Managing Regulatory Pressure: Bank Regulation and its Impact on Corporate Bond Intermediation

(Winner of the DGF 2023 Best Doctoral Paper Award and winner of the Tomas Björk Best Paper Award)

Abstract

We study the cross-sectional effects of Basel regulations on dealer intermediation in the U.S. corporate bond market. Using intra-quarter variation in the intensity of Basel regulatory requirements, we document pronounced inventory contractions when regulatory pressure rises near quarter-ends. In contrast to their behavior in short-term money markets, U.S. bank dealers do not absorb regulatory selling pressure in corporate bonds. Instead, bank dealers direct their selling primarily to nonbank financial intermediaries. In doing so, they fall back on their investor networks to offload investment grade bonds and their nonbank dealer networks to dispose of high-yield bonds. In the aggregate, leverage regulations impair liquidity conditions in the corporate bond market, specifically in balance sheet intensive trades where regulatory shadow costs amount up to 20%. Our findings have implications for the design of future regulation of both bank and non-bank financial intermediaries.

Note: The views expressed in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or any other person associated with the Federal Reserve System. All remaining errors are our own.