Post-crisis Regulations Research Articles

Inventory, market making, and liquidity in OTC markets

We develop a search-theoretic model of a dealer-intermediated over-the-counter market. Our key departure from the literature is to assume that, when a customer meets a dealer, the dealer can sell only assets that it already owns. Hence, in equilibrium, dealers choose to hold inventory. We derive the equilibrium relationship between dealers' costs of holding assets on their balance sheets, their optimal inventory holdings, and various measures of liquidity, including bid-ask spreads, trade size, volume, and turnover. Using transaction-level data from the corporate bond market, we calibrate the model to quantitatively assess the impact of post-crisis regulations on dealers' inventory costs, liquidity, and welfare.

Global banks, dollar funding, and regulation

We document significant and persistent price dislocations in secured and unsecured wholesale dollar funding markets between US money market funds (MMFs) and highly-rated global banks. We show that bargaining frictions affect prices in these key short-term dollar funding markets. Our identification strategy relies on a number of quasi-experiments, including the US MMF reform and quarter-end window-dressing by European banks. Post-crisis regulations have reduced competition in these markets and have generated incentives for regulatory arbitrage, which affect bargaining power and prices. Our results also highlight substantial heterogeneity across global banks of different nationalities in their behavior in dollar funding markets.

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

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.

Reciprocal lending relationships in shadow banking

Postcrisis regulations apply stricter liquidity rules to both money market funds (MMFs) and banks, requiring MMFs to do more overnight lending and banks to borrow longer-term. MMFs and banks resolve this dilemma by developing a “bundling” strategy across overnight and longer term markets. In particular, MMFs increase longer term funding and charge a lower rate to banks that have recently accommodated MMFs’ overnight depositing needs. Such cross-market reciprocity is stronger between MMFs and foreign banks, which depend on MMFs for dollar funding more than U.S. banks do. MMFs with lower liquidity buffers and higher flow volatility are more likely to engage in bundling.

Rethinking Regulatory Treatment of Securitisation and Covered Bonds

Regulations for securitization have been subject to wide-spread criticism continuously. Before the global financial crisis, they were blamed for creating perverse incentives for banks and after the crisis, they are blamed for punitive treatment to the securitization market. Covered Bonds share many similarities with asset-backed securities, but they are provided favorable treatment in regulations. This discriminatory treatment has given rise to many concerns among the market participants. The present study reviews the post-crisis regulations and highlights that many of these regulations may not be justified or not be able to control the problems in the securitization market. This article introduces the concept of incremental regulations and links regulations with the scale of securitization activity followed by a bank. The article also addresses the concern about discriminatory treatment of securitization with respect to covered bonds in the European market. The article concludes that regulations should devise regulations that control the limitless securitization, but also help to restart this market.

THE COMOVEMENTS OF STOCK, BOND, AND CDS ILLIQUIDITY BEFORE, DURING, AND AFTER THE GLOBAL FINANCIAL CRISIS

AbstractUsing both marketwide and firm‐level illiquidity measures of the stock, bond, and credit default swap markets, we find that comovements of illiquidity across markets increase significantly during the recent global financial crisis. Moreover, the degree of comovement remains significantly higher in the postcrisis period and regulatory period than in the precrisis period. Specifically, the distribution of firm‐level comovements is notably different before and after the crisis (e.g., a much larger portion of firms with positive pairwise correlations between illiquidity measures in the postcrisis period than in the precrisis period). Our results provide suggestive evidence of the financial crisis effects and the subsequent postcrisis regulations on the comovements of illiquidity across markets.

Liquidity Regulation and Financial Intermediaries

AbstractThe liquidity-coverage ratio (LCR) requires banks to hold enough liquidity to withstand a 30-day run. We study the effects of the LCR on broker-dealers, the financial intermediaries at the epicenter of the 2007–2009 crisis. The LCR brings some financial-stability benefits, including a significant maturity extension of triparty repos backed by lower-quality collateral, as well as the accumulation of larger liquidity pools. However, it also leads to less liquidity transformation by broker-dealers. We also discuss the liquidity risks not addressed by the LCR. Finally, we show that a major source of fire-sale risk was self-corrected before the introduction of postcrisis regulations.

Dealers’ insurance, market structure, and liquidity

We develop a parsimonious model to study the effect of regulations aimed at reducing counterparty risk on the structure of over-the-counter securities markets. We find that such regulations promote entry of dealers, thus fostering competition and lowering spreads. Greater competition, however, has an indirect negative effect on market-making profitability. General equilibrium effects imply that more competition can distort incentives of all dealers to invest in efficient technologies ex ante and so can cause a social welfare loss. Our results are consistent with empirical findings on the effects of post-crisis regulations and with the opposition of some market participants to those regulations.

