Senate Banking Hearing on Fixed Income Markets
Senate Banking Committee
Subcommittee on Securities, Insurance, and Investment
Subcommittee on Economic Policy
“Examining Current Trends and Chances in the Fixed-Income Markets”
Thursday, April 14, 2016
Key Topics & Takeaways
- Evidence of Diminished Liquidity: Powell said most measures do not point to a decrease in market depth or changes in bid-ask spreads and prices. He stressed that there is no clear trend that shows a liquidity problem. Weiss argued that pre-crisis liquidity should not be a benchmark and that the regulators should instead be forward-looking and consider the evolution of markets.
- Muni LCR: Sen.Warner (D-Va.) asked about the Fed’s recent final rule to confer Level 2B status for certain municipal securities under the Liquidity Coverage Ratio (LCR) rule. He said this seems “conservative” given that some AAA-rated municipal bonds can have a lower status than sub-sovereign bonds from European nations. Powell responded that the LCR rules are about liquidity, not credit-worthiness, and that the decision to apply 2B treatment reflects the liquidity and amount of trading in municipal securities.
- Impact of Regulations: Weiss and Powell defended post-crisis reforms, with Weiss arguing that they have produced a “higher likelihood” that liquidity conditions will be available in periods of stress.
- Living Wills: Sen. Warren (D-Mass.) said the non-credible living wills show that the largest banks are under-regulated. She said regulators need to keep pushing on tougher regulations for these financial institutions because any of them risks dragging down the whole economy.
Witnesses
- Jerome Powell, Governor, Federal Reserve Board of Governors
- Antonio Weiss, Counselor to the Secretary, Treasury Department
Opening Statements
In his opening statement, Sen. Mike Crapo (R-Idaho) said the October 15, 2014 episode of volatility in Treasury markets has generated a robust debate about its causes and the possibility of similar episodes in the future. He said several factors, including new regulations, could cause liquidity to disappear when it is most needed. Crapo noted a recent report from the Bank for International Settlements that said fixed income markets are in a state of transition and listed a series of contributing factors, including technology, competition, bank deleveraging and regulation, and monetary policy.
Sen. Mark Warner (D-Va.) opened by noting differences between equity markets and the fixed income markets, explaining that they lack a central exchange or system for trading, include large spreads, and only have post-trade reporting. He said he would be interested in hearing about post-trade transparency rules, the role of prudential regulation and its impact on liquidity, market structure, and the interaction between futures and other markets.
Sen. Dean Heller (R-Nev.) stated that there have been early warnings that fixed income markets are becoming less liquid and more fragile, and cautioned that if unchecked, these issues would spill over into the rest of the economy. He discussed the PwC report commissioned by the Global Financial Markets Association and the Institute of International Finance, which concluded that it is important that regulators understand the link between regulations and liquidity and that future regulations must balance stability and liquidity considerations.
Sen. Elizabeth Warren (D-Mass.) talked about the importance of liquid markets, but then pointed out that there does not seem to be any single measure of liquidity. She argued that every claim that liquidity is shrinking is offset by another claiming the opposite. She said the financial services industry has been arguing that regulations have negatively impacted liquidity as a “convenient boogeyman” to push for rollbacks of Dodd-Frank and other post-crisis reforms. Warren added that if post-crisis reforms have reduced liquidity, it may be that current forms of liquidity are in fact more stable and more likely to “stick around” when needed most.
Testimony
Jerome Powell, Governor, Federal Reserve Board of Governors
In his testimony, Powell noted that some market participants have expressed concerns regarding market liquidity, but that studies have not been able to show a broad reduction across markets. He said questions about whether liquidity has deteriorated are difficult to answer definitively, but what officials can tell is that trade sizes and turnover have declined and that there is some evidence that liquidity in lower-rated bonds has diminished.
Powell said a number of factors can be contributing to declines in liquidity or volatility spikes, including: 1) market makers substantially reducing their portfolios as a result of the financial crisis heightening their awareness of the risks of large portfolios and liquidity provision; 2) algorithmic trading; and 3) regulation increasing the cost of balance sheet usage, which also makes the financial system more resilient. Powell added that some reduction in market liquidity is a “cost worth paying” to make the overall system safer.
