Paper asserts Volcker Rule increased cost of liquidity, decreased market share of covered firms

An increased cost of liquidity to firms is caused by the Volcker Rule, while at the same time the rule does not decrease their exposure to liquidity risk, a new report issued Tuesday by a Treasury office finds.

The report also finds that the Volcker Rule – designed to ban proprietary trading by commercial banks and their affiliates —  has decreased the market share of covered firms, noting that customers appear to be trading more with non-bank dealers, who are exempt from the Volcker Rule but also cannot borrow at the Federal Reserve’s discount window.

The paper was published by the Office of Financial Research (OFR), the arm of the Treasury Department set up under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) designed to study financial trends.

“The Volcker rule appears to have increased the cost of the liquidity provided by covered firms and has not decreased the liquidity risk exposure of covered firms,” the OFR said in its abstract of the 48-page paper. It asserted 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 also lack access to emergency liquidity support at the Fed’s discount window.”

Additionally, the paper states that OFR found no evidence of the rule’s intended reduction in the riskiness of covered firms’ trading in corporate bonds. “We find significant adverse liquidity effects on covered firms’ corporate bond trading with 20-45 basis points higher costs for customers even for roundtrip trades of shorter duration. These effects do not appear to be transitional,” OFR states.

The Effects of the Volcker Rule on Corporate Bond Trading: Evidence from the Underwriting Exemption