Fed Official Suggests Link Between Rules and Liquidity Concerns

WASHINGTON — Federal Reserve Board Gov. Lael Brainard conceded Thursday that the flood of bank regulations may have a role in increasing the potential for diminished market liquidity.

There is increasing chatter across the financial sector about whether liquidity has been reduced across the board, which could undermine market stability or even lead to another crisis. Some have raised concerns that the Dodd-Frank Act and other regulatory measures could be the culprit. For example, certain trading activities seen as promoting market liquidity are banned under Dodd-Frank's "Volcker Rule." Other regulations prompt banks to load up on certain high-quality, lower-risk assets, meaning they are less available to other market participants.

Regulators say they are monitoring the issue, but note that any causes of market liquidity changes could be multifaceted. For example, the growth in electronic and high-frequency trading — a potential cause — predated Dodd-Frank.

But Brainard said the effects of new rules cannot be discounted.

"What's driving this? Probably a few things. Is regulation playing a role? I would guess that it is," she said at an event cosponsored by the Bipartisan Policy Center and Managed Funds Association commemorating the fifth anniversary of Dodd-Frank. Still, she added banks may be managing risk differently on their own in the wake of the crisis.

Brainard said regulators are watching for signs of unusual volatility like that seen in the U.S. Treasuries market on Oct. 15, when bond yields quickly plummeted within the span of just a few minutes before rising again.

"There's little evidence that day-to-day liquidity is materially different," Brainard said. "The question really is about the resilience of liquidity at moments of big changes and perceptions of risk or actual news that would alter people's positions."

While the Fed governor cautioned that it's premature to discuss "a set of regulatory changes or a prescriptive agenda" to address liquidity concerns, her comments echoed those of other officials that reveal growing interest in the issue. Last month, Office of Financial Research Director Richard Berner said regulations could "be contributing to more permanent adjustments that could impair market functioning." However, Berner said more research is needed before a definitive connection can be made.

In her prepared remarks, Brainard said the financial system is embarking on "an important period" five years after Dodd-Frank for determining the appropriate size and scope of the biggest banks.

"As standards for systemically important firms tighten, some institutions may determine that it is in the best interest of their stakeholders to reduce their systemic footprint," she said. "But it is also possible that some may judge that the economies of scale and scope are such that it makes sense to maintain their systemic footprint, even at the expense of the greater regulatory burdens necessary to protect the system relative to those faced by their non-systemic competitors."

The Fed governor also noted that the Fed continues to look for ways to strengthen the system further. She said the agency is still examining how to incorporate a risk-based capital surcharge into the annual stress-testing process "in order to ensure... institutions remain sufficiently resilient to reduce the expected losses to the system through periods of financial and economic stress."

"Conceptually, the stress test and the capital surcharge should work to reinforce each other — not substitute for each other," she said.