Asked Wednesday if increasing market illiquidity is worrisome, FRB Chair Yellen said it was a bit of a bother, but not a threat. Ms. Yellen must of course parse her words carefully – were she to say something like, “Yipes,” markets of course would run for the hills. There’s no need yet to do so, but there is in fact a lot of cause to be very worried about the fragility of liquidity in the wholesale-financial market, illiquidity that is in no small part the unintended consequence of all the new reform regulations and the FRB’s own highly-accommodative monetary policy. Both the rules and this policy may well be right, but they are coming at considerable risk of another systemic run, one the FRB will be far less able to corral this time around.

Last year, we alerted clients to a little-noticed, very worried report from a group of global central bankers assembled by the Bank for International Settlements. It added up all the high-quality liquid assets (HQLAs) in the world and then compared these to those that banks need to meet liquidity rules and to hold margins against their derivatives bets and securities-financing exposures. The report totalled up a $4 trillion shortfall, a conclusion that led the report to fear not only both an empowered shadow-banking sector, but also severe stress the next time banks need emergency liquidity support.

The reason for this was the collision between prudential rules and central-bank collateral demands – that is, the more HQLAs banks have to hold to meet the rules, the less they have to pledge to their central bank, to raise as margin calls rise under stress, or to sell at reasonable cost to counterparties that are themselves under stress. Hoarding HQLAs – the rational action of each bank – thus could lead to a calamitous collective-action problem that turns an HQLA scarcity into a global-market freeze.  

Observers on this side of the Atlantic may not have noticed a major response to this potential quandary from the Bank of England earlier this week. Its head, Mark Carney, announced that his august institution will henceforth offer liquidity support to large broker-dealers and central counterparties. In short, if they can’t find liquidity in the wholesale financial market, they can come to Papa. Mr. Carney did not say what collateral he would require for this privilege nor whether any new prudential rules would govern broker-dealers and CCPs accorded this privilege. To some extent, this problem is addressed already in the U.K. because the Basel III rules and a whole lot of others already apply to broker-dealers. In the U.S., not so much.

This is a vital question. If non-banking organizations are exempt from the rules that force big banks to stockpile HQLAs and at the same time they can reliquify as needed from a central bank, surely they will be inclined to operate at higher leverage and less liquidity because counterparties will fear not. For CCPs, this is particularly worrisome given their new locus as the cross-roads of derivatives markets and, thus, the center for possible seismic shock under stress.

The $4 trillion estimate cited above may well be too low – a private estimate last year clocked the HQLA shortfall as closer to $10 trillion. Whatever it is, a soft landing might result if HQLA supplies are replenished because central banks tighten monetary policy and begin to return their holdings to private hands. This, in fact, is the get-out-of-jail-free card on which the BIS counted as its solution to the HQLA crisis: nothing bad will happen fast so central banks will have time to adjust. I sure hope so.