Dealer Intermediation, Market Liquidity and the Impact of Regulatory Reform

28 Pages Posted: 19 Jul 2017

See all articles by Zijun Liu

Zijun Liu

Bank of England

Yuliya Baranova

Bank of England

Tamarah Shakir

Bank of England - Monetary Analysis

Date Written: July 14, 2017

Abstract

We develop a model of dealer intermediation in bond markets that takes account of how changing regulatory requirements for banks since the financial crisis, in particular, the introduction of minimum leverage ratio requirements, affect the cost and ability of dealer banks to provide intermediation services. The framework considers two distinct dealer functions: that of provider of repo financing (to prospective bond market participants) and that of market-maker. The cost and ability of dealers to provide these services under different regulatory constraints determines the price impact of a given trade on the market — or the level of ‘market liquidity premia’. In the model the impact on market liquidity varies for different levels of market volatility or ‘stress’. We find that under normal market conditions estimates of corporate bond liquidity risk premia are higher under the new regulations, but also that corporate bond market liquidity is more resilient due to better-capitalised dealers continuing to intermediate markets under higher levels of market stress than pre-crisis. Mapping these changes in liquidity premia to GDP, via their impact on the cost of borrowing for corporates in the real economy, the results of the model suggest that under normal market conditions there may be a greater cost of regulation via corporate bond markets than incorporated in earlier studies. However, once offset against the benefits of greater dealer resilience, including the benefits to market functioning, there remain net benefits to new regulations.

Keywords: Regulation, market liquidity, dealer intermediation, corporate bonds, cost-benefit analysis

JEL Classification: G12, G23, G24, G29

Suggested Citation

Liu, Zijun and Baranova, Yuliya and Shakir, Tamarah, Dealer Intermediation, Market Liquidity and the Impact of Regulatory Reform (July 14, 2017). Bank of England Working Paper No. 665, Available at SSRN: https://ssrn.com/abstract=3003871 or http://dx.doi.org/10.2139/ssrn.3003871

Zijun Liu (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Yuliya Baranova

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Tamarah Shakir

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

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