Fed Governor Tarullo On Shadow Banking

While there is a well-defined set of regulatory measures to address too-big-to-fail, the same cannot be said for the second major challenge revealed by the crisis: the instability of the shadow banking system. Although some elements of pre-crisis shadow banking are probably gone forever, others persist. Moreover, as time passes, memories fade, and the financial system normalizes, it seems likely that new forms of shadow banking will emerge. Indeed, the increased regulation of the major securities firms may well encourage the migration of some parts of the shadow banking system further into the darkness–that is, into largely unregulated markets. And it bears reminding that, just as the fragility of major financial firms elicited government support measures during the crisis, so the runs and threats of runs on the shadow banking system brought forth government programs such as the Treasury’s insuring of money market funds.

Reform measures to date are not wholly unrelated to the shadow banking system, and wholesale funding more generally. Dodd-Frank addresses the associated issue of derivatives trading by requiring central clearing of all standardized derivatives and margining of non-cleared trades by major actors in over-the-counter derivatives markets. Strengthened capital and liquidity standards for prudentially regulated institutions should help by giving increased assurance to counterparties about the soundness of these firms. But in periods of high stress, with substantial uncertainty as to the value of important asset classes, questions about liquidity and solvency could still arise, even with respect to well-regulated institutions. In fact, the supposed low-risk lending transactions–typically secured by apparently safe assets–that dominate the shadow banking system are likely to be questioned only in a period of high stress. It cannot be overemphasized that this systemic effect can materialize even if no firms were individually considered too-big-to-fail.

Interesting and productive academic debates continue over the sources of the rapid growth of the shadow banking system, the precise reasons for the runs of 2007 and 2008, and the possible sources of future problems. The conclusions drawn from these debates could be important in eventually framing a broadly directed regulatory plan for the shadow banking system. Domestically, among member agencies of the FSOC, and internationally, among members of the Financial Stability Board, policy officials are engaged in these debates and their implications for reform. But policymakers cannot and should not wait for the conclusion of these deliberations to address some obvious vulnerabilities in today’s shadow banking system.

Two areas where the case for reform in the short-run is compelling are money market funds and the tri-party repo market. The requirement adopted by the Securities and Exchange Commission (SEC) in 2010 for a greater liquidity buffer in money market funds was a step in the right direction, but the combination of fixed net asset value, the lack of loss absorption capacity, and the demonstrated propensity for institutional investors to run together make clear that Chairman Schapiro is right to call for additional measures. As to the tri-party repo market, there are several important concerns. A major vulnerability lies in the large amount of intraday credit extended by clearing banks on a daily basis. An industry initiative to address the issue led to some important operational improvements to the tri-party market, but, to be frank, fell short of dealing comprehensively with this problem. So it now falls to the regulatory agencies to take appropriate regulatory and supervisory measures to mitigate these and other risks.

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