taxpayers of financing growing federal deficits. p.3.
The contributions of regulations to the balance sheet bottlenecks will no doubt be debated for many years. But actions speak louder than words and economic research. The Federal Reserve itself quickly recognized that the SLR was a problem and provided relief with an emergency rulemaking that temporarily excluded balances at the Fed and holdings of Treasury securities from the SLR at the bank holding company level.[8]
Evaluating the Effectiveness of Banking Regulations that Affect Market Liquidity.
As Vice Chair Fisher suggested, any evaluation of banking regulations should take into account the effects not only on the safety and soundness of banks but also on the overall stability of the financial system. To be sure, there may be instances in which a banking regulation that impairs market liquidity may nonetheless enhance financial stability if it is necessary to ensure the safety and soundness of the banking system. By the same token, however, there may be instances in which a banking regulation only contributes marginally to bank safety and soundness and, by impairing market liquidity, makes the system as a whole weaker. The SLR and the Tier 1 leverage ratio seem prime examples of regulations, at least as currently defined and calibrated, that are unnecessary for bank safety and soundness and make the financial system as a whole weaker.
In a presentation at a joint BPI-Columbia conference on bank regulation, Kevin Stiroh, Head of Supervision at the New York Fed discussed the scope for improvements in the efficiency of bank regulation to increase financial stability and economic activity.
It is also essential to distinguish the intended consequences of supervision and regulation where informed choices are made based on careful data analysis from the unintended consequences where outcomes are not consistent with policy objectives. This requires both a conceptual framework to identify costs and benefits to society as a whole, and empirical analysis to measure them. In my view, it is entirely appropriate to continuously evaluate and rigorously assess the impact to ensure that the observed outcomes are consistent with stated objectives such as greater resilience, efficient financial intermediation over time, and financial stability.[9]
Back in April 2014 Federal Reserve Board members asked the right questions about the SLR but, as noted, the answers they received were based on faulty assumptions. More importantly, they did not ask whether the desired enhancements to bank safety and soundness could be achieved by alternative means that would have made the financial system more resilient to stress. Would the exclusion of central banks’ balances from the denominator of the SLR have meant that the SLR was no longer a credible backstop to the risk-based capital requirements? Even if one somehow reached the conclusion that the SLR would no longer be credible, why does the United States need two non-risk-based backstops to the risk-based capital requirements? And, as Vice Chair Fischer later asked, would the SLR achieve greater bank safety at the expense of a reduction in potential market liquidity under stress that increased financial fragility? In particular, if the Fed flooded the system with reserves following a financial shock, would the SLR (and the Tier 1 leverage ratio) remain backstop measures? If they became binding, how would that affect the liquidity of financial markets, especially for low-risk assets like Treasuries and reverse repos collateralized by Treasuries? And to the extent that they affect the availability of repos, how can hedge funds and other market participants that are dependent on repo financing be expected to make up for any reduction in liquidity provision by banks?
Similar questions can be asked, and need to be asked, about the other components of the regulatory regime that may have contributed to illiquidity. Such a review should include liquidity requirements that require banks to build up stockpiles of liquid assets (and hold capital against them) that they cannot use without submitting a remediation plan to their regulator. The GSIB capital surcharge, the extra capital buffer required of the largest banks, which increases when banks hold reserve balances and Treasuries or engage in market-making activities in financial markets, is another regulation that market participants often point to as a reason for reduced market liquidity, especially at year-end when many of the components of the surcharge are calculated. And as BPI noted in “The Global Market Shock and Bond Market Liquidity,” the global market shock (GMS) component of the Fed’s stress tests effectively increases capital requirements on banks’ trading books by a factor of five and has contributed to the decline of banks’ holdings of trading assets.
The U.S. Treasury markets seem likely to grow enormously in the near future, and corporate and municipal securities markets may also need to grow to meet credit demands from those sectors. Absent drastic changes in the structure of those markets, as they grow, their orderly functioning will depend on the willingness of banks to allocate additional capital to activities that support market liquidity. And absent changes in the treatment of those activities in banking regulation, banks are likely to allocate the capital needed only if they can earn significantly higher returns, which ultimately would result in higher costs for issuers of the securities.
While this note has focused on the effects of banking regulation on market liquidity, we don’t mean to imply that the regulatory framework for financial markets themselves does not also deserve careful reexamination. In the case of the U.S. Treasury markets, in particular, market infrastructure seems to have lagged behind important changes in the marketplace, notably the increased importance of principal trading firms (PTFs). Both the clearance and settlement infrastructure and the infrastructure for trade execution merit a thorough review. And that review probably should extend to some aspects of the infrastructure for corporate and municipal bonds as well. Last but not least, further reform of prime money funds seems likely, as their inability to meet heavy redemptions again required massive Fed intervention to avoid catastrophic effects on the economy.
[1] Lorie Logan, “The Federal Reserve’s Recent Actions to Support the Flow of Credit to Households and Businesses,” April 14, 2020. https://www.newyorkfed.org/newsevents/speeches/2020/log200414
[2] Federal Reserve Vice Chair Stanley Fischer. “Do We Have a Liquidity Problem Post-Crisis?”, a conference sponsored by the Initiative on Business and Public Policy at the Brookings Institution, Washington, DC, November 15, 2016.
[3] https://www.federalreserve.gov/mediacenter/files/open-board-meeting-transcript-20140409.pdf. Vice Chair Fischer did not join the Board until four months later.
[4] At the time, the Basel standards did not include a buffer requirement. As in so many cases, the Federal Reserve was “gold-plating” the Basel III standards.
[5] https://www.federalreserve.gov/publications/files/financial-stability-report-20200515.pdf, 9.
[6] Darrell Duffie (2020) https://www.brookings.edu/wp-content/uploads/2020/05/WP62_Duffie_updated.pdf
[7] Justin Baer, “The Day Coronavirus Nearly Broke the Financial Markets,” Wall Street Journal, May 20, 2020
[8] The Fed and the other agencies did not provide relief from the Tier 1 leverage ratio, which was a tighter constraint than the SLR for several banks whose activities are important to financial market liquidity. Even if the agencies believed it was appropriate to grant relief from the Tier 1 leverage ratio, they may have been concerned about whether doing so would be consistent with the Collins amendment provision of the Dodd-Frank Act}
[9] https://www.newyorkfed.org/newsevents/speeches/2017/sti170223
