Liquidity isn’t coming back, and thank goodness: James Saft

June 11, 2015

June 11 (Reuters) – Liquidity, by which I mean the official
subsidy for liquidity in financial markets, isn’t coming back
and we should all be glad.

The subsidy to financial market liquidity socializes the
liability from private gain while encouraging destructive risk
taking.

Financial executives from Jamie Dimon to Stephen Schwarzman
to Gary Cohn have warned that tightening regulations are causing
what they see as dangerous illiquidity in bond markets. The
argument, in short: markets will seize up, causing volatility,
fire sales, and, potentially, a systemic event which would hit
economic growth.

Mark Carney, governor of the Bank of England, doesn’t seem
to be buying what they are selling. While saying regulators are
open to making adjustments, Carney, in a speech Wednesday,
argued that reduced market depth and higher volatility are part
of a process with “further to run.”

“To be clear, more expensive liquidity is a price well worth
paying for making the core of the system more robust,” Carney
told an assemblage of City of London bankers at the Mansion
House.

“Removing public subsidies is absolutely necessary for real
markets to exist. Volatility characterizes such real markets and
much of the pre-crisis market-making capacity among dealers was
ephemeral.”

That may be the most sensible thing a major central banker
has said since, well, since the last time a major central
bankers said something sensible. Whenever that was.

Lower liquidity isn’t just a good price to pay for financial
stability; a system in which liquidity bears its proper cost is
a fairer way to run financial markets and the economy. Carney’s
reference to “real markets” points to the heart of the issue.

Cheap liquidity benefits two broad constituencies: borrowers
and financial intermediaries. When financial institutions take
too many chances with their balance sheets the price of risk
will tend to fall. That benefits borrowers, but only,
ultimately, to the extent that they decide to use the money they
raise for a purpose that is genuinely deserving.

All too often, though, the money finds its way into
speculative projects with insufficient fundamental demand. A
look at the aftermath of the housing crisis, in the U.S. or
Spain, shows that those investments often do not pay their own
way.

A real financial market with a real price on liquidity will
do a better job of allocating capital, and will produce better
quality, though perhaps sometimes slightly lower, growth.

SELF-SERVING ARGUMENTS

More expensive liquidity means financial assets will
deserve, and fetch, less of a premium. Part of the problem with
moving to a system in which banks only provide the liquidity
they can safely afford is that assets need to reprice to reflect
this. Illiquid securities such as corporate bonds historically
traded with more of an embedded illiquidity premium for buyers.

The idea that anyone should be able to transact, even in
government bond markets, in any size, without taking into
account the frictions that this will produce is a fantasy.

Intermediaries get by far the biggest benefit from ample
liquidity, in that its effects are concentrated among a
relatively smaller group of firms and people. A bank which runs
a larger trading book relative to its capital is taking on more
risk and will generate more revenue. The benefit of this revenue
is split between owners and employees, both private parties, but
the ultimate costs of insuring against failing banks, not to
mention cratering financial markets, is borne by the public.

That’s the irony of the self-serving arguments by the
financial industry against regulations impairing market depth:
they threaten the kind of market correction they’ve already
proved themselves more than capable of delivering.

Markets are going to have to reprice lower as borrowers and
intermediaries figure out the real costs of liquidity, but a
move from current levels to more sustainable ones will be easier
and less costly than the ultimate blow-up should we return to
pre-crisis practices.

This is not to say the process is without risk: that’s
exactly the point. There is a transitional risk as we move from
a market in which publicly backed institutions like banks took
liquidity risk in larger size to one in which they must work out
a fair price to make borrowers and investors pay.

That is going to be a bumpy process, but financial markets
should be bumpy. You can have your bumps a little at a time, or
all at once, as in 2008. The former is preferable.

Two things are likely to emerge from all this. There will be
less financial intermediation and that which happens will be
more expensive.

Banks won’t like it but the rest of us should enjoy an
economy with higher-quality growth.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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