Antonio Weiss, Counselor to the Secretary, Treasury Department
Weiss, in his testimony, said there is “little compelling evidence” of a broad-based deterioration in liquidity, despite episodes of market volatility and some indications that large transactions in corporate bonds are difficult to complete. He said high pre-crisis liquidity was the result of soaring leverage and reliance on short-term funding, and that this liquidity disappeared when panic hit and led to forced selling. He defended post-crisis reforms that have “demonstrably strengthened” the financial system by leading banks to double their capital holdings of high quality liquid assets while cutting short-term funding and increasing deposit bases.
Weiss said the fixed income markets are undergoing a period of structural change driven by technology, changing risk appetites and business models, a changing investor base, and much needed regulatory reform. He said the most immediate conclusions of regulators’ investigations into liquidity to date have been the need for greater access to data and more efficient sharing of data among regulators.
Questions and Answers
Evidence of Diminished Liquidity
Crapo read from a briefing paper developed by the European Parliamentary Financial Services Forum, which suggested that banks’ responses to post-crisis reforms are reducing the resilient liquidity of financial markets and passing trade execution risk from banks to investors and issuers. Powell responded that firms have reduced their market making activities, but suggested that one must look at individual markets when considering liquidity. He mentioned a report from the Financial Industry Regulatory Authority (FINRA) that did not find consistent evidence of a broad reduction in liquidity. Weiss added that while dealer inventories were far higher before the crisis, the vast majority of inventories were residential mortgage-backed securities and structured credit which are no longer being issued today “for good reason.”
Crapo asked the witnesses if they have concern that liquidity for corporate bonds has deteriorated in the past few years. Weiss noted strong primary issuance and trading volumes, but acknowledged declines in trade sizes and in the proportion of block trades. Powell pointed out that despite two significant economic shocks – the drop on oil prices and global economic turmoil – corporate bond markets have remained strong.
Crapo asked if market makers are leaving the markets today. Powell said most measures do not point to a decrease in market depth or changes in bid-ask spreads and prices. He stressed that there is no clear trend that shows a liquidity problem. Weiss argued that pre-crisis liquidity should not be a benchmark and that the regulators should instead be forward-looking and consider the evolution of markets.
Heller expressed frustration that Weiss and Powell did not have the same concerns about market liquidity as shared by market participants and most of the Committee members. He asked whether low interest rates might be masking the impacts of reduced liquidity. Powell replied that it is not masking liquidity, and that the real question is what will happen as the process of raising rates goes on. He said it would lead to asset managers holding more liquidity risk. Weiss said the Treasury Department’s focus on liquidity is “intense” and that it feels an “awesome responsibility” to maintain the depth and liquidity of the Treasury market.
Post-Trade Transparency and Data
Warner asked if regulators could improve post-trade transparency without impairing market liquidity. Weiss replied that a whole section of the Treasury Department’s Request for Information (RFI) deals with post-trade transparency, and he said he expects to have a process in place to ensure officials have access to all trade data by the end of the year.
Warren asked what kind of data the regulators are lacking, and where this creates vulnerabilities. Weiss answered that cash Treasury markets are very fragmented and that regulators have limited information of dealer-to-customer flows. He said it is imperative that the regulators have a concrete plan in place by year end to ensure that regulators have sufficient access to data and the ability to share it with each other.
Algorithmic Trading
Asked by Warner about the role of algorithmic trading, Weiss noted that the RFI includes questions on algorithmic trading relating to operational resiliency and the robustness of the pre-trade environment. Powell said algorithmic trading “is not going away” and that most market participants are now electronic traders.
Heller asked why it seems that electronic trading has made debt markets less liquid, when it has made equity markets more liquid. Powell answered that he does not think it makes the debt markets less liquid, but that electronic traders are new providers of liquidity. He said the real question will be whether this new liquidity provider makes markets more fragile.
Sen. Jack Reed (D-R.I.) asked about the role of electronic trading in the episodes of volatility. Powell said electronic trading is “here to stay” and that regulators must make sure that its role in markets promotes safety, soundness, and confidence.
