Backed by the president of the Federal Reserve Bank of Richmond, FDIC Vice Chairman Hoenig earlier this week made it clear he isn’t giving an inch on the demand that the biggest banks plan for their own demise without access to the Federal Reserve’s liquidity backstops. Big banks will thus need to hold billions in liquidity above and beyond the billions they are already piling up and paying for under the new leverage rules. Advocates of merciless living wills believe they will push the biggest banks to restructure into simpler, smaller, institutions using lots less short-term funding. Maybe so, but recent fixed-income market gyrations show that capital markets are now poised on a liquidity hair-trigger. If banks can’t restructure fast enough – very hard to do by early 2015 – and instead bulk up their own holdings of Treasury securities, there will be still less to go around. That supply is already way tight was all too evident on October 15, when Treasury prices rose to levels not seen since Lehman’s demise. If we aren’t very, very careful, the tough living-will standards for big banks could ring a funeral bell for hedge funds and other high flyers dependent every day for their survival on copious amounts of high-quality assets with which to cover their very big bets.
We sent you two alerts this week laying out how real the threat is to fixed-income markets. On October 15, Treasury volumes went wild and prices plummeted, dragging interest rates down in ways that not only pose near-term market risk, but also a serious challenge to the FRB’s ability to raise rates to return to a more normal monetary policy as QE3 tapers.
Fails have also become a more frequent occurrence as quarters end and balance-sheets come under strains that limit overnight supplies of high-quality paper, strains also resulting from mid-quarter factors like geopolitical-risk surges or market rumors on Fed rates that drive USG pricing and, with it, supply.
And, even if all of these market spikes are evanescent – which they aren’t – there’s another major driver of scarce Treasury supply: the better-balanced federal budget. If Treasury doesn’t need to borrow, it doesn’t. If it doesn’t borrow, there’s less paper, especially short-dated paper, out there to be had in extremis. With less paper comes higher pricing that in extremis means a rising spiral in which interbank liquidity freezes come ever more likely.
In an emergency, the Fed is supposed to step in for banks so they can fund the market and buffer this liquidity risk. But, if banks have to hoard their own liquidity, they may well just hunker down as all around them plea for help. If the banks cannot or will not serve as market-makers, the FRB will face a very dangerous decision: whether to transform its lender-of-last-resort function instead into one many have come to call a market-maker-of-last-resort one.
As market-maker of last resort, the Fed would not stand behind banks – they won’t need to come calling – but instead behind everyone else – broker-dealers, hedge funds, non-U.S. banks, and so on. We won’t have banks that are too big to fail – just everyone else.
Is this a defense of big banks and an effort to soften the tough living-will standard? No. It’s instead my goal here to show that it simply isn’t possible to squeeze banks dry and think the rest of the market still will run smoothly. Each of the new rules – living wills, liquidity, leverage, Volcker, etc. – has a strong policy rationale and critical objectives. But, all of them imposed at about the same time altogether on just one sub-set of systemic companies and you get the unintended consequences already evident in shaky markets and struggling monetary policy. If each rule makes sense on its own, but the end-result is disastrous, all we’ll have done with all these new rules is to make global finance riskier than ever before.