A Little Volatility Can Be Good for You

Excess liquidity.

Gyrations in financial markets are giving rise to a plaintive cry from investors: Prices are getting more volatile because new regulations are making big banks less willing to buy when others want to sell.

Actually, if that's what's happening, it would be no bad thing.

Following last week's selloff, investors are complaining about a lack of liquidity, the ability to buy and sell assets (particularly bonds) without moving prices too much. The problem, they say, is that big U.S. banks are pulling back from market making -- the buying and selling of assets to meet clients' needs. They blame the shift on new regulations such as higher capital requirements and the Volcker rule, which aims to limit speculative trading at banks.

Investors are right that something has changed. The big banks are holding much smaller inventories of corporate bonds than they did before the 2008 crisis. In fact, dealers were net sellers of junk bonds in recent weeks, suggesting that they weren't, in the aggregate, helping clients to unload. From the point of view of an overextended investor needing to sell, this reduction in liquidity can be scary.

That said, it's unclear that regulation is the primary cause. Banks were cutting their inventories long before Congress passed the Dodd-Frank financial reform law in 2010. And liquidity always disappears in bad times, no matter how abundant it seems in good times. Market makers are no more willing to buy than anybody else when prices appear to be in free fall. Last week's volatility hit some securities, such as U.S. Treasury bonds, to which the Volcker rule doesn't even apply.

But let's assume for the sake of argument that regulation is the reason for the banks' flight from market making. Would that be bad? Not necessarily. You can have too much liquidity, especially when it's of the wrong sort -- for instance, liquidity provided by banks that are relaxed about risk because they can count on taxpayers to bail them out. In the early 2000s, the banks' willingness to make markets in mortgage investments and provide easy financing to buyers encouraged the false sense of security that helped bring on the crash. The banks then lost billions of dollars on their trading positions -- losses that meant they couldn't lend when the economy most needed them to.

In a way, last week's volatility was salutary. Investing in securities backed by the credit of shaky companies and consumers is a perilous endeavor, particularly if done with borrowed money. If regulations are making investors and big financial institutions sensitive to the danger sooner rather than later, that's good.

--Editors: Mark Whitehouse, Clive Crook.

To contact the editor on this story:
David Shipley at davidshipley@bloomberg.net