Capital Regulation, Market-Making, and Liquidity

57 Pages Posted: 20 Oct 2022 Last revised: 2 Jan 2023

See all articles by Rainer F. H. Haselmann

Rainer F. H. Haselmann

Goethe University Frankfurt - Faculty of Economics and Business Administration; Leibniz Institute for Financial Research SAFE

Thomas K. Kick

Deutsche Bundesbank

Shikhar Singla

London Business School - Department of Finance; Goethe University Frankfurt - Center for Advanced Studies - Foundations of Law & Finance (LawFin)

Vikrant Vig

London Business School

Date Written: January 5, 2022

Abstract

We employ a proprietary transaction-level dataset in Germany to examine how capital requirements affect the liquidity of corporate bonds. Using the 2011 European Banking Authority capital exercise that mandated certain banks to increase regulatory capital, we find that affected banks reduce their inventory holdings, pre-arrange more trades, and have smaller average trade size. While non-bank affiliated dealers increase their market-making activity, they are unable to bridge this gap - aggregate liquidity declines. Our results are stronger for banks with a higher capital shortfall, for non-investment grade bonds, and for bonds where the affected banks were the dominant market-maker.

Keywords: market-making, capital regulation, bond market liquidity

JEL Classification: G01, G21, G28

Suggested Citation

Haselmann, Rainer F. H. and Kick, Thomas K. and Singla, Shikhar and Vig, Vikrant, Capital Regulation, Market-Making, and Liquidity (January 5, 2022). LawFin Working Paper No. 44, Available at SSRN: https://ssrn.com/abstract=4250896 or http://dx.doi.org/10.2139/ssrn.4250896

Rainer F. H. Haselmann

Goethe University Frankfurt - Faculty of Economics and Business Administration ( email )

Mertonstrasse 17-25
Frankfurt am Main, D-60325
Germany

Leibniz Institute for Financial Research SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Thomas K. Kick

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

Shikhar Singla (Contact Author)

London Business School - Department of Finance ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

Goethe University Frankfurt - Center for Advanced Studies - Foundations of Law & Finance (LawFin) ( email )

Theodor-W.-Adorno-Platz 3
60629 Frankfurt am Main
Germany

Vikrant Vig

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

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