This is the first in a regular series of columns by Darrell Duffie, the Dean Witter distinguished professor of finance at Stanford University's Graduate School of Business. Duffie is also professor by courtesy in the university's economics department. He has recently been an adviser on financial markets to a range of bodies, including the Financial Stability Board and several Federal Reserve banks
Big increases in the capital requirements of bank-affiliated dealers have drained liquidity from over-the-counter markets, especially for products that occupy a lot of space on dealer balance sheets, such as bonds, swaps, repos and foreign exchange contracts.
Dealers have reduced their market-making inventories and are offering less liquid two-way markets for asset classes whose capital requirements have increased significantly.
They have also deployed new financial engineering methods, such as swap compression trading and central clearing, that reduce the amount of balance sheet space required for a given amount of intermediation. To further shrink their balance sheets, dealers have been firing large numbers of less profitable prime-brokerage clients.
In the corporate bond market, dealers are now more likely to offer agency or riskless principal intermediation, which delays the execution of a client's request to sell until the dealer can find a matching buyer. Again, this reduces the amount of balance sheet space required to handle a given amount of trades. Some dealers have simply abandoned their less profitable market-making franchises.
How do we make sense of all this? Although there are many shifting factors at play, the key underlying force is the significant post-crisis increase in Basel III regulatory capital requirements. The benefits of a safer financial system easily dominate the corresponding cost in market liquidity, but a better understanding of this cost could promote some improvements in practice and regulation.
Risk-weighted capital requirements are less distortionary and equally effective in promoting financial stability if set conservatively
There has been a lot of confusion about whether or why capital requirements matter for market liquidity. I have often been asked: if capital requirements matter, wouldn't that be a violation of the Modigliani-Miller (MM) theorem? This famous result states that the total market value of a firm's assets does not depend on the firm's capital structure. Even under its own assumptions, however, MM does not speak to the incentives of a firm to add new positions to its balance sheet. Whenever a dealer adds a new position, even at zero trading profit, the market value of the dealer's equity can be affected by a change in the riskiness of the balance sheet.
For instance, adding a sufficiently risky position, even before considering any trading profit, can benefit a dealer's shareholders at the expense of its creditors, because the limited liability of shareholders allows them to walk away from insolvency at no cost. This leaves creditors with a weaker claim. Economists call this asset substitution. Even if no single trade has a big impact, the incremental effects can add up subtly over time. Capital requirements reduce or block asset-substitution incentives, and encourage a widening of bid-offer spreads.
Higher capital requirements also alter an important incentive known as debt overhang. As first explained by Stewart Myers in 1977, debt overhang implies that a trade with a positive mark-to-market dealer profit can sometimes imply a negative return for the dealer's equity. If the trade requires enough new capital, it may improve the credit quality of the dealer's debt and correspondingly reduce the equity market value associated with limited liability. This is more likely to happen when the additional capital required for the new position is large relative to the riskiness of the position. In effect, this is like asset substitution in reverse.
For example, under the US supplementary leverage ratio rule for the largest US broker-dealers, every $100 million of additional assets requires an additional $5 million of capital, regardless of the risk of the assets. This means that intermediating very safe assets such as US Treasury repos requires a lot of capital relative to the tiny risk involved, and improves the position of creditors.
So, as this capital requirement goes up, repo dealers should increase their bid-ask spreads enough to overcome the debt overhang cost to their shareholders. And that is exactly what they have been doing. Since the imposition of the supplementary leverage ratio rule, bid-ask spreads in the US Treasury repo market have increased from around 3 basis points to more than 16bp. As a consequence, volumes of trade in Treasury repos have dropped precipitously, especially in the interdealer repo market.
In general, dealers best respond to increases in capital requirements by increasing bid-ask spreads for positions that require a lot of regulatory capital relative to their risk, and using financial engineering or new intermediation methodologies to economise on the use of balance sheet space.
Regulators should reconsider the effect of the leverage ratio rule on the efficiency of markets for very safe assets. Risk-weighted capital requirements are less distortionary and equally effective in promoting financial stability if set conservatively.
Duffie, Darrell (2016) "Financial Regulatory Reform After the Crisis," 2016 ECB Forum on Central Banking, Sintra, Portugal, June, forthcoming, Management Science
Modigliani, Franco, and Merton H Miller (1958) "The Cost of Capital, Corporation Finance and the Theory of Investment," The American Economic Review, Volume 48, pages 261–297
Myers, Stewart (1977) "Determinants of Corporate Borrowing," Journal of Financial Economics, Volume 5, pages 147–175