Last week, a senior FRB official outlined a shadow-bank strategy at a closed-door session, detailing one sharply at odds with that under construction by global regulators. And, Thursday night of this week, the president of the Richmond Federal Reserve Bank followed with a resounding, on-the-record reform plan also aimed squarely at the shadows. The two Fed talks are, as yet, just thought pieces. But, they’re deep thoughts about an urgent issue that, we think, will be addressed very differently in the U.S. Big banks might like some of the Fed’s shadow remedy, but it’s strong medicine that kills off anything left of too-big-to-fail in the United States.

Let’s hope that the furtive talk on shadow banking from the aforementioned senior FRB official will soon be out in the open. Significantly, nothing in the oral comments took direct issue with the global shadow initiative. This is defined in an October, 2011 document from the Financial Stability Board and this month’s European Commission’s “Green Paper” released for comment. At the heart of each of these statements is a policy determination that the best way to kill off shadow banking is to choke off bank interconnections to it. This would, they say, be done through slapping punitive capital charges on bank funding or investments in nonbanks, standards strengthened perhaps also by simply making some bank/shadow-bank interactions impermissible for banking organizations.

As we have suggested many times, this approach is flawed for several reasons. First, it adds still more complexity to already daunting bank-regulatory standards, heightening their burden even as opportunities for regulatory arbitrage grow still greater. Second – and rather importantly – they won’t work. Financial systems have all sorts of market mechanisms that aren’t bank-dependent, especially in the U.S. Thus, choking off bank dealings with shadow firms will throttle banks, while giving shadow firms only a bit of a sniffle. The emerging FRB approach to shadow banking rightly rejects the global, bank-centric model. The president of the Federal Reserve Bank of Richmond, Jeffrey Lacker, calls his model a “market discipline” one, and this also well describes the other Fed concept paper. Although each of the talks differs in key details, they both aim their formidable firepower at one target: implicit guarantees, taking these dirty words out of the GSE context and, now, building a far broader financial-regulatory construct based on ending suggestions of future support.

The Fed speeches do this by arguing that some shadow products – most notably money-market funds (MMFs) – pose undue risk because investors expect the government to bail them or their sponsors out. The repurchase (repo) market also comes under fire here, with the still-secret Fed official’s contemplating a new facility, possibly even in the Federal Reserve, to serve as the short-term counterparty for the triparty repo market.

Mr. Lacker’s ideas are still more startling. Key to his recommendations here are two dramatic rewrites to the U.S. resolution regime that would doom its ability to serve as a TBTF safety net.

First, Mr. Lacker suggests a rewrite of the Bankruptcy Code so that derivatives and similar exposures are no longer automatically protected when a large firm falters. This would, he believes, force counterparties to fend for themselves through tougher collateral and other market-disciplinary measures that would reduce, if not end, any need for “bridge” institutions or other resolution structures involving the U.S. Government. Second, he goes farther than Dodd-Frank in snipping the FRB’s liquidity-support capacity, arguing that the Fed should provide only discount-window support and, then, only on traditional terms and conditions to traditional banking organizations.

In their way, each of these Fed talks gets to the heart of the big-bank regulatory dilemma: either you are TBTF and, thus, rightly subject to surcharges and a host of systemic rules, or you aren’t and should then be regulated accordingly. In the end, banks will do better and, more important, serve economic and customer needs far more efficiently, if they bow to meaningful market discipline and rewrite their business model to suit. Giving up what’s left of TBTF poses serious operational and intellectual challenges – for example, the Bankruptcy Code change is a big, big think. But, it’s an urgent one if large banks want to avoid the bank-centric, surcharge-laden regulatory framework that would turn them into utilities that lies in store for them as long as TBTF claims have clout

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