Muni LCR
Warner asked about the Fed’s recent final rule to confer Level 2B status for certain municipal securities under the Liquidity Coverage Ratio (LCR) rule. He said this seems “conservative” given that some AAA-rated municipal bonds can have a lower status than sub-sovereign bonds from European nations. Powell responded that the LCR rules are about liquidity, not credit-worthiness, and that the decision to apply 2B treatment reflects the liquidity and amount of trading in municipal securities.
Warner reiterated that he does not believe it appropriate that sub-sovereign European debt does not face the same level of restrictions as that of U.S. municipalities, and he urged the banking regulators to reconsider this.
Warren asked why the Federal Reserve’s recent rule allows municipal securities to count as Level 2B assets, but not Level 2A. Powell replied that investment-grade municipal bonds are more akin in liquidity to highly-rated corporate bonds than to sub-sovereigns that trade more similarly to Treasurys. He said giving municipal bonds Level 2A treatment “would give them too much credit.”
Sen. Mike Rounds (R-S.D.) asked if episodes of volatility in Treasury markets support arguments that banks should hold a wide variety of liquid capital, such as municipal securities. Powell said the LCR counts different securities differently, and stressed that it in no way limits how much a bank can hold in municipal securities, but rather reflects that they are less liquid.
Impact of Regulation
Heller cited Larry Summers as having said it is a legitimate concern that regulators in their actions are losing sight of the need to keep markets liquid. Weiss dismissed the comparison between financial institution stability and market stability, and also stressed the pre-crisis liquidity was fueled by highly-leveraged banks. He said conditions today are far more stable because of regulatory reform, and argued against using pre-crisis liquidity as a benchmark.
Heller asked if it is fair to question whether regulations are having an impact on market liquidity and whether they are having the intended effects. Weiss answered that the prudential regulators have tailored rules for institutions of different sizes, and that this coupled with the discretion afforded them to react to market developments provides ample flexibility to addressing changing conditions.
Heller asked if it was the regulators’ intention to push banks out of their traditional roles as market makers. Weiss retorted that banks are still responsible for the majority of market making in the Treasury and corporate bond markets, and said market participants are only responding to changing technology, changing risk appetites and business models, and much-needed reforms.
Warren argued that pre-crisis liquidity built on excessive leverage proved not to be available in stressed times, and asked whether new rules have led to a better chance that liquidity will be available during a panic. Weiss answered that regulation has produced a “higher likelihood” that liquidity conditions will be available in periods of stress.
Warren said liquidity that disappears in times of stress is not valuable, and that the focus should be on ensuring liquidity is available during such times. She said Dodd-Frank and other reforms have done “exactly that.”
Crapo noted that the European Commission launched a Call for Evidence on the European Union’s regulatory framework, but expressed concern that it seems Weiss and Powell are suggesting the U.S. does not need a similar effort to look at the impacts of regulations. Weiss said the regulators’ agenda is forward-looking and that he would not advocate revisiting regulations already in place because they have effectively created confidence in financial institutions and the system as a whole. Powell said regulation is considered as one of a series of factors that might affect liquidity, but that “some of that is by design.”
Heller asked if the Federal Reserve is reviewing global rules, such as those stemming from the Basel Committee, and whether capital requirements have an effect on liquidity. Powell said the Fed is “very focused” on conditions in fixed income markets. He continued that capital requirements have made balance sheet-heavy businesses more expensive to run, so there are effects on liquidity, but that this was “not unintended” and that the negative consequences can be dealt with.
Rounds asked if Powell and Weiss ever worry that requiring banks to hold more capital may have unintended consequences. Powell said the Fed considers all input when it publishes proposals, and that it is a constant concern that its capital requirements are not too high or too low. Weiss added that the “wrong level” of capital was what existed before the crisis. He credited post-crisis reforms for building confidence in financial markets.
Living Wills
Warren said the announcement by the Federal Reserve and Federal Deposit Insurance Corporation that some of the country’s largest institutions did not have credible living wills shows that too big to fail is still a problem. She asked Powell about the role of liquidity in the living wills. Powell responded that the regulators require a model that estimates a firm’s liquidity needs and considers the firm’s structure and placement of liquidity.
Warren said the non-credible living wills show that the largest banks are under-regulated. She said regulators need to keep pushing on tougher regulations for these financial institutions because any of them risks dragging down the whole economy.
