The fifth and last of the Federal Reserve Bank of New York’s Liberty Street Economics blog series on liquidity was called “What’s Driving Dealer Balance Sheet Stagnation?”. Authored by Tobias Adrian, Michael Fleming, Daniel Stackman, and Erik Vogt, it was published August 21st. The primary focus is on the run-up of dealer leverage prior to the financial crisis and subsequent shrinking of dealer balance sheets during the crisis and beyond.
The discussion in the press about diminished liquidity in the financial markets has mostly been about blaming financial regulation. Higher capital levels, the Volcker Rule, Basel III, stress testing, and capturing all major broker/dealers in the bank regulatory constellation are some of the reasons cited for reduced broker/dealer balance sheets. Smaller balance sheets, so the logic goes, reduces liquidity.
Broker/dealer balance sheets have stabilized around $3 trillion.
From the post:
“…Total financial assets of dealers in the United States have not shown any growth since 2009. This stagnation in their balance sheets raises the worry that dealers’ market-making capacity could be constrained, adversely affecting market liquidity…”
The LSE post argues that dealer balance sheets contracted as a result of the financial crisis and regulation only came along afterwards. Dealer leverage went from 48 times in 2008:Q1 to 25 just fifteen months later. The authors do concede, sort of, that post-Dodd-Frank dealer balance sheets and leverage have stagnated. Dealer leverage has gone from 25 just after the passage of Dodd-Frank and Basel III to about 20 now. A 20% fall (taking us back to levels not seen since 1990) without a crisis alongside, is still significant.
“…On the one hand, most dealer deleveraging occurred prior to the announcement of potentially constraining regulation, suggesting post-crisis dealer balance sheet contraction is largely attributable to a decrease in dealers’ risk appetite. On the other hand, while Dodd-Frank and Basel III regulations may help explain the moderate deleveraging since 2010, it is unclear to what extent regulations constrain growth in dealer leverage and risk-taking today, over and above a lingering lack of risk appetite…”
The broker/dealers, who expanded the most into the financial crisis and/or took the most risk, were also the ones who shrunk the most. “…we show that dealers that expanded their balance sheets more in the run-up to the crisis (2002-2007) tended to contract their balance sheets more after the crisis (2009-2014)…”
This procyclical behavior certainly won’t be surprising. Broker/dealers got carried away, especially when it came to securitization, and paid a price. The riskier the markets, the greater the losses – although AAA super senior tranches, further wrapped by AAA bond insurers, may not have seemed so risky at the time.
Finally the article cites “electronification”, a/k/a program trading, as a reason for dealers shying away from market making.
“…The growing role of electronic trading has likely narrowed bid-ask spreads and reduced dealers’ profits from intermediating customer order flow, causing dealers to step back from making markets and reducing their need for large balance sheets…”
It is challenging to reconcile the fifth article about broker/dealers exhibiting their expected pro-cyclical behavior, albeit with a dose of counter-cyclical constraint from regulation more recently, leading to less liquid markets and the first article that suggested that when judged by a number of metrics – bid-ask spread, order book depth, pricing impact for a given flow, trade size, pricing differences between on and off-the-run securities, and securities with similar risk – that market liquidity was doing just fine. See our August 31st SFM post “The NY Fed’s Liberty Street Economics blog: is there evidence of UST liquidity in decline?”.
There can be little debate that broker/dealer behavior moving forward will constrained by the regulatory environment. They couldn’t radically expand their balance sheets if they wanted to. With broker/dealers taking less principal risk, the banking system is certainly a safer place. But there is a cost to less liquidity and that cost is increasingly borne downstream by investors.