TO ENSURE that it meets the 750 new rules on capital imposed in the aftermath of the financial crisis, JPMorgan Chase employs over 950 people. A further 400 or so try to follow around 500 regulations on the liquidity of its assets, designed to stop the bank toppling over if markets seize up. A team of 300 is needed to monitor compliance with the Volcker rule, which in almost 1,000 pages restricts banks from trading on their own account.

The intention of all these rules is to prevent a repeat of the bankruptcies and bail-outs of 2008.

But some observers, including JPMorgan’s boss, Jamie Dimon, and Larry Summers, a former Treasury secretary, argue that in their rush to make banks safer, regulators may have created a riskier financial system. By throttling the bits of banks that “make markets” in bonds, shares, currencies and commodities, the theory goes, watchdogs have made such assets less liquid.

Investors may not be able to buy and sell them quickly, cheaply and without moving the price.

The consequences in a downturn, when markets are less liquid anyway, could be severe.  

Banks have undoubtedly cut back as the plethora of new rules has made it difficult for their trading arms to eke out a satisfactory profit. They used to “warehouse” lots of bonds and other securities they had bought from one client and hoped to sell to another. But they must now hold more capital and liquid assets to offset the potential losses from trading, so keep much smaller inventories and place fewer bets. Broadly speaking, trading desks are still happy to match buyers and sellers but are reluctant to commit to a purchase before lining up a buyer.

Meanwhile, the value of outstanding bonds has swollen to record levels, most of them in the hands of asset managers (see chart). That is in part a corollary of banks trimming lending, and so pushing borrowers to the bond market instead, and in part a natural response to low interest rates. Even firms with patchy credit records are issuing “high-yield” debt to investors clamouring for returns. Governments have remained eager borrowers, too.
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The result is an imbalance. In America, investment funds used to hold only three times as many bonds as banks. Now they hold 20 times as many, according to the Federal Reserve (see chart).

Mr Dimon paints an even starker picture for Treasuries. In 2007 JPMorgan and its peers used to have $2.7 trillion available to make markets. Now they have just $1.7 trillion—while the American national debt has doubled. In Europe, where banks have trimmed investment banking even more, the situation is if anything worse.

The result of this lopsidedness, pessimists say, are events like the “flash crash” last year, during which yields on Treasuries suddenly tumbled by 0.34 percentage points for no apparent reason—an extraordinary shift for the bedrock security of the global financial system. They are worried about bonds of all sorts, which are much less heavily traded than shares, currencies and commodities.

Funds that track corporate bonds often promise their investors their money back whenever they want it, despite the relative illiquidity of their assets. The IMF recently calculated that it might take 50-60 days for a fund holding American high-yield corporate bonds to find buyers for its securities.

Meanwhile, investors are typically entitled to their money back within seven days of asking for it. “No investment vehicle should promise greater liquidity than is afforded by its underlying assets,” says Howard Marks, boss of Oaktree, a debt fund.

Regulators are mindful of all this. The Securities and Exchange Commission in America has called for stress tests of asset managers to ensure they can muddle through a crisis. The Bank of England wants them to look closely at redemption policies. They also suspect, however, that the high level of liquidity before the crisis was an anomaly that bankers are harping on about in an effort to roll back regulation.

Asset managers are also aware of the risks of diminished liquidity. BlackRock, the world’s biggest, has said it is limiting its exposure to certain bonds as a result. Others are breaking up big trades into smaller orders, to prevent them moving prices in an adverse direction, or trading less than they might otherwise. Funds tracking bond indices hold cash to meet redemptions. They can also invest in derivatives linked to the index, which are typically more liquid than individual bonds. If faced with a rash of redemptions, these can be sold off without much loss.

Another solution is for the asset managers to bypass the banks. Many are trying to “cross-trade”, exchanging assets with one another directly, instead of using banks as go-betweens. But matching buy and sell orders electronically is tricky for bonds: whereas most firms have only one or two classes of shares, many have issued dozens of bonds, in different currencies and with different maturities. There have been several attempts to set up trading platforms, but few have attracted much volumen.

Even if such schemes get off the ground, asset managers cannot fully substitute for banks. They do not have as much purchasing power, since their balance-sheets are not swollen with borrowed money. Relatively few of them have a mandate to be contrarian: most (especially those passively tracking an index) want to enter or exit the same positions at the same time.

All this may mean that asset managers are indeed forced to offload securities at fire-sale prices in times of turmoil. But unlike banks, which can fail due to trading losses, asset managers are mere custodians of money. Any losses in their funds are passed on directly to investors. Having banks—highly leveraged and interconnected institutions—sit on top of that risk proved a disastrous recipe during the crisis. Maybe their retrenchment has indeed made markets riskier. Yet that may be an acceptable price for making banks safer.