Basel today says it’s now – at very long last – considering not just the merits of each of its rules, but also what they do all taken together. If nothing else sparked this overdue bout of introspection, the spirals of near-death liquidity crises seen throughout 2014 and, most recently, last week should make it clear why rules that are each good on their own can combine with pernicious and perverse consequences. Case in point: these liquidity crises right on the heels of new rules designed to prevent them.

Under the liquidity coverage ratio (LCR), each bank is to protect itself by holding large enough stocks of “high-quality liquid assets” (HQLAs) that it could sell under stress to pay all the bank’s obligations when short-term funding sources dry up. HQLAs are assets like U.S. Treasury bonds.

The more HQLAs banks hold, the less there are to go around and the farther HQLAs pricing goes from the fundamentals set by the market to bank-demand driven pricing that distorts the transparency and benchmark qualities that got them their HQLA status in the first place. Irrational pricing can be offset to some extent by complex structured transactions – but this is another perverse incentive of the liquidity rules since banks can shed liquidity risk and still take on lots more credit, trading, operational, and other risks with systemic potential.

The LCR will soon be joined by a tough net stable funding ratio that will increase demand for HQLAs and ramp up its potentially distorting market effect. However, the liquidity rules aren’t the only ones scrimping market liquidity. The G-SIB leverage rule also plays a critical part here. HQLAs require leverage capital even if they score a happy zero under the risk-based capital standards. That makes sense, but it has an unintended effect: another strong incentive for banks to offset low-profit HQLAs with higher-risk assets in hopes of making earnings come out right.

Even with the wonders – not to mention risks – of complex structured finance, big banks can’t raise infinite amounts of capital nor does it appear that capital costs drop as capital stocks rise. The more they hold for HQLAs, the less for other lower-risk assets. As a result, the smaller is their ability to bankroll market-making, a service provided to customers in hopes of other business.

Market-making continues, of course, but at reduced amounts and for selected customers, meaning that some – see the brokers cast on the rocks during the Swiss-franc crisis – have no backstop liquidity. Securities “fails” result, not to mention downstreamed risk of loss to investors unaware that their brokers couldn’t cover their bets. Add in downstream risk because the new central counterparties required to trade derivatives can’t back their own clearing obligations under stress and even more risk created by the liquidity and leverage rules finds itself in investors’ laps.

However, the liquidity and leverage rules are only part of the market-illiquidity conundrum. New margin requirements further diminish the supply of HQLAs and, under stress, create liquidity squeezes of their own. Although margins protect counterparties on CCPs and other trading venues, counterparties are required to boost collateral under stress and, with liquidity and leverage shortages, may well need to do so when the supply is scant and the price is high. This ramps up market illiquidity as one after another counterparty fails to meet its obligations because it can’t find the HQLAs needed to do so.

Again, there’s nothing wrong with margin rules, especially if they prove as “universal” as the current moniker hopefully has it. However, margin requirements demand HQLA collateral, forcing counterparties either to amass it or reduce trading activities. It might sound fine for big banks to shutter their trading operations, but this too drains lots of liquidity – for every bank in derivative, futures, or similar transaction there’s a counterparty on the other side. Some of these trades are surely structured and speculative; lots of others hedge real risk and trade financial instruments for portfolio- and risk-management purposes. Without banks, markets must shrink, leaving counterparties to fend for themselves.

Basel is on to its cumulative-impact problem because central bankers already fear its adverse impact on their ability to handle monetary policy during this all too tricky time. Central bankers thus came up with a hoped-for cure so that all the tough new rules could stay as is without adversely affecting overall market liquidity: collateral transformation.

What is collateral transformation? It’s a financial-market philosopher’s stone – it takes low-quality collateral otherwise ineligible as an HQLA or as margin collateral and converts it into something a counterparty can take, boosting a bit of yield along the way to soften the pain of the leverage-capital standards. In a 2014 paper (see FSM Report SYSTEMIC73), central bankers not only posited collateral transformation as the way to ensure market liquidity, but also discounted shadow-bank worries in hope that bankers could take on these collateral-transformation services.

Nice thought – if they did, all this alchemy would stay under the scrutiny of central banks and bank supervisors. But, how are big banks – especially big U.S. ones – supposed to handle all their own liquidity, leverage, and margin needs and at the same time support the rest of the market? If one or another can, then there’s one more perverse incentive to contemplate: ramped-up concentration in which the financial system relies ever more on just a handful of humongous banks to ensure market liquidity.

But, if none of the G-SIBs has the liquidity and capital capacity to take this on – and I very much doubt any does – then the collateral-transformation cure will accelerate the conversion of the financial system into one in which asset managers will play the principal market-making role. They can do so because they are exempt from the liquidity, capital, resolution, and activity constraints hobbling the biggest banks.

So, if non-banks make markets through the wizardry of collateral transformation , then big banks theoretically can bear all the liquidity, leverage, margin, and other rules at cost only to themselves, not the broader market and its long-term stability. But these rules are designed to ensure that critical market players can protect market liquidity even as they save themselves. What protects us if this function shifts to non-banks? So far, not much.