The Volcker Rule is not going to bring your house back

Got a great deal of hate mail lately on the post entitled Regulate it all, ask questions later. Many want to see solid research that would point to potential pitfalls of the so-called Volcker Rule. Otherwise they will fully support this regulation. Much has been written on the subject, but a recent paper by Darrell Duffie of Stanford, provides support to that Sober Look post.

Duffie draws two conclusions from his work:

1. "Over the years during which the financial industry adjusts to the Volcker Rule, investors would experience higher market execution costs and delays. Prices would be more volatile in the face of supply and demand shocks. This loss of market liquidity would also entail a loss of price discovery and higher costs of financing for homeowners, municipalities, and businesses."

2. "The financial industry would eventually adjust through a signi cant migration of market making to the outside of the regulated bank sector. This would have unpredictable and potentially important adverse consequences for financial stability."

As an example of flaws in the proposed regulation (among many in the paper), take a look at the chart below that shows the average return for stocks over time after they have been been removed from the S&P500 index. Typically as index mutual funds, ETFs, and other index linked investment programs (the AUM of these is in the hundreds of billions) are forced to sell a stock, the market makers step in for large blocks of shares. The dealers involved in the stock will make a profit over time as the newly excluded stock recovers, but they need the ability to take risk by holding the stock over a period. If the dealers are no longer there to make markets in these shares, the stock would crater, ultimately disrupting the market. And no, none of the other players, including algo traders, hedge funds, etc. will generally be willing to step in for such large blocks of shares. Since they are not market makers, they are not obligated to show a bid. That disruption hurts the non-index investors and the company itself.

Average cumulative returns for deleted S&P 500 stocks (Source: Darrell Duffie - 2010a).

Ultimately the answer to the banking crisis is in the improved overall capitalization and strengthened bank liquidity positions. The Volcker Rule, particularly in its current form is not the answer, because it has never been about market making. So before writing another hate mail on how you lost your house and how the Volcker Rule would have prevented it, read the paper. A little bit of knowledge will go a long way.

Enjoy!

DuffieVolckerRule

SoberLook.com

Pending regulation is squeezing dealer inventories

Here is a quick followup to the post on the unintended consequences in the corporate bond market. The dealer inventory of corporate bonds (both investment and non-investment grade) continues to decline to levels not seen since 2002 when the corporate bond market was a fraction of what it is today. Anyone who has ever been involved in market making - whether it is bonds or baseball cards - knows how important it is to have the flexibility to manage your inventory. Otherwise one simply becomes a broker and the liquidity in the product disappears. In such an environment you can only execute if there is someone on the other side, vs. trading with a dealer who can hold a position until she finds the other side of the trade.

Primary Dealer net inventory of corporate bonds (source: NY Fed)

The pending regulation is putting a squeeze on inventories, rapidly diminishing liquidity, particularly for middle market corporate names. Yes, dealers have less risk on the books because of lower inventories, but the risk to investors is increasing because it will be that much harder to buy and sell securities in a low liquidity environment. 

SoberLook.com

Paul Volcker's beef with money market funds

Paul Volcker is obsessed with protecting banks from "unregulated competition". In his view this competition comes from money market funds who offer a product that competes with bank deposits.

"In my vision of the new financial system, you obviously want to protect banks and have strong banks, and I don't think they should be put at a competitive disadvantage vis-a-vis money-market funds," (from Reuters)

In some ways this proposal is equivalent to suggesting that UPS and FedEx should be regulated (or federally owned) because they present competition to the USPS. Sounds like socialism, doesn't it?

It is not clear just how much competition money market funds actually pose to banks. Money markets are restricted on the average (and maximum) maturity of their assets. As an example let's take a look at SPRXX, the Fidelity's money market fund. It's assets' average maturity is now 74 days and the current yield is 0.33% - annualized. Banks on the other hand don't have significant maturity restrictions and can take advantage of the steep yield curve. If they are lending at 5-6% longer term, they can afford to pay higher rates to depositors.

The chart below compares yield on average bank money market deposit rates (national average) with the yield on the Fidelity money market fund.

As the yield curve gets steeper the differential gets worse for money market mutual funds. Even bank checking account rates are higher than money fund rates. The table below shows current (national average) rates banks are paying on retail deposits of different types:



An individual who wants a safe place to deposit cash will generally choose an FDIC insured account yielding 1.17% rather than an unsecured account yielding 0.33%. One of the reasons people hold cash with money market funds is to get convenient access to their brokerage or mutual fund accounts (such as Fidelity). Another reason (as is sometimes the case with institutional investors), they just don't trust the stability of banks. Money funds therefore serve an extremely useful purpose. Without a money market product for example cash in a brokerage account would have to be moved into a bank account and back to facilitate securities trading.

In addition, money funds purchase commercial paper that gives corporations (and banks) access to inexpensive short-term financing - some of which translates into better financing and lower costs for consumers.

To the extent money funds present some competition to banks because of the their niche role, it would be counterproductive to eliminate this competition. The approach Mr. Volcker is suggesting is to regulate money funds the way banks are regulated. That means the following:

1. Insuring money market funds via the FDIC program
2. Giving funds access to the Fed's emergency facilities
3. Requiring them to hold capital

FDIC insurance will force a fee on money funds, that combined with more stringent maturity restrictions (that are definitely coming), will squeeze the return on funds and their ability to charge fees, making the business completely unprofitable. This will also have a potential to put additional pressure on the FDIC deposit insurance fund. Giving money market funds access to the Fed's emergency liquidity facilities would help the funds, but will put the taxpayer at an increased risk. Requiring money funds to hold capital is an impossibility, because unlike banks, mutual funds can't raise separate equity.

Mr. Volcker's need to protect the banking system from money market fund competition is misguided. From Bloomberg:

His proposals “would eliminate money funds as we know them,” Paul Schott Stevens, head of the Investment Company Institute ...

Which is exactly how far Mr. Volcker wants to take this in order to help the banks.