OFR Paper Examines Effects of Volcker Rule on Corporate Bond Trading
OFR published a working paper that examines the effects of Volcker rule on corporate bond trading. The paper examines the impact of the Volcker rule, which bans proprietary trading by commercial banks and their affiliates, with some exceptions. The paper finds evidence that the rule has increased the cost of liquidity provided by firms it covers, but not decreased the firms’ exposure to liquidity risk. It also finds that the rule has decreased the market share of covered firms. Customers appear to be trading more with non-bank dealers, who are exempt from the Volcker rule, but cannot borrow at the discount window of FED.
The study used the underwriting exemption of the Volcker rule combined with the regulatory TRACE dataset to identify the Volcker rule’s impact on bank holding company affiliated dealers’ trading in the corporate bond market. This identification strategy separates out the effects of market liquidity and other contemporaneous changes in financial regulation. Using regulatory data on secondary market transactions in corporate bonds, the authors classify round-trip trades of different duration completed by all dealers. The analysis in this paper makes use of three datasets to obtain information on corporate bond transactions, bond characteristics, and dealer type, including transaction data and round-trip trades, bond characteristics and underwriter information, and Volcker-covered status of dealers. Using a novel within-dealer, within-security identification strategy, the paper examines intended and unintended effects of the Volcker rule on covered firms’ corporate bond trading, using dealer-identified regulatory data. The underwriting exemption was used to isolate the Volcker rule’s effects separate from other post-crisis changes in bank regulation and broader trends in market liquidity.
A reduction of the riskiness of covered dealer trades in this market was one of the intended effects of the Volcker rule. The paper found no evidence of the rule’s intended reduction in the riskiness of covered firms’ trading in corporate bonds. The markups significantly increased for trades by covered dealers, even after controlling for other contemporaneous effects. This increase in costs of 20 to 45 basis points per round-trip trade represents a statistically and economically significant change in corporate bond market liquidity. After controlling for the 16-month transition period immediately following the implementation of the rule, these effects remain persistent. It was further found that covered dealers are losing corporate bond market share to non-bank dealers as a result of the Volcker rule. Overall, the paper suggests that the rule in its current form is not reducing dealer risk-taking in corporate bonds and may be increasing the spreads charged by covered dealers. The results of this study, however, cannot be extrapolated to the effects of the rule on trading in other asset classes.
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Keywords: Americas, US, Banking, Securities, Volcker Rule, Covered Bonds, Proprietary Trading, Corporate Bond, OFR
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