Four years after the passage of Dodd-Frank, we are still discussing whether the law has made the financial system more stable. These discussions are important, yet too little attention is being paid to a Federal Reserve program called the Overnight Reverse Repurchase Facility, also referred to as ON RRP. This program, while well-intentioned, could be a new source of financial instability. It needs a closer look.

The Federal Reserve Bank of New York operates the reverse repurchase facility as part of the central bank's open-market operations. The Fed "sells" securities that are part of its enormous, $4.4 trillion balance sheet to a host of financial institutions, while it simultaneously agrees to "repurchase" those assets the next day while paying the institutions a slight return (currently 0.01% to 0.05%). In effect, the Fed's counterparties are giving a secured loan to the most creditworthy borrower on the planet. They get a supersafe place to put their money and a little interest as well. Not a bad deal.

The Fed began the program in September as a way to test a potential new tool for raising interest rates whenever that day arises. Obviously, no counterparty would be willing to lend funds into the market at a rate cheaper than that paid by the Fed. So by raising the overnight reverse repurchase rate, the Fed can raise the floor rate at which their counterparties are willing to lend to other, less safe, borrowers.

I applaud the Fed's desire to eventually return interest rates to historical norms, but it is far from clear that its existing tools are insufficient to do so. The Fed can always sell government securities as part of its normal open-market operations. And Congress has given it authority to pay interest on bank reserves to set a floor on the rate at which banks will lend.

Moreover, the reverse repurchase program doesn't look like a temporary experiment. Large institutional investors, notably including money-market funds and government-sponsored entities (such as Fannie Mae are using it regularly. The facility hit an overnight high of $242 billion at the end of the first quarter of 2014. The Fed has raised the overnight allotment cap for individual buyers from $500 million in September to $10 billion today.

The mere existence of this facility could exacerbate liquidity runs during times of market stress. Borrowers in the short-term debt markets will have to compete with it for investment dollars and all, to varying degrees, will be viewed as higher risk than lending to the Fed. Even a relatively minor market event could encourage a massive flow of funds to the Fed while contributing to a flow away from other short-term borrowers.

Nonfinancial companies could find themselves unable to find buyers for their commercial paper. Banks could confront a sudden outflow of deposits, particularly those which are uninsured. Even the U.S. Treasury—traditionally viewed as the safest harbor—could see its borrowing costs spike as investors decide that the Fed is even safer.

Ironically, faced with a more acute liquidity crisis, the Fed would likely have to use the funds it is borrowing through reverse repos to provide a lifeline to the very markets that suffered. For investors seeking safety, the Fed would become the borrower of first resort. For borrowers affected by the resulting diversion of funding, the Fed would become the backstop lender.

The reverse repurchase facility also seems to be at cross-purposes with Congress's efforts to contain the government safety net. After many years of consideration, Congress in 2008 reluctantly gave the Fed authority to pay banks interest on the money they keep on deposit with it. The reverse repurchase facility essentially gives large nonbank financial institutions the routine ability to place money in the functional equivalent of an overnight deposit with the Fed and receive interest.

In December 2012 Congress allowed the Federal Deposit Insurance Corporation's crisis-era program to provide unlimited guarantees for non-interest-bearing transaction accounts—such as those used by businesses and local governments to process payroll and other expenses—to lapse. So the Transaction Account Guarantee Program is dead—but the Fed's reverse repurchase facility enables large nonbank financial institutions to obtain explicit government backing for billions placed with the Fed, but without the burdens of deposit insurance premiums and the kind of prudential supervision that applies to banks.

Finally, the reverse repurchase facility seems to be at cross-purposes with the Fed's own efforts to address systemic risks emanating from money-market funds, which were subject to disruptive runs after Lehman Brothers collapsed in September 2008. Market pressure should be causing this unstable sector of the financial system to shrink, particularly in today's near-zero interest-rate environment. But by giving money funds a de facto insurance program, the Fed has thrown them a lifeline.

Fortunately, the Fed has made no decisions about whether to make its reverse repurchase facility permanent. At least two Federal Reserve Bank presidents—New York's Bill Dudley and Boston's Eric Rosengren —have publicly acknowledged some of the risks that it poses and the need for caps on the use of the facility. 

 In my view the Fed should lock up the reverse repurchase facility in its toolbox and throw away the key. We need less, not more, government intervention in the financial markets.


Ms. Bair, a former chairwoman of the Federal Deposit Insurance Corp. (2006-11), heads the private, nonpartisan Systemic Risk Council.