Fed’s Tarullo: Shadow Banking Pathologies May Rebound

From: Market News International

By Denny Gulino

WASHINGTON (MNI) – Federal Reserve Gov. Daniel Tarullo Tuesday warned that money market funds, triparty repos and securities lending “all share a common underlying pathology,” the illusion that they are almost as risk free as cash, and regulation must address mispricing, run risk and potential moral hazard.

Speaking via satellite to a San Francisco Fed conference, Tarullo acknowledged that there are “ongoing disagreements concerning the roles of various factors contributing to the rapid growth of the shadow banking system, the precise dynamics of the runs in 2007 and 2008, and the relative social utility of some elements of this system.”

The Securities and Exchange Commission is battling the mutual fund industry over increased regulation, among the industries pushing back against the widening reach of new Dodd-Frank regulation.

But Tarullo said regulators should not be paralyzed by the academic debate. “It is neither necessary nor wise to await such conclusions in order to begin implementing a regulatory response,” he said.

As the governor carrying the main Dodd-Frank regulatory portfolio, he recommended “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.”

Even sophisticated investors, he said, have noted the history of “explicit and implicit commitments combined with a history of discretionary support” and so assume “that low-risk assets are free of credit and liquidity risk and are effectively cash.”

“Although the experiences of money market funds, triparty repos, and securities lending vary in the details, they all share a common underlying pathology,” he said. Despite the warnings contained in offering documents, there is “pervasive underpricing of the risks embedded in these money-like instruments and made them an artificially cheap source of funding.” That led to their “oversupply,” a important contribution to systemic risk.

Such assumptions “generally worked in the relatively calm years leading up to the financial crisis and, to some extent, well into the crisis,” he said. Then as financial market stress grew acute, “questions arose about the ability or willingness of large financial institutions to follow through on their implicit commitments.”

“The unwinding of this risk illusion helped transform a dramatic correction in real estate valuations — which itself would have had serious consequences for the economy — into a crisis that threatened the entire financial system,” he said.

The shadow banking system deserves continued research and regulators should “continue to seek the analytic and policy consensus that must precede the creation of a regulatory program that meets these conditions.”

“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,” Tarullo said. “We should act now to address some obvious sources of vulnerability in the financial system” and identify areas where misunderstanding and mispricing of risk are more likely, with the result that destabilizing runs are a real possibility.”

More transparency about shadow banking transactions and markets is necessary. “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,” he said.

“Second, the risk of runs on money market mutual funds should be further reduced through additional measures to address the structural vulnerabilities that have persisted even after the measures taken by the SEC in 2010 to improve the resilience of those funds,” he said.

A third short-term priority is to address the settlement process for triparty repurchase agreements, he said. “The key risk reduction goal of the effective elimination of intraday credit has not yet been achieved,” he said.

“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,” he said.

As the economy recovers, it is likely that, without policy changes, “existing channels for shadow banking will grow, and new forms creating new vulnerabilities will arise.”

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