The Volcker Rule and Market-Making in Times of Stress

Abstract

Focusing on downgrades as stress events that drive the selling of corporate bonds, we document that the illiquidity of stressed bonds has increased after the Volcker Rule. Dealers regulated by the Rule have decreased their market-making activities while non-Volcker-affected dealers have stepped in to provide some additional liquidity. Furthermore, even Volcker-affected dealers that are not constrained by Basel III and CCAR regulations change their behavior, inconsistent with the effects being driven by these other regulations. Since Volcker-affected dealers have been the main liquidity providers, the net effect is that bonds are less liquid during times of stress due to the Volcker Rule.

Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs

“…Bessembinder et al (2017) show that dealers commit less capital in the post-regulation period, and this reduction in committed capital is driven mainly by bank-affiliated dealers. Bao et al (2017) find that dealers that are affected by the Volcker Rule provide less inventory service during downgrade events after the Volcker Rule was implemented. Schultz (2017) shows that dealers are less likely to take bonds into inventory after the Volcker Rule.…”

“…Bao et al (2017) study bond downgrade events and find that liquidity during these events is worse than it was before the crisis. Anderson and Stulz (2017) find that liquidity is worse in the post-regulation period when the VIX spikes up but not during bond idiosyncratic events.…”

“…Three broad findings have emerged from the academic literature. First, dealers-especially those more heavily affected by various bank regulations-have decreased capital commitment and liquidity provision (Bessembinder, Jacobsen, Maxwell and Venkataraman (2017), Bao, O'Hara and Zhou (2017), and Schultz (2017)). However, broad price-based measures of liquidity have not worsened (Trebbi and Xiao (2017), Adrian, Fleming, Shachar and Vogt (2017), Anderson and Stulz (2017)).…”

“…However, broad price-based measures of liquidity have not worsened (Trebbi and Xiao (2017), Adrian, Fleming, Shachar and Vogt (2017), Anderson and Stulz (2017)). Finally, liquidity during specific market stress or liquidity events, such as rating downgrades or index rebalancing, has worsened (Bao et al (2017), Dick-Nielsen and Rossi (2016)). …”

Does bank transparency benefit from the Volcker Rule?

“…Bao et al . () find evidence that supports the possibility that the rule reduces bond market liquidity. Keppo and Korte () examine whether the Volcker Rule can reduce bank risk.…”