Just ahead of Ron Paul's latest Fed hearing, a Fed paper questions blanket bailouts

Is the Fed saying goodbye to moral hazard? Likely not. At least, not for the Fab Five (or is it the Turby Twenty), who will get their liquidity fixes until the Fed no longer presides over the POMO opium fields. For everyone else, though, a new NY Fed policy paper seems to float just this idea: that a resolution procedure (read--gasp--breakup) might be preferred to providing blanket liquidity to all takers. That is, Kalamazoo S&L might starve at the discount window (or similar) waiting for Zimbabwe Ben to drop some morsels, while JPM and Goldman dine at the table on lobster and tenderloin.

Though the NY Fed paper has undoubtedly been in the works for months, if not longer, the timing is interesting. Only today, the top lawyers of the NY Fed and the Board of Governors will get grilled in front of Ron Paul's monetary committee in a hearing entitled "Federal Reserve Lending Disclosure: FOIA, Dodd-Frank, and the Data Dump". Of particular interest will be why certain (sometimes unexpected) names pop up so frequently in the thousands of pages of bailout docs released by the Fed.

The research paper is called, "A Model of Liquidity Hoarding and Term Premia in Inter-Bank Markets" and primarily focuses on rollover risk as a determinant of market stress and freezes. (Unfortunately, it is left to the reader to extrapolate to the logical extreme and wonder what happens when rollover risk of the US debt portfolio itself surfaces, concurrent with the last marginal buyer of Treasurys losing all credibility).

The interesting part is the Policy Conjectures on page 22, which we reproduce in full (emphasis and brackets ours):

4.3 Policy conjectures

It is important to consider cases where the lending banks' precautionary demand for liquidity may be excessive relative to its socially efficient level. In turn, this would suggest possible policy interventions to address excessive hoarding of liquidity by highly leveraged banks. Is it desirable to have an unconditional (traditional) lender of last resort (LOLR) in which a central bank provides liquidity to strong as well as weak banks? Or would it be better to have a solvency-contingent LOLR in which the central bank provides liquidity only to sufficiently strong banks? And should there instead (or in addition) be a resolution authority that forces weak banks to reduce their rollover risk? We conjecture that (i) a resolution authority to address weak banks' excess leverage and rollover risk, and (ii) a solvency-contingent LOLR by a central bank (that itself has lower credit and rollover risk than its banks), are likely to be more effective interventions than the traditional, unconditional LOLR.

Such welfare analysis can also help understand the impact of interventions that were put in place during the crisis of 2007-09, such as the Term Auction Facility (TAF) by the Federal Reserve for 28-day and later 84-day loans. We conjecture that through these facilities, the Federal Reserve, acting as a relatively risk-free intermediary, intermediated liquidity hoardings (reserves) of riskier banks to banks that participated in the facilities. This intervention should have increased volumes of lending to the real sector by the participating banks. [Note, lending in the real sector did not pick up, so is this a tacit suggestion that the Fed exacerbated the problem with its bailouts?] Note that under the alternative view, that stress in inter-bank markets is caused purely by borrower credit-risk problems, lending by central bank to banks at lower than market rates would effectively constitute a "bail out" of these banks and engender severe moral hazard. However, a resolution authority to address weak banks' leverage and rollover risk would be a robust intervention also under this alternative view.

Though carefully couched in academic objectivity, this is probably the strongest internal rebuke we've read of Federal Reserve intervention during the crisis. That bank resolution is discussed at all might signal a shift in priorities at the Fed, or perhaps hint of the pressure it's come under. Or, maybe this is simply a prelude to a renewed turf battle between the lethargic FDIC and the profligate Fed. We might even entertain the notion that one or more token TBTF banks could go down. Watch out Blankfein.