The Volcker Rule and Market-Making in Times of Stress

Abstract

Focusing on downgrades as stress events that drive the selling of corporate bonds, we document that the illiquidity of stressed bonds has increased after the Volcker Rule. Dealers regulated by the Rule have decreased their market-making activities while non-Volcker-affected dealers have not offset the decreased activities of Volcker-affected dealers. Furthermore, even Volcker-affected dealers that are not constrained by Basel III and CCAR regulations change their behavior, inconsistent with the effects being driven by these other regulations. Since Volcker-affected dealers have been the main liquidity providers, bonds have become less liquid during times of stress due to the Volcker Rule.

Keywords: Volcker Rule, Corporate Bond Illiquidity, Regulation, Capital Commitment, Dealer Inventory, Market-Making, Financial Crisis

JEL Classification: G14, G21, G23, G24, G28