Concern about a thing called liquidity has become one of the biggest obstacles to reforms aimed at making the U.S. financial system more resilient. Wall Street banks say that new capital requirements or constraints on speculative trading will cause it to dry up. They warn of dire consequences.

They’re wrong: At the very least, they’re exaggerating the problem. To see why, consider what this magic substance actually does. Once you understand that, you see that more liquidity isn’t always better -- and it’s possible to have too much.

In the broadest sense, liquidity is the ease with which something can be traded for something else. Cash is extremely liquid, because people will readily accept it as payment for just about anything. A bond issued by a troubled company tends to be less liquid: Finding a buyer could take months, making it hard to know what the bond is worth at any moment.

When markets are active, with lots of trading, all kinds of assets become liquid. This is good. Transaction costs drop as intermediaries, typically the market-making operations of large banks, charge less to connect buyers and sellers. People who need cash can sell stocks at a moment’s notice. Mutual funds can buy and sell large blocks of securities without sending the market into gyrations. In theory, prices in liquid markets should contain more information about the outlook for companies and the economy, because they reflect the combined wisdom of more individual trades. More accurate prices, in turn, should make everyone better off by improving the allocation of capital.

Wall Street banks have used the need to preserve the many benefits of liquidity as an argument against various pieces of the Dodd-Frank financial reform act. They say that the Volcker rule, designed to ban speculative trading at federally insured banks, will harm trading by forcing banks to curtail their market-making operations. They say that if new capital rules require banks to finance themselves with more loss-absorbing equity, the added costs will make them less willing to hold the inventory of assets needed to keep markets running smoothly.

What their arguments ignore is that beyond a certain point, the advantages of liquidity wane. The great ease and low cost of trading can encourage investors to chase short-term price moves that have nothing to do with fundamental value -- a problem identified by economists including Joseph Stiglitz, Larry Summers and Adair Turner, the former chairman of the U.K.’s Financial Services Authority. This “noise trading” doesn’t necessarily make prices more informative and can even make markets too volatile.

The challenge is to find the point at which liquidity ceases to be useful. If U.S. markets haven’t reached it, with tens of thousands of trades per second and transaction costs measured in hundredths of a percentage point, then concerns about the adverse effects of regulation are valid, and regulators would have to weigh the balance between safer banks and less liquid markets. If they’ve already passed it, a bit less liquidity might be helpful in its own right.

New research by three economists -- Jennie Bai of Georgetown University, with Thomas Philippon and Alexi Savov of New York University -- offers a clue as to where the threshold might be. They find that prices of stocks and bonds in the U.S. are no better at predicting the profitability of companies than they were 50 years ago, despite the vast increase in trading volumes and sharp decrease in transaction costs over the same period. In other words, in terms of price discovery and capital allocation, it’s possible that liquidity could be rolled back to the level of the 1960s with no adverse effect.

Somebody must benefit from all the extra trading, you might think. True: Extra trading means extra fees. Separate research by Philippon shows that over the past 30 years, financial intermediaries’ income as a share of output has risen to its highest level in more than a century. He estimates that despite advances in technology that should have improved efficiency, the aggregate fee that intermediaries extract from all the assets that pass through their hands has increased to 2.3 percent, from roughly 1.5 percent in the 1970s.

When banks invoke liquidity, there’s a chance they’re not talking about the kind that makes everybody better off. Regulators would do well to keep this in mind as they work on putting Dodd-Frank into effect.

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