We present a model of market makers subject to recent banking regulations: liquidity and capital constraints in the style of Basel III and a position limit in the style of the Volcker Rule. Regulation causes market makers to reduce their intermediation by refusing principal positions. However, it can improve the bid-ask spread because it induces new market makers to enter. Since market makers intermediate less, asset prices exhibit a liquidity premium. Costs of regulation can be assessed by measuring principal positions and asset prices but not by measuring bid-ask spreads.
free text keywords: Economics and Econometrics, Finance, G14, G20, L10, Financial markets, Market structure and pricing, Financial system regulation and policies, Liquidity risk, Market microstructure, Basel III, Liquidity crisis, Order (exchange), Business, Financial system, Mark to model, Market impact, Market liquidity, Market maker, ddc:330