Increasing Corporate Bond Liquidity Premium and Post-Crisis Regulations

I employ the corporate bond liquidity premium to understand the important changes in corporate bond market liquidity from 2004 to 2019. I show that while commonly-used transaction cost measures such as the bid-ask spread have been declining, the corporate bond liquidity premium has actually increased since the financial crisis. For speculative bonds, about 30% of their yield spread now compensates for illiquidity compared to 15% before the crisis. I demonstrate that this increasing liquidity premium is due to investors facing longer trading delays as dealers have become less willing to provide immediacy, and develop a structural over-the-counter model to estimate the latent trading delays implied by the size of the liquidity premium. The estimation results suggest that bonds that took less than one day to sell before the financial crisis now take weeks to trade. Finally, I establish a causal relationship between the major post-crisis regulations and the variations in the corporate bond liquidity premium to uncover the potential cause of dealers' unwillingness to provide liquidity. I show that Basel II.5, by introducing the stressed value-at-risk and incremental risk charges for credit products, contributed the most to increasing the liquidity premium out of all regulatory changes examined. The longer trading delays and the impact of regulations are consistent with practitioners' descriptions of the post-crisis market and corroborate the relevance of using the liquidity premium to understand corporate bond market liquidity.

Global Banks, Dollar Funding, and Regulation

We document that non-US global banks are increasingly heterogeneous in their dollar banking activities and dollar demand. We study the implications for dollar funding markets using data on security-level money market fund holdings. We find that funds charge higher prices to banks with weaker bargaining positions, consistent with theories of over-the-counter markets. For identification, we use exogenous variation in bargaining power due to window-dressing at quarter-ends and the US money market fund reform. We show that post-crisis regulations have reduced competition in certain segments of dollar funding markets and have generated incentives for regulatory arbitrage, with potentially adverse unintended consequences.

Post-Crisis Regulations, Market Making, and Liquidity in the Corporate Bond Market

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.

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ORGANIZATIONAL MODEL OF POLISH COOPERATIVE BANKS IN THE POST-CRISIS REGULATORY ENVIRONMENT

Even though the Polish cooperative banks were affected by the global crisis only indirectly, yet after the crisis their condition has begun to deteriorate. This was the result of numerous changes taking place within the macroeconomic and regulatory environment. This paper is to define the impact of crucial post-crisis regulations passed by the EU – CRDIV/CRR package, the directives on DGS and BRR – on the directions in which the organizational model of domestic cooperative banking should evolve.CRDIV/CRR is a regulatory package implementing the provisions of Basel III (Third Capital Agreement, Basel III). As part of the package, changes were made in two main areas determining banks’ security: the first one is capital adequacy, the second – liquidity and liquidity risk. Implementation of the provisions of the CRD IV/CRR package regarding banks' capital base policy into the Polish legal regime began in mid-2015 on the back of the act on macro-prudential supervision of the financial system and crisis management in the financial system dated 5 August 2015.Directive 2014/49/EU of the European Parliament and of the Council concerning Deposit Guarantee Schemes (DGS) essentially increases the protection of depositors' savings and one of its main provisions is harmonizing the methods of financing deposit-guarantee schemes ex ante. The Directive of the European Parliament and Council 2014/59/EU (BRRD) defines the principles of establishing national recovery and resolution mechanisms. The DGS and BRR Directives were introduced into the Polish legal regime by means of the act on the bank guarantee fund, deposit guarantee scheme and resolution of 10 June 2016.Based on an analysis of the impact of selected EU and national post-crisis regulations on the cooperative banking sector in Poland, two final conclusions were reached. First and foremost, in the hitherto existing regulatory environment imposing additional burdens on all banks, privileges were foreseen mainly for Institutional Protection Schemes (IPSs) members, while in the new legal regime the proportionality rule was applied to a limited extent. Secondly, due to the privileges arising from existing regulations, the evolution of the organizational model of Poland’s cooperative banking sector towards IPS seems to be inevitable.

