From The Wall Street Journal, How the Next Financial Crisis Will Happen by Stephen Schwarzman:
Despite good intentions, however, politicians and regulators constructed an expansive and untested regulatory framework that will have unintended consequences for liquidity in our financial system. Taken together, these regulatory changes may well fuel the next financial crisis as well as slow U.S. economic growth.
The Volcker Rule, for example, bans proprietary trading by banks. The prohibition, when combined with enhanced capital and liquidity requirements, has led banks to avoid some market-making functions in certain key equity and debt markets. This has reduced liquidity in the trading markets, especially for debt. A warning flashed last October in the U.S. Treasury market with huge intraday moves, unrelated to external events. Deutsche Bank has reported that dealer inventories of corporate bonds are down 90% since 2001, despite outstanding corporate bonds almost doubling. A liquidity drought can exacerbate, or even trigger, the next financial crisis. Sellers will offer securities, but there will be no buyers. Prices will drop sharply, causing large losses for investors, pension funds and financial institutions. Additional fire sales will aggravate the decline.
Why should we care? Because new capital, liquidity and trading rules are interrelated, and locked-up markets and rapidly falling securities prices will force banks to reduce assets and hoard liquidity in order to satisfy applicable regulatory tests. With individuals suffering losses and companies not able to raise capital, the economy will contract with layoffs, lower tax revenues and pain for middle- and lower-income Americans.
Small business owners will be particularly vulnerable because the number of community banks declined by 41% between 2007 and 2013. Recent studies by economists at the Richmond Federal Reserveand Harvard University both concluded that the 2010 Dodd-Frank financial law contributed to this decline. Dodd-Frank has disproportionately burdened community banks, despite their having no role in the financial crisis. We must revisit Dodd-Frank’s application to community banks because of their special relationship with borrowers in agriculture, small business and local real estate.
The lack of liquidity in the bond market is already being felt and is increasing volatility. We also see private companies starting to emerge to fill the void from lackluster bank lending.
Systemic changes such as Dodd Frank have some improvements but they tend to fight the last war without realizing their role in the next one.