Earlier this week, we sent clients an in-depth assessment of the actions FSOC will now take to address the systemic risk it fears could soon sweep through the asset-management industry. FSOC has put itself on the right path by finally turning to the activity-and-practice approach, but sadly so late as to make its ability to avert any near-term crisis questionable at best. Record numbers of repo fails at the end of July shook but thankfully didn’t collapse the financial system. Thus, we’ve withstood another systemic-risk squeaker. How long can markets do so in the absence of a coherent regulatory and resolution framework for all large players? Not long, I fear, and this could force the FRB to become the market-maker of last resort so often discussed behind the FRB’s closed doors. Market intervention of this magnitude will stabilize the system, but at grave cost to any hopes of ending TBTF.

Repo-market jitters result from an array of factors – all of them well understood in the wake of Lehman’s failure in 2008. As a result, some changes have occurred since the crisis. After being pushed hard by the Federal Reserve Bank of New York, the two U.S. clearing banks have made big changes to risk in the tri-party repo market. Big banks are also a lot more liquid than they were and are set to come under even stricter sanctions in this critical arena.

However, reforms always come at cost – and not just to the big banks that complain about them. The more high-quality liquid assets (HQLAs) banks must hold to ensure their liquidity under stress, the fewer there are of these out in the market and the greater the ability of hedge funds and other big asset managers to scoop up what’s left at a significant comparative advantage. These institutions – often dubbed the shadows – have already demonstrated formidable capacity as big banks shrink their repo books, but their lack of capital to withstand margin increases is also evident. The July fails were in part the result of precisely this risk, as were sharp intakes of breath in the agency RMBS market when last month some hedge funds had a heck of a time making margin on leveraged holdings in GSE risk-share paper.

What’s particularly frightening about the repo market now is that it could be in one of those “perfect storm” moments when shadow-bank competitive advantage combines with growing shortages of HQLA to make margin calls an increasingly make-or-break brush with systemic risk. Geopolitical risk is one reason markets keep confounding fixed-income traders and inspiring hoarding of short-term Treasuries, but the FRB’s continued unwillingness to raise rates makes the challenge still more striking. Treasury is also issuing a lot less short-term paper these days because market demand for its safe-haven obligations has allowed it to issue a lot of long-term paper at rates rarely seen before. This saves taxpayers billions, but exacerbates the short-term shortfall.

This critical HQLA shortage is also something regulators know full well and worry a lot about even as little is done to address it. We last year highlighted this challenge for clients, pointing then to an important – if often overlooked – paper prepared by the world’s most senior central bankers under the august auspices of the Bank for International Settlements. BIS ran through scenarios for HQLA shortfalls, noted the power these give shadow banks, identified the systemic risk this poses, and went on to lay out the risks also presented to effective monetary policy in the continued macroeconomic slump. However, after laying all this out, the BIS said hopefully that maybe HQLA shortages would be alleviated by an end to accommodative monetary policy that would start to return to the market the big HQLA books now housed in central banks. Happy talk, but none of the FRB’s trillions in USG and agency paper is coming back yet and, even though it has curtailed purchases some, the market is still begging when it comes to eligible collateral.

Which brings me back to the Federal Reserve’s emergency-liquidity role. Its statute clearly authorizes it to pump liquidity only to banks through the discount window, although it still has some latitude under Section 13(3) to fund others in distress despite Dodd-Frank’s efforts to circumscribe this. Under stress and within current law, the Board could still make a finding that “financial stability” is so threatened by a liquidity – not solvency – problem as to warrant massive intervention. This would be the aforementioned market-maker of last resort role.

In a crisis, it will be necessary for the FRB to act as it fears it may be compelled to do. Until there is a crisis, though, we need to understand just what would happen were the FRB to act and put in place impediments to any Lehman-like repo repeat as fast as we can. If markets expect the FRB to bail out hedge funds and asset managers – which they do – then these non-banks will be the beneficiaries of new-age moral hazard. This will happen even if the FRB is never forced to act, no matter what the Dodd-Frank framework demands of the biggest banks. If markets expect FRB intervention and, worse still, get it, TBTF will have been demonstrated all over again. When the smoke clears, the U.S. financial system would then get a restructuring that makes current proposals look like pabulum.