The effects of banking regulation on bond market liquidity
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School of Business |
Master's thesis
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Date
2025
Department
Major/Subject
Mcode
Degree programme
Economics
Language
en
Pages
71+2
Series
Abstract
This thesis is a literature review that examines the mechanisms by which banking regulation impacts bond market liquidity, with a focus on the European Union. Banks have a fundamental role in facilitating various securities markets by matching buyers and sellers of financial securities. In bond markets, banks can operate as market-makers, meaning that they match investors’ buy- and sell orders. However, since the implementation of banks’ regulatory framework Basel III, this market-making function of banks is facing new constraints that affect bond market liquidity, which is in the focus of this thesis. To study the transmission mechanisms between banking regulation and liquidity, I compare three theoretical models that capture individual transmission mechanisms and I reflect the models’ findings in light of empirical literature. I find that there are two main transmission mechanisms between banking regulation and bond market liquidity: The cost of banks’ balance sheet space and banks’ increased funding costs and frictions that affect bond market liquidity negatively. The main contribution of this thesis is to provide a holistic analysis of several transmission mechanisms and their significance against each other. Traditional literature has concentrated on individual transmission mechanisms between banking regulation and bond market liquidity. Instead, this thesis provides a holistic assessment of these transmission mechanisms and compares them to each other. The thesis also compares the costs and benefits of banking regulation for bond market liquidity. The key finding is that raising banks’ risk resilience through banking regulation can also support bond market liquidity in the long term since banks are better capitalized, supporting their role as bond market-makers in the economy.Description
Supervisor
Välimäki, JuusoThesis advisor
Välimäki, JuusoKeywords
Basel III, banking regulation, bond market liquidity, market-making