A week ago, the president of the New York Fed, Bill Dudley, offered an eye-popping suggestion: open the central bank’s liquidity facilities to non-banks if the company met social-utility criteria. Due to the deluge of regulatory pronouncements, this one seems to have passed largely unnoticed. Too bad – it’s a big thought. Many — myself included — have drawn from the financial crisis the conclusion that government safety nets should be drawn tightly so that only a very few, very tightly regulated firms get as little liquidity support as possible. However, Mr. Dudley contemplates a very different future: one in which the Federal Reserve is Lady Bountiful, handing out the safety-net benefit to those it deems deserving. But, Lady Bountiful did little good in Bleak House and, I fear, a Fed that emulated her would be just as damaging even if it held to her high-minded principles.
What Did Mr. Dudley say on this critical point? It’s worth quoting in detail:
Which path to go down—limit wholesale funding or backstop it more broadly—would depend in large part on the social value of the capital markets-based activities presently being financed in unstable short-term wholesale markets and the utility of short-term wholesale funding for lenders.
Of course, the choice might not be as black and white as this. Some activities undertaken by securities firms or other nonbank entities presumably are much more socially useful than others. In this case, legislators might deem that certain classes of securities firms should be granted access to a lender of last resort facility, but restricted in the scope of their permitted activities to those that do clearly create social value. … The issue of the social value created by market-based financial intermediation and appropriate scope and terms associated with a lender of last resort function are complex ones that require further study and analysis. However, regardless of where we come out on these questions, we must make the basic structure of the wholesale funding market as sound as possible. As the last sentence suggests, the thrust of Mr. Dudley’s talk centers on the systemic risk caused by the reliance of large financial firms (especially BHCs) on short-term wholesale funding to float huge portfolios of longer-dated assets. This problem was first raised by Sen. Brown (D-OH) in legislation soon to be reintroduced to cap these holdings at some percentage of GDP. Since then, Mr. Dudley’s Fed colleague, Gov. Dan Tarullo, has laid out preliminary thinking on ways to achieve a flat limit and, yesterday, another Board member, Jeremy Stein, discussed ways to mobilize monetary policy against pernicious mis-matches.
As these other proposals indicate, the short-term debt issue generally travels its own way, separated from another frequent one in global deliberations: ensuring that firms with access to the deposit insurance and central-bank liquidity provide social value, value like that derives from offering only truly-needed intermediation products and doing so for all customers at reasonable prices. In essence, banks here become like utilities – serving a vital function and, in grateful thanks for this from a protected public, receiving benefits unique to their charters.
Mr. Dudley brings the debt-limit and social-utility ideas together in novel fashion: offering to provide central-bank backstop to all comers, not just banks, as long as they meet social-value goals. What these are, he doesn’t say. As the quote above indicates, this critical point is ducked on grounds that it’s a legislative, not regulatory, criterion.
But, not so fast. Without knowing what Mr. Dudley thinks constitutes “social value,” how can one come close to contemplating open access to the lender of last resort? Could all banks still belly up to the discount window or would they only be granted access if they meet the type of social-welfare criteria some already contemplate for them (see, for example, a speech last year on this point by FRB Gov. Sarah Bloom Raskin). If broker-dealers are to get access as Mr. Dudley suggests, which of their services provide social value? Which securities could be sold to whom at what price how? Are some trading venues nice – traditional exchanges, for example – and others – HFT venues – not-so nice and, thus to be barred to socially-valuable broker-dealers? What about insurers? Are they just no damn good?
The social-value criterion for federal financial policy is a very slippery slope not just to ethical judgment, but also to political ones. To date, banks have been given privileged central-bank access not because they are seen as “good,” but rather because they fulfill a limited financial-intermediation role deemed essential for a functioning capital market. This is already a tricky construct – see Richard Fisher’s call for containing banks to “narrow” activities as a new price for this powerful benefit. Going beyond it to contemplate similarly thorny social standards for non-banks is even more complex in concept and dangerous in effect. I’m not at all sure how to divide socially-valuable financial services from downright rotten ones, but I know one thing: setting financial policy on this subjective principle will open the safety net wide, wide open to all sorts of actors who, smiling sweetly, will rob us blind.