Volcker Rule sapped bond liquidity during market stress, Fed paper says

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5 January 2017. By Neil Roland.

The Volcker Rule has drained liquidity from corporate bond markets during market stress in the last couple of years, US Federal Reserve staff economists found.

The findings, in a working paper, give ammunition to congressional Republicans’ efforts to trim or eliminate the 2014 rule barring federally insured banks from making risky bets with their own money.

The 46-page study found that bond liquidity has ebbed after corporate bonds were downgraded to junk.

“The relative deterioration in liquidity around these stress events is as high during the post-Volcker period as during the financial crisis,” said the paper by two PhD Fed economists and a Cornell University finance professor.

“Given how badly liquidity deteriorated during the financial crisis, this finding suggests that the Volcker Rule may have serious consequences for corporate bond market functioning in stress times,” it said.

Dealers to which the rule applied backed off participation in dealer-to-customer trades and significantly reduced their commitment of capital, the study said.

The Volcker Rule was part of the 2010 Dodd-Frank Act.

Lew: Volcker ‘important reform’

The paper was careful not to pass judgment on the overall impact of the rule. Still, the study is noteworthy because the Fed played a key part in the Obama administration’s push to adopt the standard.

US Treasury Secretary Jacob Lew, in his exit memo Thursday, said the rule was one of several “important reforms” adopted through coordination among federal regulators.

“Because of these efforts, our system today is more stable, more transparent, and more consumer-focused,” he said.

Congress targeting Volcker Rule

Last September, the House cleared a rollback of the Dodd-Frank Act that would, among other things, repeal the Volcker Rule.

After Donald Trump won the presidential election in November, US Representative Jeb Hensarling said his committee plans to tinker with this legislation and reintroduce it in early 2017.

Hensarling, who heads the House Financial Services Committee, invited banks and other lobbyists to weigh in on changes that should be made to the bill.

Industry lobbyists have started meeting with congressional staff to discuss possible Volcker Rule changes.