WORD ON THE STREET: Ideally, a regulatory response to the shadow banking system would be grounded in a full understanding of the dynamics that drove its rapid growth, the social utility of its intermediation activities and the risks they create. Such a response would be comprehensive, meaning that it would cover in an effective and efficient manner any activities that create these vulnerabilities, without regard to how the activities were denominated, what transaction forms were used, or where they were conducted.
Of course, many of the key issues are still being debated, and even those who agree on the desirability of a comprehensive response may differ on its basic form. We should continue to seek the analytic and policy consensus that must precede the creation of a regulatory program that meets these conditions. More work is needed on fundamental issues, such as the implications of private money creation and of intermediaries behaving like banks but without bank-like regulation.
These implications are potentially quite profound for central banking and banking regulation, considering that the shadow banking system has caused the volume of money-like instruments created outside the purview of central bank and regulatory control to grow markedly.
But regulators need not wait for the full resolution of contested issues or the development of comprehensive alternatives, nor would it be prudent for them to do so. We should act now to address some obvious sources of vulnerability in the financial system. I believe that the foregoing discussion of implicit support for various shadow banking instruments helps identify areas where misunderstanding and mispricing of risk are more likely, with the result that destabilizing runs are a real possibility.
Let me then suggest three immediate steps that regulators here and abroad should take, as well as a medium-term reform undertaking.
First, we should create greater transparency with respect to the various transactions and markets that comprise the shadow banking system. For example, large segments of the repo market remain opaque today.
In fact, at present, there is no way that regulators or market participants can precisely determine even the overall volume of bilateral repo transactions – that is, transactions not settled using the triparty mechanism. It is encouraging that the Treasury Department's new Office of Financial Research is working to improve information about this market, while the U.S. Securities and Exchange Commission (SEC) is considering approaches to enhance transparency in the closely related securities lending market.
Second, the risk of runs on money-market mutual funds should be further reduced through additional measures that address the structural vulnerabilities that have persisted even after the measures taken by the SEC in 2010 to improve the resilience of those funds. The SEC is currently considering several possible reforms, including a floating net asset value, capital requirements and restrictions on redemption.
Clearly, as suggested by SEC Chairwoman Mary Schapiro, action by the SEC to address the vulnerabilities that were so evident in 2008, while also preserving the economic role of money-market funds, is the preferable route. But in the absence of such action, there are several second-best alternatives, including the recent suggestion by Deputy Governor Paul Tucker of the Bank of England that supervisors consider setting new limits on banks' reliance on funding provided by money-market funds.
A third short-term priority is to address the settlement process for triparty repurchase agreements. Some progress has been made since 2008, but clearly, more remains to be done. An industry-led task force established in 2009 orchestrated the implementation of some important improvements to the settlement process.
The unwind, with its reliance on vast amounts of discretionary and uncommitted intraday credit from the two clearing banks, was pushed to later in the day, reducing the period during which the intraday credit was extended. In addition, new tools were developed for better intraday collateral management, and an improved confirmation process was instituted.
Though these were useful steps, the key risk-reduction goal of the effective elimination of intraday credit has not yet been achieved. A second phase of triparty reform is now under way, with the Federal Reserve using its supervisory authority to press for further action not only by the clearing banks, who of course manage the settlement process, but also by the dealer affiliates of bank holding companies, who are the clearing banks' largest customers for triparty transactions.
But this approach alone will not suffice. All regulators and supervisors with responsibility for overseeing the various entities active in the triparty market will need to work together to ensure that critical enhancements to risk management and settlement processes are implemented uniformly and robustly across the entire market, and to encourage the development of mechanisms for orderly liquidation of collateral, so as to prevent a fire sale of assets in the event that any major triparty market participant faces distress.
In the medium term, a broader reform agenda for shadow banking will first need to address the fact that there is little constraint on the use of leverage in some key types of transactions. One proposal is for a system of haircut and margin requirements that would be uniformly applied across a range of markets, including over-the-counter (OTC) derivatives, repurchase agreements and securities lending. Work is ongoing to develop globally uniform margin requirements for OTC derivatives, but there is not yet an agreement to develop globally uniform margin requirements for securities financing transactions.
Such a margining system would not only limit leverage, but – to the extent it is, in fact, uniform – also diminish incentives to use more complicated and less transparent transactional forms to increase leverage or reduce its cost. Some proponents suggest that such systems of uniform haircut and margin requirements could also dampen the observed procyclical character of many collateralized borrowings that results from changes in margins and haircuts following general economic or credit trends.
The shadow banking system today is considerably smaller than at the height of the housing bubble six or seven years ago. And it is very likely that some forms of shadow banking most closely associated with that bubble already disappeared forever.
But as the economy recovers, it is nearly as likely that, without policy changes, existing channels for shadow banking will grow, and new forms creating new vulnerabilities will arise. That is why I suggest what is, in essence, a two-pronged agenda: first, near-term action to address current channels where mispricing, run risk and potential moral hazard are evident; and, second, continuation of the academic and policy debate on more fundamental measures to address these issues more broadly and proactively.
Daniel K. Tarullo is a governor of the Federal Reserve Board. This article is adapted and edited from a speech delivered at the Federal Reserve Bank of San Francisco's Conference on Challenges in Global Finance: The Role of Asia. The full text is available online.
