22 November 2013

Fed/Tarullo: Shadow banking and systemic risk regulation

In some cases, the perception of claims on shadow banks as cash equivalents was based on explicit or implicit promises by regulated institutions to provide liquidity and credit support to such entities. In other cases, the perception came about because market participants viewed the instruments held on the balance sheets of shadow banking entities--notably highly rated, asset-backed securities--as liquid and safe. While reliance on private mechanisms to create seemingly riskless assets was sustainable in relatively calm years, the stress that marked the onset of the financial crisis reminded investors that claims on the shadow banking system could pose far more risk than deposits insured by the Federal Deposit Insurance Corporation (FDIC). Once reminded of their potential exposure, investors engaged in broad-based and sometimes disorderly flight from the shadow banking system.

This experience of the run on the shadow banking system that occurred in 2007 and 2008 reminds us that similar disorderly flights of uninsured deposits from banks lay at the heart of the financial panics that afflicted the nation in the late nineteenth and early twentieth centuries. The most dramatic of these episodes were the bank runs of the early 1930s that culminated in the bank holiday in 1933. Just as it was necessary, though not sufficient, to alter the environment that led to those successive deposit runs by introducing deposit insurance in order to create a stable financial system in the early-twentieth century, today it is necessary, though not sufficient, to alter the environment that can lead to short-term wholesale funding runs in order to create a stable financial system for the early twenty-first century.

Support provided for shadow banking activities may be either explicit or implicit. In some cases, there are explicit contractual provisions for credit enhancements and liquidity support. In other cases, the support is implicit, based on a bank's historical pattern of providing support or a belief among investors that a bank will provide support to maintain the value of its franchise. In the lead-up to the crisis, explicit and implicit commitments by regulated banking firms to shadow banks often combined to create the assumption that the liabilities of such entities were risk-free. This perception led to an underpricing of the risks embedded in these money-like instruments, making them an artificially cheap source of funding and creating an oversupply of these instruments that contributed to systemic risk.

Implicit support presents more of a regulatory challenge. Identifying implicit forms of support requires a supervisory judgement that, despite sometimes stern warnings in offering documents, a banking organisation bears some of the risk associated with that investment. Regulators must decide how much of the risk the banking organisation retains and make context-sensitive judgements about the financial stability implications of various remedies. These challenges notwithstanding, regulators have made some progress in addressing instances of implicit support that played a major role in the last crisis.

There are two kinds of policy options that can be considered, individually or together, in responding to the financial stability vulnerabilities inherent in firms with large amounts of short-term wholesale funding--whether loaned, borrowed or both. The first would impose a regulatory charge calculated by reference to reliance on SFTs and other forms of short-term wholesale funding, whether the firm uses that funding to finance inventory or an SFT matched book. The second would directly increase the very low charges under current and pending regulatory standards attracted by SFT matched books.

The process established by the Dodd-Frank Wall Street Reform and Consumer Protection Act for designation of systemically important non-bank firms has provided a means for ensuring that the perimeter of prudential regulation can be extended as appropriate to cover large shadow banking institutions. The proposals of the Securities and Exchange Commission on money market fund regulation are a response to continuing vulnerabilities as well as to the run in the fall of 2008. These are important initiatives that will contribute to a safer system of funding throughout the financial system. Yet the risk of contagious runs would persist even in the absence of individually systemic institutions. And with less vulnerable money market funds, other cash-rich entities could emerge as a source of inexpensive funding for the shadow banking system. Finally, as I have noted, the systemic risks associated with short-term wholesale funding in prudentially regulated institutions have not fully been countered by the important capital and liquidity standards adopted since the crisis. My purpose today has been to reinforce the point that a sounder, more stable financial system requires a more comprehensive reform agenda.

Full speech

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