Banking is, at its heart, liquidity transformation. Banks fund themselves with liquid deposits and invest in illiquid loans to businesses and households. Recent decisions by the Federal Reserve and Federal Deposit Insurance Corp. on the living wills of several U.S. banks, while phrased as bank-specific decisions on the credibility of a firm's resolution plan, effectively make important policy decisions about the ability of U.S. banks to engage in liquidity transformation. These decisions, which reinforce other post-crisis regulatory changes, were not subject to notice and comment or mandated by Congress. Nevertheless, they have important ramifications for the ability of the U.S. banking system to fund economic growth.

Liquidity transformation can be potentially unstable, however, because each individual depositor or overnight creditor has an incentive to run if there is a whiff of trouble, but the bank can't liquidate its illiquid asset to meet the run. One way to eliminate this inherent risk is, of course, to require banks to make no loans and hold only completely safe and liquid assets such as Treasury bills. Another is to require banks to stop offering savings or checking accounts and fund themselves only with long-term debt. For a variety of reasons, however, modern economies have consistently opted for a banking system in which lending and deposit-taking are combined.

Historically, the government has addressed the instability inherent in liquidity transformation in three ways: deposit insurance, reserve requirements and providing a lender of last resort. The banking industry has addressed the risk by developing interbank markets for liquidity. The post-crisis regulatory reforms have strengthened deposit insurance and expanded reserve requirements in the form of a new liquidity requirements. But over the same period, governments have acted to reduce the roles of the lender of last resort and the interbank market.

A lender of last resort supports the ability of banks to engage in liquidity transformation by standing ready to provide a loan to a solvent (assets worth more than liabilities) but illiquid (unable to meet immediate payments) bank, against abundant collateral and at a penalty rate, thus avoiding an unnecessary bankruptcy at virtually no risk to the public. Interbank markets allow banks that need liquidity to borrow from other banks that have a temporary excess, making it unnecessary for each individual bank to hold sufficient liquidity to meet its anticipated peak needs. Together, access to a lender of last resort and the interbank market permit banks to devote more of their balance sheet to loans that help small businesses grow or to mortgages that help put families in a home rather than to highly liquid but unproductive assets.

The post-crisis regulatory and supervisory changes have scaled back the Fed's role as lender of last resort in a variety of ways. The situations in which the Fed can lend have been curtailed, and even where that role remains, new liquidity rules generally ignore it when assessing banks' liquidity strength, effectively requiring banks to structure themselves as if it did not exist. With respect to the interbank market, Basel III liquidity rules, the U.S. capital surcharge for "global systemically important banks" and counterparty credit limit requirements treat borrowing and lending between financial institutions unfavorably. New capital requirements require banks to hold high amounts of capital against low-risk money market transactions, or have been designed to specifically penalize short-term wholesale funding.

The living-will guidance would appear to make it even more expensive for banks to engage in liquidity transformation. The guidance regulators provided in April in conjunction with their assessment of 2015 plans instruct bank holding companies to hold sufficient liquid assets to meet the peak potential funding needs of each of their material entities, including their broker-dealer subsidiaries, on a standalone basis, even though the guidance also requires that the subsidiaries have sufficient capital after recapitalization to maintain the confidence of the markets. If that is indeed the case, it is the living-will guidance, and not the other liquidity regulations that have been developed over the past seven years, that is the binding determinant of the amount of liquidity transformation that occurs in the banking system. The potentially profound impact of these new policies on economic and job growth may be one reason why the Government Accountability Office suggested that the agencies should be more transparent about the criteria they are applying when determining if the living wills are credible.

William Nelson is the head of research and chief economist for The Clearing House. He is a former deputy director of the Federal Reserve Board's division of monetary affairs.