Regulatory constraints on bank balance sheets may result in reduced market liquidity, but regulators are willing to pay that price to build more resilient financial institutions.
The new year began with a roller-coaster ride of financial market volatility, driven in particular by weak Chinese economic indicators and tumbling oil prices. The stressed market conditions coincided with the Basel Committee’s completion of its new framework for the capital that banks must hold against market risks.
The industry’s first response has been a familiar one: in their bid to make banks stronger, regulators are also making markets more fragile. If the largest dealer banks cannot afford to run large inventories of securities, they cannot act as a shock absorber during rough seas such as those witnessed at the start of 2016. Credit markets have allegedly been especially hard hit – our investment banking editor Michael Watt examines the impact of regulation on single-name credit default swaps in this edition.
In the current climate, it is very tempting to heed this call and wonder if the burden of new regulation has gone too far. But the more far-sighted analysts are painting a broader and more nuanced picture. It is not just regulation driving bank balance sheet constraints. Investors understandably questioned whether banks are the right vehicles to intermediate their funds after the financial crisis. Instead, direct investment through fund managers, and even passive index tracking, has steadily grown. While banks create money through fractional reserve lending, the asset managers that regulators have taken to calling “shadow banks” do so by lending against high quality collateral.
The trouble is, the supply of that collateral is stagnant at best. True, liquidity rules for banks and mandatory central clearing of derivatives are contributing factors. But so too are widespread sovereign downgrades in Europe and continued quantitative easing (QE), especially from the ECB and Bank of Japan, which soaks up collateral onto central bank balance sheets. In other words, a reduction of QE might even benefit market liquidity.
Throw in the steep decline of foreign exchange reserves held by China and the big oil exporters, and you have a recipe for reduced market liquidity that has rather less to do with regulation. And as a number of regulators, most prominently the Bank of England’s Jon Cunliffe, have repeatedly pointed out, their aim is not to reduce market liquidity. It is to ensure that all market participants are putting the right price on liquidity risks, which they clearly were not before 2008. In other words, volatile markets are here to stay; get used to them.