Do Post-Crisis Regulations Affect Market Liquidity? Evidence from the Co-Movement of Stock, Bond, and CDS Illiquidity

Using both market-wide and firm-level illiquidity measures of the stock, bond, and CDS markets, we find that the co-movements of illiquidity across markets increase significantly during the recent global financial crisis. Moreover, the degree of co-movements remains significantly higher in the post-crisis period and regulatory period than in the pre-crisis period. Specifically, the distribution of firm-level co-movements is notably different before and after the crisis (e.g., a much larger portion of firms with positive pairwise correlations between illiquidity measures in the post-crisis period than in the pre-crisis period). Our results provide suggestive evidence of the effects of financial crisis and the subsequent post-crisis regulations on the co-movements of illiquidity across markets.

Liquidity Regulation and Financial Intermediaries

We document several effects of the Liquidity Coverage Ratio (LCR) rule on dealers' financing and intermediation of securities. For identification, we exploit the fact that the US implementation is more stringent than that in foreign jurisdictions. In line with LCR incentives, US dealers reduce their reliance on repos as a way to finance inventories of high-quality assets and increase the maturity of lower-quality repos relative to foreign dealers; additionally, US dealers cut back on trades that downgrade their own collateral. Dealers are nevertheless still providing significant maturity transformation. We also show that significant de-risking occurs immediately after the 2007-09 crisis, before post-crisis regulations.

Dealer Funding and Market Liquidity

We consider a model in which dealers intermediate trades between clients and provide immediacy, or, market liquidity. Dealers can exert unobservable search effort to improve the chance of intermediating profitably. This moral-hazard friction impairs dealers’ ability to raise external finance and hence to compete aggressively with each other in providing liquidity. Market liquidity is limited even for safe assets and more so for assets with higher search cost. To alleviate the financing friction, dealers opt to finance with debt and intermediate in several markets simultaneously. Dealer leverage is therefore endogenous and related to variations in liquidity across otherwise unrelated markets. Our results shed light on how post-crisis regulations influence the provision of immediacy in bond markets.

Bank-Intermediated Arbitrage

We argue that post-crisis banking regulations pass through from regulated institutions to unregulated arbitrageurs. We document that, once post-crisis regulations bind post 2014, hedge funds use a larger number of prime brokers and diversify away from GSIB-affiliated prime brokers, and that the match to such prime brokers is more fragile. Tighter regulatory constraints disincentivize regulated institutions not only to engage in arbitrage activity themselves but also to provide leverage to other arbitrageurs. Indeed, we show that the maximum leverage allowed and the implied return on basis trades is considerably lower under post-crisis regulation, in spite of persistently wider spreads.

Liquidity Regulation and Financial Intermediaries

We document several effects of the Liquidity Coverage Ratio (LCR) rule on dealers' financing and intermediation of securities. For identification, we exploit the fact that the US implementation is more stringent than that in foreign jurisdictions. In line with LCR incentives, US dealers reduce their reliance on repos as a way to finance inventories of high-quality assets and increase the maturity of lower-quality repos relative to foreign dealers; additionally, US dealers cut back on trades that downgrade their own collateral. Dealers are nevertheless still providing significant maturity transformation. We also show that significant de-risking occurs immediately after the 2007-09 crisis, before post-crisis regulations.

Regulatory Cycles: Revisiting the Political Economy of Financial Crises

Financial crises are traditionally analyzed as purely economic phenomena. The political economy of financial booms and busts remains both under-emphasized and limited to isolated episodes. This paper examines the political economy of financial policy during ten of the most infamous financial booms and busts since the 18th century, and presents consistent evidence of pro-cyclical regulatory policies by governments. Financial booms, and risk-taking during these episodes, were often amplified by political regulatory stimuli, credit subsidies, and an increasing light-touch approach to financial supervision. The regulatory backlash that ensues from financial crises can only be understood in the context of the deep political ramifications of these crises. Post-crisis regulations do not always survive the following boom. The interplay between politics and financial policy over these cycles deserves further attention. History suggests that politics can be the undoing of macro-prudential regulations.

Regulatory Cycles: Revisiting the Political Economy of Financial Crises

Financial crises are traditionally analyzed as purely economic phenomena. The political economy of financial booms and busts remains both under-emphasized and limited to isolated episodes. This paper examines the political economy of financial policy during ten of the most infamous financial booms and busts since the 18th century, and presents consistent evidence of pro-cyclical regulatory policies by governments. Financial booms, and risk-taking during these episodes, were often amplified by political regulatory stimuli, credit subsidies, and an increasing light-touch approach to financial supervision. The regulatory backlash that ensues from financial crises can only be understood in the context of the deep political ramifications of these crises. Post-crisis regulations do not always survive the following boom. The interplay between politics and financial policy over these cycles deserves further attention. History suggests that politics can be the undoing of macro-prudential regulations.