For more information on this hearing, please click here.
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Senate Banking Committee
Subcommittee on Securities, Insurance, and Investment
Subcommittee on Economic Policy
“Examining Current Trends and Chances in the Fixed-Income Markets”
Thursday, April 14, 2016
Key Topics & Takeaways
- Evidence of Diminished Liquidity: Powell said most measures do not point to a decrease in market depth or changes in bid-ask spreads and prices. He stressed that there is no clear trend that shows a liquidity problem. Weiss argued that pre-crisis liquidity should not be a benchmark and that the regulators should instead be forward-looking and consider the evolution of markets.
- Muni LCR: Sen.Warner (D-Va.) asked about the Fed’s recent final rule to confer Level 2B status for certain municipal securities under the Liquidity Coverage Ratio (LCR) rule. He said this seems “conservative” given that some AAA-rated municipal bonds can have a lower status than sub-sovereign bonds from European nations. Powell responded that the LCR rules are about liquidity, not credit-worthiness, and that the decision to apply 2B treatment reflects the liquidity and amount of trading in municipal securities.
- Impact of Regulations: Weiss and Powell defended post-crisis reforms, with Weiss arguing that they have produced a “higher likelihood” that liquidity conditions will be available in periods of stress.
- Living Wills: Sen. Warren (D-Mass.) said the non-credible living wills show that the largest banks are under-regulated. She said regulators need to keep pushing on tougher regulations for these financial institutions because any of them risks dragging down the whole economy.
Witnesses
- Jerome Powell, Governor, Federal Reserve Board of Governors
- Antonio Weiss, Counselor to the Secretary, Treasury Department
Opening Statements
In his opening statement, Sen. Mike Crapo (R-Idaho) said the October 15, 2014 episode of volatility in Treasury markets has generated a robust debate about its causes and the possibility of similar episodes in the future. He said several factors, including new regulations, could cause liquidity to disappear when it is most needed. Crapo noted a recent report from the Bank for International Settlements that said fixed income markets are in a state of transition and listed a series of contributing factors, including technology, competition, bank deleveraging and regulation, and monetary policy.
Sen. Mark Warner (D-Va.) opened by noting differences between equity markets and the fixed income markets, explaining that they lack a central exchange or system for trading, include large spreads, and only have post-trade reporting. He said he would be interested in hearing about post-trade transparency rules, the role of prudential regulation and its impact on liquidity, market structure, and the interaction between futures and other markets.
Sen. Dean Heller (R-Nev.) stated that there have been early warnings that fixed income markets are becoming less liquid and more fragile, and cautioned that if unchecked, these issues would spill over into the rest of the economy. He discussed the PwC report commissioned by the Global Financial Markets Association and the Institute of International Finance, which concluded that it is important that regulators understand the link between regulations and liquidity and that future regulations must balance stability and liquidity considerations.
Sen. Elizabeth Warren (D-Mass.) talked about the importance of liquid markets, but then pointed out that there does not seem to be any single measure of liquidity. She argued that every claim that liquidity is shrinking is offset by another claiming the opposite. She said the financial services industry has been arguing that regulations have negatively impacted liquidity as a “convenient boogeyman” to push for rollbacks of Dodd-Frank and other post-crisis reforms. Warren added that if post-crisis reforms have reduced liquidity, it may be that current forms of liquidity are in fact more stable and more likely to “stick around” when needed most.
Testimony
Jerome Powell, Governor, Federal Reserve Board of Governors
In his testimony, Powell noted that some market participants have expressed concerns regarding market liquidity, but that studies have not been able to show a broad reduction across markets. He said questions about whether liquidity has deteriorated are difficult to answer definitively, but what officials can tell is that trade sizes and turnover have declined and that there is some evidence that liquidity in lower-rated bonds has diminished.
Powell said a number of factors can be contributing to declines in liquidity or volatility spikes, including: 1) market makers substantially reducing their portfolios as a result of the financial crisis heightening their awareness of the risks of large portfolios and liquidity provision; 2) algorithmic trading; and 3) regulation increasing the cost of balance sheet usage, which also makes the financial system more resilient. Powell added that some reduction in market liquidity is a “cost worth paying” to make the overall system safer.
