Tuesday, July 12, 2016
In a July 12, 2016 address at the Center for American Progress and Americans for Financial Reform Conference, Washington, DC, Federal Reserve Board Governor Daniel K. Tarullo provided some insights in to the Fed and FSOC’s current thinking on regulation of shadow banking.
Shadow banking is an imprecise term, so Tarullo counsels turning away from definitional questions and efforts to create a shadow banking taxonomy in favor of a greater focus on characteristics of shadow banking-related financial activities and institutions that are most likely to pose risks to financial stability. According to Tarullo, the financial crisis began as a run on short-term liabilities by investor who had come to doubt the value of the assets they were funding through various kinds of financial intermediaries. Because these kinds of runs and panics are characteristic of every financial crisis, Tarullo suggests focusing analysis and policy initiatives with regard to the universe of shadow banking activities on the presence of runnable funding.
"It is important to note that the short-term funding or immediately redeemable investments that can run when a shock hits are likely to have contributed to the vulnerability of relevant asset classes to those shocks. The very short-term nature of the transaction reduces the incentives of counterparties to evaluate carefully the loan or investment they are making. If you can refuse to roll over your repo tomorrow, why be too concerned about whether the underlying collateral may prove to be overvalued a few months later? Consequently, funds may flow into asset classes with less sensitivity to information relevant to the value of the assets, driving asset values up and lending standards down, until the moment at which negative information becomes so powerful that everyone wants out at once."
Tarullo acknowledges that this type of funding is currently far less prevalent than it was prior to the crisis. The largest broker-dealers, both domestic and foreign, that were so dependent on short-term funding in the pre-crisis period have now either converted to, or been absorbed into, bank holding companies subject to prudential capital and liquidity regulation, and structured investment vehicles so infamously dependent upon runnable funding have all but disappeared. In addition, new are in place constraining relationships between shadow banking and prudentially regulated banking organizations, and the Securities and Exchange Commission tightened regulation of money market funds and other asset managers whose business models involve substantial amounts of liquidity transformation.
Notwithstanding the reduced reliance on runnable sources of funding and new regulations, Tarullo still sees room for more analysis and policy work in the area to prevent conditions for destructive runs that threaten financial stability from arising again:
"But just because the levels of runnable funding are significantly lower than before the crisis does not necessarily mean they are at safe or optimal levels. And it seems quite reasonable to expect that new forms of financial intermediation based substantially on runnable funding could develop in the future. As liquidity standards, stress testing, and resolution planning evolve, regulators will continue to work on this issue with prudentially regulated firms. But the conditions for destructive runs that threaten financial stability could exist even where no institutions that might be perceived as too-big-to-fail are immediately involved. So I continue to believe that the post-crisis work to create a solid regime to protect financial stability cannot be deemed complete without a well-considered approach to regulating runnable funding outside, as well as inside, the regulatory perimeter."
In order to fashion his new approach to runnable funding, Tarullo poses five questions that must be answered:
1. To what degree will it rely on uniform regulation of users of runnable funding no matter what the characteristics of the market actors and business models involved in the funding relationship?
2. What agency or agencies would be the appropriate regulators?
3. What form or forms would the regulation take? (e.g., outright prohibition, minimum margining requirements and practices, capital requirements, taxation, etc.).
4. To what extent is the supply of short-term funding a response to a persistent demand for more safe assets?
5. To what extent does a comprehensive regulatory approach to shadow banking need to include mechanisms--involving the government directly or indirectly--for the creation of more genuinely safe assets, as well as limitations on the runnable varieties that can precipitate or exacerbate financial stress?
Governor Tarullo asks questions 4 and 5 in the context of the current environment of extreme demand for “safe assets”:
“[N]umerous commentators have observed that, for a variety of reasons, demand for safe assets in recent decades has been growing substantially faster than the supply of these most obvious and truly safe forms of government-backed assets. In these circumstances, they note, the demand for privately created safe assets has increased. One problem, of course, is that the privately created assets may be treated as safe in normal times but, as seen in 2008, not in periods of high stress. Hence the phenomenon of runs. Another consideration is that the private creation of putatively safe assets is, at least to some degree, the creation of money outside of the operations of central banks or of depository institutions subject to reserve requirements and other regulations."
The question of whether government policy should be used to create safe assets or foster conditions encouraging the private creation of safe assets has implications reaching far beyond the regulation of shadow banking. Governor Tarullo counsels a cautious approach but maintains that the implications of these questions must be confronted when devising policy responses to the very real risks of runnable liabilities.