Bank of England’s Cunliffe: era of free liquidity is over

11 November 2014

Tighter market liquidity will be lasting constraint, says Bank of England official. Comments follow those from a senior US official, who said regulators are “beginning to understand it is an issue”  

Investors should get used to tighter liquidity and higher costs, but it is not clear how much of that can be chalked up to post-crisis regulation. That was the message Jon Cunliffe, deputy governor for financial stability at the Bank of England (BoE) delivered to a UK House of Lords subcommittee yesterday.

Referring to claims from banks and their customers that new capital and leverage rules have made markets less liquid and more volatile, Cunliffe acknowledged that liquidity has suffered, but said supervisors “are not sure” of the cause. To some extent, it could be attributed to changes in bank business models, he said.

He was the second senior supervisor to address the issue in recent weeks, after Charles Taylor – an official at the US Office of the Comptroller of the Currency (OCC) – told a conference in New York that regulators were “beginning to understand it is an issue.”

The BoE’s Cunliffe argued the pre-crisis perception of bottomless liquidity had been damaging: “It was there, freely available and you could sell what you wanted, when you wanted, where you wanted, until one day you couldn’t and the whole system came to a crash… We are not going back to that. People will have to pay more.”

Cunliffe was giving evidence to the House of Lords sub-committee on European Union economic and financial affairs. He spoke alongside David Rule, executive director for prudential policy at the Prudential Regulation Authority (PRA), and Andrew Bailey, deputy governor for prudential regulation at the BoE and chief executive of the PRA.

Over the past three years, banks have been seeking to reduce or avoid business that attracts high levels of regulatory capital, ranging from correlation trading and other forms of securitisation, to inflation trading and any long-dated, uncollateralised positions. But there has also been a broad impact on market-making of all kinds – ranging from cash equities to government bonds – because it has become more expensive to hold large inventories.

The impact on investors first came to widespread attention in the third quarter of 2013, when a bout of severe fixed-income volatility followed relatively innocuous comments from then-Federal Reserve chairman, Ben Bernanke. Asset managers found it took longer than expected to exit positions in a variety of securities.

“Banks look at regulatory constraints they face and quite naturally adjust their business accordingly,” said the PRA’s Rule. “They are starting to do that but we haven’t seen the full swipe of that. Some of the things you can see broadly – banks have been reducing their financial markets activity relative to their real economy activity and I think that is certainly part of the back-of-the-mind intention of regulators.”

As an example, Rule pointed to banks that have chosen to exit correlation trading.

The BoE’s Cunliffe accepted there is a possibility regulation will have unintended consequences and said further analysis is needed on how liquidity is being affected. He also criticised the European regulatory process, saying it was currently too difficult to fix problems and calling for a closer relationship between the European Commission and the technical specialists at the European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (Eiopa) and European Securities and Markets Authority (Esma).

“The European process is not pretty… In terms of the technical detail, there is often a lot that has to be revisited afterwards. I think we need quicker, better mechanisms in Europe to be able to spot where there are problems and fix them. I think the technical supervisors – the EBA, Esma and Eiopa – need to feed more directly to the commission,” he said.

The OCC’s Taylor, meanwhile, was speaking at the Risk USA conference in New York on November 22. Like Cunliffe, he recognised regulation was playing a part in the post-crisis drop in liquidity. Rather than the capital, liquidity and leverage rules promulgated by the Basel Committee on Banking Supervision, he pointed to rules relating to bank structure and specific banking activities, such as the Volcker rule’s ban on proprietary trading in the US, the Vickers report’s insistence that retail and investment banking should be ringfenced in the UK, and similar, ongoing work in Europe, which followed the Liikanen report.

“On this question of market liquidity and the Volcker rule – the same issue exists in Europe with Vickers and Liikanen – I think we’re beginning to understand it is an issue, the extent of the issue, and to watch it quite closely,” he said.

Taylor is deputy comptroller for the OCC’s regulatory policy office and chairman of the supervision and implementation group at the Basel Committee.

Questioned on the point, following his keynote address, Taylor accepted prudential rules might also be having an impact on the ability of banks to warehouse risk, but argued the activity-based restrictions are a more direct cause.

“I think the capital and liquidity requirements are sufficiently broad that they give institutions quite a lot of latitude about how they reach those requirements, whereas the activity restrictions are sufficiently specific that you don’t have that latitude. Of the two sets of requirements, in terms of their impact on market liquidity, I suspect the activity requirements are going to be much more material at the end of the day,” he said.

By Joe Rennison