Antonio Weiss, Counselor to the Secretary, Treasury Department
Weiss, in his testimony, said there is “little compelling evidence” of a broad-based deterioration in liquidity, despite episodes of market volatility and some indications that large transactions in corporate bonds are difficult to complete. He said high pre-crisis liquidity was the result of soaring leverage and reliance on short-term funding, and that this liquidity disappeared when panic hit and led to forced selling. He defended post-crisis reforms that have “demonstrably strengthened” the financial system by leading banks to double their capital holdings of high quality liquid assets while cutting short-term funding and increasing deposit bases.
Weiss said the fixed income markets are undergoing a period of structural change driven by technology, changing risk appetites and business models, a changing investor base, and much needed regulatory reform. He said the most immediate conclusions of regulators’ investigations into liquidity to date have been the need for greater access to data and more efficient sharing of data among regulators.
Questions and Answers
Evidence of Diminished Liquidity
Crapo read from a briefing paper developed by the European Parliamentary Financial Services Forum, which suggested that banks’ responses to post-crisis reforms are reducing the resilient liquidity of financial markets and passing trade execution risk from banks to investors and issuers. Powell responded that firms have reduced their market making activities, but suggested that one must look at individual markets when considering liquidity. He mentioned a report from the Financial Industry Regulatory Authority (FINRA) that did not find consistent evidence of a broad reduction in liquidity. Weiss added that while dealer inventories were far higher before the crisis, the vast majority of inventories were residential mortgage-backed securities and structured credit which are no longer being issued today “for good reason.”
Crapo asked the witnesses if they have concern that liquidity for corporate bonds has deteriorated in the past few years. Weiss noted strong primary issuance and trading volumes, but acknowledged declines in trade sizes and in the proportion of block trades. Powell pointed out that despite two significant economic shocks – the drop on oil prices and global economic turmoil – corporate bond markets have remained strong.
Crapo asked if market makers are leaving the markets today. Powell said most measures do not point to a decrease in market depth or changes in bid-ask spreads and prices. He stressed that there is no clear trend that shows a liquidity problem. Weiss argued that pre-crisis liquidity should not be a benchmark and that the regulators should instead be forward-looking and consider the evolution of markets.
Heller expressed frustration that Weiss and Powell did not have the same concerns about market liquidity as shared by market participants and most of the Committee members. He asked whether low interest rates might be masking the impacts of reduced liquidity. Powell replied that it is not masking liquidity, and that the real question is what will happen as the process of raising rates goes on. He said it would lead to asset managers holding more liquidity risk. Weiss said the Treasury Department’s focus on liquidity is “intense” and that it feels an “awesome responsibility” to maintain the depth and liquidity of the Treasury market.
Post-Trade Transparency and Data
Warner asked if regulators could improve post-trade transparency without impairing market liquidity. Weiss replied that a whole section of the Treasury Department’s Request for Information (RFI) deals with post-trade transparency, and he said he expects to have a process in place to ensure officials have access to all trade data by the end of the year.
Warren asked what kind of data the regulators are lacking, and where this creates vulnerabilities. Weiss answered that cash Treasury markets are very fragmented and that regulators have limited information of dealer-to-customer flows. He said it is imperative that the regulators have a concrete plan in place by year end to ensure that regulators have sufficient access to data and the ability to share it with each other.
Algorithmic Trading
Asked by Warner about the role of algorithmic trading, Weiss noted that the RFI includes questions on algorithmic trading relating to operational resiliency and the robustness of the pre-trade environment. Powell said algorithmic trading “is not going away” and that most market participants are now electronic traders.
Heller asked why it seems that electronic trading has made debt markets less liquid, when it has made equity markets more liquid. Powell answered that he does not think it makes the debt markets less liquid, but that electronic traders are new providers of liquidity. He said the real question will be whether this new liquidity provider makes markets more fragile.
Sen. Jack Reed (D-R.I.) asked about the role of electronic trading in the episodes of volatility. Powell said electronic trading is “here to stay” and that regulators must make sure that its role in markets promotes safety, soundness, and confidence.
