Also, capital and liquidity requirements for the largest securities dealers – which have been raised significantly since the financial crisis – might have adversely impacted market liquidity. These regulatory changes likely have affected the profitability of dealer intermediation activities and consequently the provision of market liquidity. For the Treasury market, the most important change in regulatory requirements appears to be the supplementary leverage ratio (SLR). The SLR limits the leverage of dealer balance sheets. In the SLR, all assets are treated the same in terms of required regulatory capital. Consequently, the SLR is much tougher on low-risk assets as compared to the risk-based capital measures that it complements. This makes the economics of repo-financing much less attractive. Not surprisingly, we observe significant declines in the quantity of repo financing by dealers (Exhibit 5). For the corporate bond market, the most relevant regulatory changes appear to be the increase in the Basel risk-weighted capital ratio, the Comprehensive Capital and Analysis Review (CCAR) stress tests and the Volcker Rule – which prohibits proprietary trading for a number of asset classes such as corporate bonds, albeit not U.S. Treasuries. We do observe significant declines in recent years in securities dealers’ holdings of corporate bonds (Exhibit 6). It would be surprising if these declines in repo and corporate bond holdings did not have some consequence for market liquidity. However, we do not observe marked declines in dealer holdings of Treasuries, even as overall dealer assets have stagnated (Exhibit 7).

Market liquidity reflects a number of factors, including any direct transaction expense, such as brokerage costs; the price the transaction is executed at relative to the midpoint of the bid-ask spread; how much, if at all, the transaction moves the market price; and the immediacy or speediness with which the transaction can be completed. With respect to market liquidity, there are a number of important open questions. Has market liquidity declined for some asset classes? If so, what are the causes? In particular, has the increase in the regulatory requirements imposed on systemically-important securities dealers adversely impacted market liquidity? If this is the case, are there adjustments that could be made that might improve market liquidity without impairing financial stability? The second important type of liquidity is funding liquidity. By funding liquidity, I mean the ability of a financial entity to raise cash by borrowing on either an unsecured or a secured basis. Although market and funding liquidity are often treated as distinct, they can be closely related. This is especially the case during a financial crisis. If funding liquidity declines because of market stress, for example, this may cause intermediaries to become less willing to provide market liquidity. Declines in market liquidity, in turn, may further impair funding liquidity, creating a negative feedback dynamic. Capital and liquidity requirements play a role in preventing such a self-reinforcing negative dynamic. The central bank may also have an important role to play as the lender-of-lastresort.