At the Senate Banking hearings this week wrestling with the President’s proposed proptrade ban, Sen. Jack Reed (D-RI) floated an alternative: limiting discount-window access for non-traditional banking organizations. It got a favorable response from Chairman Dodd, in part because he’s so non plussed by the timing of the Administration’s latest assault on financial reform. Sen. Reed has so far not detailed his idea, but, based on his comments, we infer that it would deny access to the Fed’s discount window to any banking organization where non-banking operations comprised 75 percent or more of the firm’s activities. This could turn out, though, to do more to exacerbate systemic risk than to control it, because the Fed would lose a vital liquidity tool essential to preventing otherwise-avoidable market collapse.

Definitions will of course be key to knowing who’s in or out of the Fed’s ambit under the Reed proposal. If banking is defined the old-fashioned way – intermediation between depositors and borrowers – then every big bank would be defenestrated. However, if “activities” is defined by reference to assets, then most, if not all, would remain eligible for central-bank support because most investment-banking activities – including proprietary trading – are fee-based ones that play a huge role in profit – or loss – without bulking up the balance sheet.

Another possible way to implement the Reed idea – supported by Goldman Sachs at the Thursday hearing – would be to permit the Fed to supply discount-window liquidity to insured depositories, but not to parent holding companies. However, big banking organizations could move most – if not all – of their “non-traditional” activities into the bank, mooting the whole point of the proposal as we understand it. However, even if these not-so trivial details are dealt with, the discount-window ban has the more fundamental flaw noted above: it would in fact worsen systemic risk. The reason we have a Fed in the first place is the discount window – yes, we know the central bank also does this or that monetary-policy thing, but the Fed’s principal function in the financial market is as the lender of last resort. Congress decided on this in 1913 when crisis after crisis showed that, when J. P. Morgan wasn’t willing or couldn’t help, financial markets froze with disastrous macroeconomic consequences. It thus set up the central bank to ensure that the government stepped in when no one else could. As the 2008 financial crisis worsened, the Federal Reserve strode into the market with all the discount-window and other emergency supports that eventually ballooned its balance sheet to the current humongous sum of $2.2 trillion. At the time, we criticized some of these facilities on grounds that the Fed was confusing liquidity with solvency – that is, it propped up some firms (AIG comes to mind, but it’s not the only one) that weren’t struggling because of short-term calamities in the credit market. Instead, counterparties quickly realized that some of their claims were endangered by real solvency problems at some of the most troubled firms and ran for the exit. The Fed intervened and saved the day – sometimes that and the night too – for these counterparties, taking the solvency risk out of the market and onto its own books.

It’s for this reason – the Fed’s confusion between liquidity and solvency risk – that critics now argue that the FRB exacerbated moral hazard and salvaged too-big-to-fail institutions, making them still more enormous and, thus, untouchable. The key to fixing too-big-to-fail isn’t in cutting off liquidity support to big banks or, even their nonbanking affiliates if these are critical to market function. Instead, the trick is to know the difference between short-term liquidity squeezes – when the Fed should act – and long term solvency debacles – when it should stand aside. When big banks bet the ranch and bet wrong, they – along with shareholders, creditors and management – should take all the lumps due them.

The lesson we draw from the crisis is not the need to withdraw liquidity support for even the biggest financial firm. Rather, it’s that the Fed – and all the other prudential regulators – need to get a lot better a lot quicker about knowing the difference between liquidity and solvency risk. The central bank can and should come to the aid of solvent firms squeezed by credit-market forces beyond their control – without this power, we all face ruin. But, if it uses its windows to aid the insolvent – as was done all too often in this crisis – moral hazard will be exacerbated and ruin will yet again threaten us all.