Liquidity and Risk - How Financial Markets Judge Regulatory Proposals

In the eight years that have passed since the height of the financial crisis, many regulatory reforms have been discussed:  Some have been abandoned altogether, some have been passed but not yet implemented, and some are in the process of being implemented with the nitty-gritty details being worked out. Throughout this entire process financial market actors and the financial press have made judgments about the likely consequences of reform proposals on financial markets, leveraging broadly shared ideas about market effectiveness, liquidity and risk management in conflicts over reform proposals.

In such debates liquidity has been held up as a universal good for financial markets, yet this concept is rarely if ever being clearly defined nor is it discussed as existing in a trade-off relationship with other goods and functions which financial markets are supposed to perform for the broader economy. More liquid markets are always “good”, less liquid is bad. Similarly, concerns about the efficient operation of banks’ internal risk management systems are actively used in regulatory debates. The idea of the superiority of internal risk management over regulatory rules appears to have survived the crisis, as sector-based risk management remains useful as a counterargument toward regulatory proposals seen as interfering with such systems.

This paper examines three sets of regulatory proposals that have been broadly discussed in various domestic jurisdictions as well as among international regulators, investigating how concepts and ideas are negotiated and leveraged by various parties in policy-processes characterized by strong conflicts of interests. The first set of proposals concern the ring-fencing of certain financial activities from commercial banking activities in an effort to re-install some form of the Glass-Steagall Act. These proposals have largely failed, mainly due to severe push-bank from financial actors. The second set of proposals concern the raising of capital adequacy requirements, pushed by the Basel Committee and largely adopted in most member countries. The final set of proposals concern proprietary trading, with a focus on the development of this policy in the American regulatory jurisdiction. From a simple ban on such trading, proposed by Paul Volker, the prop trading proposal has evolved to become a complex set of rules containing many loopholes which the financial sector successfully lobbied for using arguments concerning market efficiency, liquidity concerns and the need for effective risk management.