Regulation, the Bane of Bond Market Liquidity

The phrase “bank run” likely conjures up a black and white image of a Depression-era mob rushing the entrance of a generic, Roman-columned bank. Everyone wants their cash back, but the bank only has 10 percent or so on hand, creating increasingly vociferous demand to withdraw as panic spreads.

Lately, regulators have wondered if money managers could be at risk of a similar “run” event if their clientele decided to redeem fund shares en masse. The fund would be forced to sell its underlying holdings, possibly at steep discounts, to free up cash for demanding clients. Investors would face even steeper discounts if willing buyers for a fund’s underlying holdings were not readily available. Regulators are therefore examining the role of liquidity, or lack thereof, in the bond marketplace. Banks, the trading counterparties of major fund companies, are nowadays forced to limit holdings of risky debt in favor of safer assets to meet regulatory capital ratios. The unintended result is that banks no longer “warehouse” the same trading inventory or take the same risk they used to just ten years ago.

The Economist points out that investment funds now hold 20 times as many bonds as banks, compared to only three times as many in the early 2000s, according to Federal Reserve data. Regulators are now evaluating whether stress-testing large investment firms, particularly with liquidity in mind, might provide additional insight into incremental risk that savers now bear. The Financial Times wrote that the debate over whether or not an asset manager should be declared “systemically important” is heating up.

Not surprisingly, some of the largest money managers disagree with proponents of additional regulatory scrutiny. BlackRock’s head of fundamental credit says that although more corporate bonds have been issued as companies take advantage of cheap borrowing rates, things are very different than in 2006. Banks and households are less levered, and forced selling is not as likely as it was pre-Crisis. Vanguard’s head of risk management similarly argues that his firm monitors liquidity regularly and does not expect a “liquidity crunch.”

Asset managers, including SNWAM, are taking steps to deal with reduced liquidity by breaking up orders into smaller pieces, trading less, focusing on short-dated holdings where liquidity is more readily available and cross-trading to limit the impact of redemptions. The Economist concludes, ominously, that less bond market liquidity is perhaps an acceptable trade-off to ensure a robust banking system. Although regulators still want to limit the potential for another taxpayer-funded bailout, it seems taxpayers will nonetheless pay the cost via additional risk in their portfolios.

This is not an ideal trade-off, though it may be the least worst option.

Sources: Federal Reserve, The Economist, FT, BlackRock, SNWAM Research