The FRB has coined a new term: “runnable” liabilities. When I hear the word “runnable” – if it’s even a word – I don’t think about liabilities, but rather my nose now that it’s allergy season in Washington. I do know what the Fed means by runnable – short-term funds that flee when markets get antsy, but I’m not at all sure the FRB’s cure for them makes sense given all the other nostrums it’s plying these days for the nation’s biggest banks. Some runny noses are symptoms of cold, others may be signs of pneumonia. A good doctor doesn’t give a sick patient every pill in the cabinet in hopes one works. The FRB should also be careful to understand its financial-market patients and be sure to do no harm.

First, what has the FRB in mind? Gov. Tarullo is manning the anti-run dyke, suggesting as recently as Tuesday that the new “enhanced supplementary” leverage standard will be paired soon with a surcharge for systemic banks comprised not just of a risk-based capital toll akin to the one approved by global regulators, but also a requirement topped off by a factor derived from undue reliance on the aforesaid-runnable liabilities. Liquidity risk is of course a systemic driver – this is a lesson learned the hard way during the financial crisis not just from all the banks that came calling at the FRB’s various emergency windows, but also from the failure of Bear Stearns, Lehman, AIG, and the Primary Reserve Fund. Some, if not all, of these companies could have survived the assaults in the fall of 2008 because they were fundamentally solvent, just not liquid enough to pay overnight claims as they came due.

But, even as the FRB contemplates taxing runnable liabilities at the biggest banks and imposing liquidity rules across the broader banking spectrum, it is clinging jealously to its ability to provide emergency liquidity support in stress scenarios. Title XI of Dodd-Frank is designed to prevent one-off rescues, but it does afford the FRB flexibility to offer liquidity support to firms otherwise ineligible for the discount window if the Board decides that financial stability is at risk. Congress has pressed the FRB to explain just what this risk might entail, but the proposed rule it forced the Fed to release does as little as possible to constrain the central bank’s flexibility. Even so, one important member of Federal Reserve leadership, FRB-NY President Dudley, has gone further and suggested that Congress should expressly open the discount window to non-banks engaged in securities financing so that systemic risk from this sector can be averted even as these non-banks are exempt from the liquidity and capital rules – runnable ones included – coming soon to the FRB’s big-bank arsenal.

In short, the Federal Reserve wants to have its cake and eat it too. It wants to penalize the very biggest banks for short-term funding and yet still provide a comfy safety-net not just for them, but also for anyone else that might need it even though they are exempt from capital rules and all the big-bank surcharges and thus can happily rely on big books of runnable funds. Will smacking sloppy, runnable big banks do much for systemic liquidity risk if smaller banks or giant “shadow” non-banks are similarly afloat and the FRB promises to bail them out – at least as long as it thinks the risk to financial stability comes not from solvency, but from liquidity drivers?

Of course not. However, the cure to growing complexity and burden for big banks paired with a safety-net for unregulated unbanks is not simply to give up on the new systemic framework and go back to the bad old days pre-2008. Instead, it’s to take a far more careful and incremental approach to rulemaking so that major initiatives are finalized, tested, and improved in an orderly fashion that takes their cumulative effect into account and corrects for perverse consequences if and when needed. Done right, this isn’t go slow – it’s go smart.

A paper released yesterday by the Federal Reserve observes that:

[P]ost-crisis regulatory reforms are virtually devoid of concerns about uncertainty. For example, requirements for higher bank capital ratios are based on a risk model that ignores uncertainty. In particular, capital charges are based on a unique loss-distribution function. While such an assumption may be plausible for normal times, it might not be during a crisis, when standard asset-valuation measures fail. Thus, rules aimed at ensuring adequate capital buffers in stressful circumstances could prove inadequate to the extent they are calibrated to a paradigm that abstracts from reality by assuming banks and investors can perfectly foresee all states of the world.[1]


In prose, this means that current capital models are uncertain. Since they have a lot of impact on liquidity risk, the FRB should understand this interaction not just in the academic fashion described at Tuesday’s Board meeting, but also in a forward-looking way that recalibrates as each new rule is finalized. There are so many new rules to contemplate – the enhanced supplementary leverage charge, the liquidity coverage ratio, the net stable funding ratio, credit exposure limits, new margin requirements, and so much else with such big impact. Lost in the complexities of all of these rules, the FRB is yet proposing to spread its safety net beneath the financial system without, as far as one can tell, correlating this proposal with all the others, let alone with the most important initiative in the wake of the financial crisis: finalizing ASAP a credible resolution mechanism that ends too-big-to-fail for real and thus makes most of these rules unnecessary.


[1] Doriana Ruffino, FRB, Some Implications of Knightian Uncertainty for Finance and Regulation (Apr 10, 2014), available at