Managing Regulatory Pressure: Bank Regulation and its Impact on Corporate Bond Intermediation

Abstract

We study how Basel regulations impact corporate bond intermediation in the cross-section of differently regulated intermediaries. Using intra-quarter variation in the intensity of Basel requirements, we document pronounced inventory contractions when regulatory pressure rises near quarter ends. In contrast to their behavior in short-term money markets, U.S. bank dealers do not absorb regulatory selling pressure in corporate bonds. Instead, bank dealers direct their selling primarily to nonbank financial intermediaries at sizeable price concessions. In doing so, they fall back on institutional investors to offload investment-grade bonds and nonbank dealers to dispose of high-yield bonds. In the aggregate, Basel leverage regulation significantly impairs liquidity conditions in the corporate bond market, specifically in balance sheet-intensive trades in which regulatory shadow costs account for up to 20% of average transaction costs. Our findings have implications for the design of future regulation of both bank and non-bank financial intermediaries.

Keywords: Corporate Bond, Dealer, Regulation, Liquidity, Nonbank Financial Intermediation, Insurance Companies, Networks

JEL Classification: G12, G21, G22, G23, G24