Post-crisis regulations, market making, and liquidity in over-the-counter markets

Abstract

We augment a simple inventory model with new features of the post-crisis regulations to offer new predictions on the effects of post-crisis regulations on the over-the-counter markets. First, the increased capital requirements of Basel III lead to an overall increase in order rejection rates of large orders. Second, and more importantly, the effects on order rejection rates depend on the risk weights used in calculating risk-weighted assets (RWAs). More specifically, the increase in order rejection rates is more severe for assets with higher risk weights, but less severe for assets with lower risk weights. In fact, for the cases of the lowest risk weights, simulations suggest that we may even see a decrease in order rejection rate. Third, the price impact of assets with higher risk weights increases, while the price impact of assets with lower risk weight decreases in the post-regulation period. Overall, our paper points to an important unintended consequence of the post-crisis regulations—the re-distribution of liquidity among assets with different risk weights assigned to them.