Today, Dan Tarullo looked into the shadows and was blinded by the light cast by the very biggest banks. Looking at one of the biggest systemic worries left largely unaddressed by recent reforms – liquidity risk in wholesale-funding markets – Mr. Tarullo’s cure is entirely bank-centric. Like FRB Gov. Stein, Gov. Tarullo readily acknowledges that smacking big-banks in SFT may well just fire up the hedge funds. Thus, the FRB rallies around a hoped-for global “universal-margining” standard. Don’t wait up.

Messrs. Tarullo and Stein aren’t the only Federal Reserve officials worried about SFT and tri-party repos. The presidents of the Federal Reserve Bank of New York and Boston are also eloquent on the topic, each calling for variations on the SFT cures reiterated today by Dan Tarullo. Boston’s Eric Rosengren would add a new capital charge for broker-dealers housed in BHCs to the mix, while Bill Dudley likes all the bank-centric rules, but suggests a backstop: give non-banks in the repo rodeo access to the FRB just in case. Whether any of the bank-centric rules would apply to these ennobled non-banks is not at all clear, meaning that the Dudley approach might ameliorate systemic liquidity risk, but do so at grave competitive cost to the banking sector.

Is SFT systemic? Surely – volume assumptions are all over the map, but every one I’ve seen is well over $1 trillion of rapidly-revolving funds. But, do we know for sure that all the capital and liquidity rules already being imposed on the biggest banks are insufficient to reduce their risk and, thus, contagion throughout the repo market? Will none of the single-counterparty credit exposure limits about to go on the books suffice? We don’t know because none of these rules is fully in force, but the FRB still wants to pile a series of SFT-specific capital surcharges and add-on liquidity requirements atop all the other rules mandated for the biggest banks.

I suspect this growing regulatory mountain is because Mr. Tarullo has hit a roadblock in his effort to limit the percentage of total short-term funding big banks can hold – this blunt-force approach has all sorts of perverse consequences based on its formidable technical complexity. The simple limit would have crimped big-bank style for sure, but at high risk to deposit markets, as well as to overall financial-market liquidity.

In a formidable paper from the University of Chicago, two leading scholars join their colleagues in a hard look at how best to judge the benefits versus the costs of financial regulation. Benefit-cost analysis must, they conclude “account for: the externalities of excessive risk-taking by financial institutions, the value of information provided by markets, the capacity of markets to either mitigate or exacerbate risks and the benefits and costs of increased credit availability to consumers.” In the SFT arena, the FRB has its eye so transfixed by negative externalities that it’s missing the other three criteria for effective, reasonable regulation. Given that the FRB’s solution to SFT “shadow” risk is a global rule sure not to come soon, if at all, or in anything like the stringent form the FRB espouses, a better approach to systemic risk in this sector is to assess the extent to which current rules rein in big banks and determine the extent to which comparable ones need to be applied to non-banks active in like-kind activities. Through the FSOC, the FRB has a ready tool at hand to share the pain – systemic activity-or-practice designation under Section 120 of the Dodd-Frank Act.

Does the Fed despair of FOSC ever acting or has it simply not yet tried this more even-handed solution? The real answer to SFT systemic risk isn’t to be found in all of these rules, but rather in an honest assessment of whether Dodd-Frank and all the tools the regulators now have can readily be mobilized for activities that can leap from banks to non-banks at the sight of a stringent bank requirement. If all we can do is squeeze banks into ever tighter vises, systemic risk will rear its head sooner and with far more force than a bank-centric strategy can handle.