Muni LCR
Warner asked about the Fed’s recent final rule to confer Level 2B status for certain municipal securities under the Liquidity Coverage Ratio (LCR) rule. He said this seems “conservative” given that some AAA-rated municipal bonds can have a lower status than sub-sovereign bonds from European nations. Powell responded that the LCR rules are about liquidity, not credit-worthiness, and that the decision to apply 2B treatment reflects the liquidity and amount of trading in municipal securities.
Warner reiterated that he does not believe it appropriate that sub-sovereign European debt does not face the same level of restrictions as that of U.S. municipalities, and he urged the banking regulators to reconsider this.
Warren asked why the Federal Reserve’s recent rule allows municipal securities to count as Level 2B assets, but not Level 2A. Powell replied that investment-grade municipal bonds are more akin in liquidity to highly-rated corporate bonds than to sub-sovereigns that trade more similarly to Treasurys. He said giving municipal bonds Level 2A treatment “would give them too much credit.”
Sen. Mike Rounds (R-S.D.) asked if episodes of volatility in Treasury markets support arguments that banks should hold a wide variety of liquid capital, such as municipal securities. Powell said the LCR counts different securities differently, and stressed that it in no way limits how much a bank can hold in municipal securities, but rather reflects that they are less liquid.
Impact of Regulation
Heller cited Larry Summers as having said it is a legitimate concern that regulators in their actions are losing sight of the need to keep markets liquid. Weiss dismissed the comparison between financial institution stability and market stability, and also stressed the pre-crisis liquidity was fueled by highly-leveraged banks. He said conditions today are far more stable because of regulatory reform, and argued against using pre-crisis liquidity as a benchmark.
Heller asked if it is fair to question whether regulations are having an impact on market liquidity and whether they are having the intended effects. Weiss answered that the prudential regulators have tailored rules for institutions of different sizes, and that this coupled with the discretion afforded them to react to market developments provides ample flexibility to addressing changing conditions.
Heller asked if it was the regulators’ intention to push banks out of their traditional roles as market makers. Weiss retorted that banks are still responsible for the majority of market making in the Treasury and corporate bond markets, and said market participants are only responding to changing technology, changing risk appetites and business models, and much-needed reforms.
Warren argued that pre-crisis liquidity built on excessive leverage proved not to be available in stressed times, and asked whether new rules have led to a better chance that liquidity will be available during a panic. Weiss answered that regulation has produced a “higher likelihood” that liquidity conditions will be available in periods of stress.
Warren said liquidity that disappears in times of stress is not valuable, and that the focus should be on ensuring liquidity is available during such times. She said Dodd-Frank and other reforms have done “exactly that.”
Crapo noted that the European Commission launched a Call for Evidence on the European Union’s regulatory framework, but expressed concern that it seems Weiss and Powell are suggesting the U.S. does not need a similar effort to look at the impacts of regulations. Weiss said the regulators’ agenda is forward-looking and that he would not advocate revisiting regulations already in place because they have effectively created confidence in financial institutions and the system as a whole. Powell said regulation is considered as one of a series of factors that might affect liquidity, but that “some of that is by design.”
Heller asked if the Federal Reserve is reviewing global rules, such as those stemming from the Basel Committee, and whether capital requirements have an effect on liquidity. Powell said the Fed is “very focused” on conditions in fixed income markets. He continued that capital requirements have made balance sheet-heavy businesses more expensive to run, so there are effects on liquidity, but that this was “not unintended” and that the negative consequences can be dealt with.
Rounds asked if Powell and Weiss ever worry that requiring banks to hold more capital may have unintended consequences. Powell said the Fed considers all input when it publishes proposals, and that it is a constant concern that its capital requirements are not too high or too low. Weiss added that the “wrong level” of capital was what existed before the crisis. He credited post-crisis reforms for building confidence in financial markets.
Living Wills
Warren said the announcement by the Federal Reserve and Federal Deposit Insurance Corporation that some of the country’s largest institutions did not have credible living wills shows that too big to fail is still a problem. She asked Powell about the role of liquidity in the living wills. Powell responded that the regulators require a model that estimates a firm’s liquidity needs and considers the firm’s structure and placement of liquidity.
Warren said the non-credible living wills show that the largest banks are under-regulated. She said regulators need to keep pushing on tougher regulations for these financial institutions because any of them risks dragging down the whole economy.
For more information on this hearing, please click here.