In June, Blackstone Group L.P. (BX) CEO Stephen Schwarzman penned an article in the Wall Street Journal about the potential of over-regulation contributing to, if not causing, the next financial crisis. Schwarzman’s overarching argument is that the reforms made after the last financial crisis are so stringent that they will foster conditions conducive to a new crisis predicated on the lack of market liquidity.

While each individual institution is undoubtedly safer due to capital constraints imposed by Dodd-Frank, this makes for a more illiquid market overall. The lack of liquidity will be especially potent in the bond market, where all securities are not mark-to-market and many bonds lack a constant supply of buyers and sellers.  

Dodd-Frank and Banking Reforms

As a result of the 2008 financial crisis and subsequent recession, the rampant abuse in the financial sector entered the limelight. Thus, it is no surprise that the entire banking system was put under much higher scrutiny, regulation and restraints. The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010 to lower the risk of another recession stemming from bank collapses and to protect consumers from the consequences of financial abuse. The main goals of Dodd-Frank were to increase accountability and transparency in the financial system, end taxpayer-funded government bailouts, limit the riskiness of financial services practices and to prevent institutions from becoming “too big to fail.”

Some of the regulations that Dodd-Frank put in place include increased monitoring of financial institutions, more strict reserve requirements and greater emphasis on liquidity. A new organization, the Consumer Financial Protection Bureau, was created with the sole goal of keeping an eye on mortgage lending, especially the subprime mortgage market that was the underlying cause of the 2008 catastrophe.

The higher reserve requirements under Dodd-Frank mean banks must hold a higher percentage of their assets in cash, which decreases the amount they are able to hold in marketable securities. In effect, this limits the market-making role that banks have traditionally undertaken. Liquidity suffers as a result, and while this might not be a problem in high-volume markets, it can be especially painful in some debt markets. This could possibly lead to a minor intraday pullback quickly snowballing into a full-scale bond market drawdown.

Liquidity Issue

The bond market is much larger than the equity market, and a 30-year bond bull run has many investors and institutions heavily invested in the asset class. Furthermore, studies have shown bond investors to be more sensitive to poor performance since the asset class is usually perceived as having lower risk than equities. Thus, bond investors tend to withdraw from markets very rapidly when prices fall, and a relatively small sell-off can grow into an outsized drop in the market.

According to a Deutsche Bank report, bank inventories of corporate bonds are down 90% since 2001. With banks unable to play the part of market maker, this means that prospective buyers will have a harder time finding counteracting sellers, but, more importantly, prospective sellers will find it more difficult to find counteracting buyers. Schwarzman contends that the capital requirements will mean that there is no safety valve to catch rapidly falling security prices, a task normally undertaken by dealers at banks. This will force market contractions that will subsequently induce layoffs, lower tax revenues and place greater stress on middle-class families.

Imagine when the Federal Reserve finally announces a rate hike, investors scramble to sell their devalued bonds, but there are no buyers at the outgoing price. Investors will be forced to take a haircut to sell them off, and other investors who see increasing bid-ask spreads will rush to sell their fixed-income investments as well. This is especially a possibility in less liquid markets – such as corporate, high-yield and municipal bonds – where the sheer number of unique bonds, in addition to greater credit risk, means there are fewer buyers and sellers for each security. Without banks acting as market makers and buying up these bonds, investors will rush out of the market, causing additional fire sales and a massive devaluation of all fixed-income securities. (For more, see How Bond Market Pricing Works.)

From there, the ball rolls on, and a contracted fixed-income market will crush not only savings, but companies’ ability to raise capital as well. Next thing you know, since companies can’t expand, they will look to cut costs and jobs, and suddenly the next recession is upon us. (For more, see Understanding Liquidity Risk.)

Impact on Small Business

While bulge bracket banks are largely responsible for the overextension of credit and ensuing crash in 2008, community banks are more affected by Dodd-Frank despite playing no part in the recession. These banks, which suffered a 41% decline between 2007 and 2013, normally work with small business owners and local farmers. In a credit crunch, these owners will be hard-pressed to find additional sources of credit as banks try to meet Dodd-Frank reserve requirements. While larger companies can issue equity, draw on cash reserves or borrow from subsidiaries, this isn’t an option for the majority of mom and pop shops. These businesses will have no choice but to close up shop or lay-off employees. As frequently seems to be the case, those that are least to blame get the short end of the stick.

The Bottom Line

Schwarzman certainly hasn’t been the only notable figure to bring up the liquidity problem. Others, like former Treasury Secretary Larry Summers, renowned activist Carl Icahn and JPMorgan Chase & Co. (JPM) CEO Jamie Dimon have similarly voiced their concerns to the media. If their fears are confirmed and illiquidity causes another financial meltdown, the majority of the blame will lay on Capitol Hill this time rather than bankers. Regulatory authorities must not view the financial industry solely through the lens of the last crisis – a dangerously myopic perspective can get us all into trouble.  

In the end, Schwarzman is not critiquing the banking reforms that created stronger capital requirements and a more stable financial system. Rather, he is speculating that the next crisis, barring any change in legislation, will ironically be caused by reforms implemented to protect us from the circumstances that caused the last one. Hopefully, increasing the awareness surrounding the issue is the first step towards creating a healthy balance between market liquidity and reserve requirements that will keep the engine humming as it has for the last six years.