Last night, Federal Reserve Chairman Ben Bernanke spoke at the 2012 Federal Reserve Bank of Atlanta Financial Markets Conference in Stone Mountain, Georgia on "Fostering Financial Stability." The Chairman weighed in on "shadow banking" extensively, and had several things to say on money market funds. He says, "Tonight I will discuss some ways in which the Federal Reserve, since the crisis, has reoriented itself from being (in its financial regulatory capacity) primarily a supervisor of a specific set of financial institutions toward being an agency with a broader focus on systemic stability as well. I will highlight some of the ways we and other agencies are working to increase the resiliency of systemically important financial firms and identify and mitigate systemic risks, including those associated with the so-called shadow banking system. I will also discuss the broad outlines of our evolving approach to monitoring financial stability. Our efforts are a work in progress, and we are learning as we go. But I hope to convey a sense of the strong commitment of the Federal Reserve to fostering a more stable and resilient financial system."

Bernanke explains, "Gaps in the regulatory structure, which allowed some systemically important nonbank financial firms to avoid strong, comprehensive oversight, were a significant contributor to the crisis. The Federal Reserve has been working with the other member agencies of the Financial Stability Oversight Council (FSOC), established by the Dodd-Frank Act, to close these regulatory gaps. On April 3 the FSOC issued a final rule and interpretive guidance implementing the criteria and process it will use to designate nonbank financial firms as systemically important. Once designated, these firms would be subject to consolidated supervision by the Federal Reserve.... The FSOC's rule provides detail on the framework the FSOC intends to use to assess the potential for a particular firm to threaten U.S. financial stability. The analysis would take into account the firm's size, interconnectedness, leverage, provision of critical products or services, and reliance on short-term funding, as well as its existing regulatory arrangements."

He continues, "I have been discussing the oversight of systemically important financial institutions in a macroprudential context. However, an important lesson learned from the financial crisis is that the growth of what has been termed "shadow banking" creates additional potential channels for the propagation of shocks through the financial system and the economy. Shadow banking refers to the intermediation of credit through a collection of institutions, instruments, and markets that lie at least partly outside of the traditional banking system."

Bernanke says, "Although the shadow banking system taken as a whole performs traditional banking functions, including credit intermediation and maturity transformation, unlike banks, it cannot rely on the protections afforded by deposit insurance and access to the Federal Reserve's discount window to help ensure its stability. Shadow banking depends instead upon an alternative set of contractual and regulatory protections--for example, the posting of collateral in short-term borrowing transactions. It also relies on certain regulatory restrictions on key entities, such as the significant portfolio restrictions on money market funds required by rule 2a-7 of the Securities and Exchange Commission (SEC), which are designed to ensure adequate liquidity and avoid credit losses. During the financial crisis, however, these types of measures failed to stave off a classic and self-reinforcing panic that took hold in parts of the shadow banking system and ultimately spread across the financial system more broadly."

He adds, "Because of these and other connections, panics and other stresses in shadow banking can spill over into traditional banking. Indeed, the markets and institutions I mentioned--the repo market, the ABCP market, and money market funds--all suffered panics to some degree during the financial crisis. As a result, many traditional financial institutions lost important funding channels for their assets; in addition, for reputational and contractual reasons, many banks supported their affiliated funds and conduits, compounding their own mounting liquidity pressures."

On the "Status of Shadow Banking Reform Efforts," Bernanke comments, "Given the substantial stakes, I am encouraged that both regulators and the private sector have begun to take actions to prevent future panics and other disruptions in shadow banking. However, in many key areas these efforts are still at early stages."

He tells us, "A second area of ongoing reform is money market funds. In an important step toward greater stability, the SEC in 2010 amended its regulations to, among other things, require that money market funds maintain larger buffers of liquid assets, which may help reassure investors and reduce the likelihood of runs. Notwithstanding the new regulations, the risk of runs created by a combination of fixed net asset values, extremely risk-averse investors, and the absence of explicit loss absorption capacity remains a concern, particularly since some of the tools that policymakers employed to stem the runs during the crisis are no longer available. SEC Chairman Mary Schapiro has advocated additional measures to reduce the vulnerability of money market funds to runs, including possibly requiring funds to maintain loss-absorbing capital buffers or to redeem shares at the market value of the underlying assets rather than a fixed price of $1. Alternative approaches to ensuring the stability of these funds have been proposed as well. Additional steps to increase the resiliency of money market funds are important for the overall stability of our financial system and warrant serious consideration."

Bernanke comments, "A third set of emerging reforms is aimed at repo markets, an area in which the Federal Reserve has taken an active role. The initial efforts have focused on the vulnerabilities created by the large amounts of intraday credit provided by clearing banks in the triparty repo market.... An industry task force recognized this mutual vulnerability in 2010 and recommended the "practical elimination" of intraday credit in the triparty repo market. Although some progress has been made, securities dealers and clearing banks have yet to fully implement that recommendation. Nevertheless, through supervision and other means, we continue to push the industry toward this critical goal. In doing so, we are collaborating with other agencies, notably the SEC, which has regulatory responsibility for money market funds and securities dealers, institutions that are active in the triparty repo market. At the same time, we continue to urge market participants to improve their risk-management practices, and, in particular, to ensure that tools are in place to address the risks that would be posed to the repo market by the default of a major firm."

Finally, he adds, "International regulatory groups have also been focused on addressing the financial stability risks of shadow banking. The Group of Twenty leaders have directed the Financial Stability Board (FSB), whose membership consists of key regulators from around the world, including the Federal Reserve, with developing policy recommendations to strengthen the regulation of the shadow banking system. The FSB currently has five major projects under way devoted to understanding the risks of, and developing policy recommendations for, shadow banking. The areas under study include money market funds, securitization, securities lending and the repo market, banks' interactions with shadow banks, and "other" shadow banking entities. Given the substantial variation in the structure of shadow banking in different countries, the FSB's agenda is ambitious. But it is also critical in light of the potential risks to stability from shadow banking and the ease with which shadow banking entities can create intermediation chains across national borders."

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