A stunning statistic buried in the FDIC’s brokered-deposit advance notice is that, of the 5,477 insured depository institutions across America, only 22 now are less than well-capitalized.  Talk about an easy A!  Are banks really so impregnable?  It wouldn’t matter so much if they aren’t but for the fact that ten years after the great financial crisis, we’re still not sure if big banks can be shuttered without systemic ill-effect.  The new FDIC/FRB GSIB-resolution guidance is far from reassuring.  Even more disconcerting, though, was Janet Yellen’s suggestion yesterday that the Fed’s discount window be opened to broker-dealers, albeit only those housed in BHCs under the Fed’s thumb.  That someone so close to the post-crisis framework thinks it’s so necessary to expand the Fed’s safety net is deeply troubling, especially at a time of so much equity-market turmoil and the odd currency-market flash crash or two.

In 2008, the nation’s largest broker-dealers – Goldman Sachs, Morgan Stanley, Merrill Lynch, and Bear Stearns – came under BHC control one way or the other because central-bank access was critical to their survival.  The one big broker-dealer that died – Lehman – desperately sought a bank buyer.  The broker-dealers that became BHCs paid a high regulatory cost for doing so at the time, a cost they countenanced because their only other option was failure.  Now, the Fed is offering broker-dealers a far better deal: affiliate with a bank and get direct access to the discount window.  Which broker-dealer would scruple at an opportunistic small bank acquisition if so generous a lifeline was part of the package?

The entire construct of central-bank liquidity is premised on the time-honored “Bagehot Rule.”  Under it, banks are regulated to ensure solvency and must collateralize central-bank liquidity draws to ensure that central-bank funds serve only as extra liquidity, not a bail-out.   This liquidity isn’t supposed to help the bank – it’s for borrowers needing additional funding during seasonable funding-flow interruptions or short-term market dysfunction.

The Bagehot framework does not apply to broker-dealers in or out of BHCs because broker-dealer clients are not the farmers and businesses for whom central-bank liquidity support is intended and whom bank regulation aims to protect.  Broker-dealers are critical to repo and other systemically-critical markets, but so is electricity.  Why not just open the discount window to any entity the Fed thinks important?  Sure, the broker-dealers Ms. Yellen has in mind are affiliated with banks, but that doesn’t make them banks.  By this logic, Amazon would be entitled to discount-window access if it acquires a banking charter – after all, it’s at least as critical to U.S. macroeconomic health these days.

And, for all the Fed’s nominal top-down power over non-bank subsidiaries in bank holding companies, the fact remains that BHC broker-dealers are broker-dealers whose primary regulator is the SEC, not the Fed, OCC, or FDIC.  This means that broker-dealers are exempt from bank-like capital regulation, falling instead under a regime designed long ago to ensure that brokers had enough money on hand to return at least some of it to investors, not to safeguard solvency so that discount-window advances could be repaid in accordance with Mr. Bagehot’s precepts.

Current law is so concerned about backdoor extensions of discount-window support from banks to broker-dealer affiliates that the Federal Reserve Act includes inter-affiliate transaction restraints in sections 23A and 23B that the Dodd-Frank Act toughened up.  Direct broker-dealer access to the discount window obviates these controls and could well weaken affiliated banks if BHCs use ambiguities in current law to move collateral from an insured depository to the broker-dealer to gain Fed support.

As the battle royal over the SEC “push-out” rule in the 1999 Gramm-Leach-Bliley Act made clear, the barrier between banking and brokering is extremely permeable. Banks pay for more than FDIC insurance; they are of course subject to many costly prudential standards.  These are consolidated at the parent-company level in ways that sometimes subsume a BHC’s broker-dealer, but this does not in any way impede all sorts of regulatory-arbitrage opportunities.  Indeed, this occurs even within banks, where differences in the capital rules governing the banking book versus the trading book within an insured depository are a constant cause of gamesmanship.  BHCs also have a lot of flexibility about which activities to move outside the bank’s trading desks into the broker-dealer.  Add in a central-bank backstop, and the broker-dealer might well prove a lot more comfy. 

Given the light-touch SEC rules governing broker-dealers, it would take an awesome amount of consolidation to eliminate the arbitrage opportunities sure to rev up once customers know that a broker-dealer has access to the central bank.  Has the Fed given any thought to preventing this and, if so, would the SEC concur?  Turf battles are a constant fact of regulatory life and it’s not hard to imagine an SEC that would like it just fine for its charges to stay under its regulation but get a Federal Reserve lifeline.