3/31/2017 USlawmakersdividedoverVolckerrulesimpactonbondliquidityRisk.

net

US lawmakers divided over

Volcker rules impact on bond
liquidity
Both sides cite Fed data to support their interpretations of
prop trading ban

New analysis: Fed data showed banks under the prop trading ban had not pulled back from
credit markets in two periods of market stress

Peter Madigan
30 Mar 2017

http://www.risk.net/regulation/4561866/uslawmakersdividedovervolckerrulesimpactonbondliquidity 1/5
3/31/2017 USlawmakersdividedoverVolckerrulesimpactonbondliquidityRisk.net

House Republicans and Democrats have clashed over the impact of the Volcker
rule on US credit markets, with both parties citing Federal Reserve data to
support their almost diametrically opposed arguments.

At a hearing of the House Committee on Financial Services Capital Markets

Subcommittee on March 29, Republican members said the ban had significantly
impaired liquidity in US credit markets. Jeb Hensarling, the Republican
chairman of the House Financial Services Committee, had earlier gone as far as
proposing legislation torepeal the Volcker rule.

But House Democrats said the proprietary trading ban had had a limited effect
on US bond markets.

Risk levels on bank trading desks have been largely steady since the Volcker
rule took effect, said Carolyn Maloney, the ranking Democrat on the
subcommittee, citing what she called the first hard data on the rule.

The data, from the Federal Reserve, showed banks under the prop trading ban
had not pulled back from credit markets during two periods of market stress: the
suspension of withdrawals from the credit fund run by Third Avenue
Management in December 2015, and the market scare over Chinas slowing
economic growth in January and February 2016.

In fact they increased their exposure during these episodes. My takeaway from
the Fed data is the Volcker rule has not caused banks to pull back from market-
making, even in periods of market stress, said Maloney.

The Fed is one of the five US regulators charged with implementing the
regulation that Maloney asked in August to provide her with an analysis of the
relevant metrics collected from banks under the prop trading ban.

Maloneys evidence took the subcommittee chairman, Republican Bill Huizenga,

by surprise. He said he hadn'thad access to the data until it was presented by
his Democrat counterpart and relied instead on a September 2016 report by the
Federal Reserve as the basis for his questions at the hearing.

The 46-page report, entitled The Volcker Rule and Market-Making in Times of
Stress, concluded the proprietary trading ban had unambiguously damaged
liquidity in US credit markets, although the paper did not focus on the two stress
events examined by the Fed.

http://www.risk.net/regulation/4561866/uslawmakersdividedovervolckerrulesimpactonbondliquidity 2/5
3/31/2017 USlawmakersdividedoverVolckerrulesimpactonbondliquidityRisk.net

Our main finding is the Volcker rule has a deleterious effect on corporate bond
liquidity and dealers subject to the rule become less willing to provide liquidity
during stress times. While dealers not affected by the Volcker rule have stepped
in to provide liquidity, we find the net effect is a less liquid corporate bond
market, the report reads.

The debate over the impact of the rule was further fuelled at the hearing when
Marc Jarsulic, from left-leaning think tankthe Center for American Progress,
said many of the indicators of worsening credit markets cited by Volcker critics
were misleading.

Critics of the Volcker rule have long

forecast dire consequences for the corporate bond
market, including declining liquidity and harm to
the functioning of capital markets. These negative
effects have not materialised
Marc Jarsulic, Center for American Progress

While total assets held by securities brokers and dealers have declined from
peak values of about $5 trillion in 2008 to approximately $3.5 trillion in 2016,
the connection between the decline and the Volcker rule is really not that
strong, he said.

Jarsulic argued the large run-up in bond inventories before the financial crisis
reflected the accumulation of private-label mortgage-backed security inventories
and that declining issuance of mortgage bonds explained the dwindling
inventories in the years since.

Critics of the Volcker rule have long forecast dire consequences for the
corporate bond market, including declining liquidity and harm to the functioning
of capital markets. These negative effects have not materialised. The bid/ask
spread for both investment-grade and high-yield corporate bonds is now lower
than it was in the pre-crisis period. A standard measure of price impact has
declined for both high-yield and investment-grade bonds, and is now very low
relative to pre-crisis levels, he said.

The forecasted harm to corporate access to capital has also failed to appear.
New issues of corporate bonds are at record levels at or above the $1 trillion

http://www.risk.net/regulation/4561866/uslawmakersdividedovervolckerrulesimpactonbondliquidity 3/5
3/31/2017 USlawmakersdividedoverVolckerrulesimpactonbondliquidityRisk.net

per year level for the period 2010 to 2015. In conclusion, the exit of large banks
from proprietary trading has not had a measurable effect on corporate bond
liquidity. Under these criteria, our bond markets are functioning at least as well
if not better than they were in the pre-crisis period, Jarsulic added.

The effects of the Volcker rule may become clearer when economists at the
Securities and Exchange Commission (SEC) report to Congress in May,
according to theoriginalschedule on the impact of post-crisis regulation on
market liquidity. The economists have yet to establish a causal relationship
between the new rules and thinning bond-market liquidity, according to
comments in Novemberby then-SEC chair Mary Jo White.

Controversial wording
The Volcker rule also came under attack at the March 29 hearing for some of its
wording. The rule requires banks to report a series of quantitative trading
metrics, such as risk levels on each trading desk, to help regulators spot any
prohibited proprietary trading.

Various exemptions from the rule exist for certain permitted activities, such as
risk-mitigating hedging and market-making activities. In order to qualify for the
market-making exception, however, banks are required to report their
reasonablyexpected near-term demand (RENTD) in a given security.

Firms are required to prove to regulators they are holding an inventory of a

given asset for market-making purposes, rather than in order to make a
proprietary gain.

The RENTD provision has proved controversial, with bank lobbyists arguing it
is a wholly subjective test and regulated firms have no means of gauging
whether an inventory of bonds they are holding in anticipation of future client
demand would be deemed to be appropriately sized.

RENTD is a concept only government could devise, said Ronald Kruszewski,

chief executive of Stifel Financial Corp, testifying at the hearing. Seven years
after the enactment of Dodd-Frank, I am no closer to understanding what that
term means or how to implement something so amorphous.

The Volcker rule should be repealed. If not repealed, at a minimumit should be

modified to reverse language that assumes all trades are proprietary unless
proven otherwise and eliminate the RENTD requirement," he added.

http://www.risk.net/regulation/4561866/uslawmakersdividedovervolckerrulesimpactonbondliquidity 4/5
3/31/2017 USlawmakersdividedoverVolckerrulesimpactonbondliquidityRisk.net

http://www.risk.net/regulation/4561866/uslawmakersdividedovervolckerrulesimpactonbondliquidity 5/5