In this report, we analyze a new paper from the Bank for International Settlements (BIS) addressing central-bank concerns that fixed-income market illiquidity – recently evidencing itself with alarming frequency and strength – could pose systemic risk. The BIS’s work follows a 2013 paper from a BIS committee noting this potential in the wake of new leverage and liquidity rules (see FSM Report SYSTEMIC64) and one last year arguing that illiquidity can be cured by collateral transformation (see FSM Report SYSTEMIC73). The BIS paper does not hark back to this collateral-transformation solution, likely due to the concern expressed here – but not as clearly in prior work – that transferring market-making from banks to a few large asset managers could create significant systemic risk all its own. This results in part from the lack of clear regulatory requirements for non-banks to hold buffers or undertake liquidity-stress tests, as well as from the lack of central-bank backstops outside the banking sector. Reflecting recent statements from the Federal Reserve Bank of New York, the paper thus suggests a “market-maker of last resort” function for central banks. While noting that policy-makers should assess the cumulative effect of all of their rules on banks, the paper does not discuss the extent to which market-making might transfer still more quickly from banks to non-banks were central-bank facilities established for them, nor the types of rules that could be imposed in tandem with any such access. In the U.S., the FSOC is studying some of these issues (see FSM Report SYSTEMIC75), although the market-making questions addressed in the BIS paper are a small aspect of FSOC’s work, work that could most immediately push the largest U.S. banks even farther out of this arena.
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