Federal Reserve Board Governor Daniel Tarullo spoke Tuesday on "Shadow Banking After the Financial Crisis." He said, "The three decades preceding the financial crisis were characterized in the United States by the progressive integration of traditional lending and capital markets activities. This trend diminished the importance of deposits as a source of funding for credit extension in favor of capital market instruments sold to institutional investors. It also altered the structure of the financial services industry, both transforming the activities of broker-dealers and fostering the emergence of large financial conglomerates. Although the structure of foreign banking systems was less noticeably changed, many foreign banks drew increasingly on the resulting wholesale funding markets and made significant investments in the mortgage-backed securities that had proliferated in the first decade of this century."

Tarullo continued, "The financial crisis underscored the failure of the American regulatory system to keep pace with these developments and revealed the need for two reform agendas. One must be aimed specifically at the problem of too-big-to-fail institutions. The other must be directed at the so-called shadow banking system, which refers to credit intermediation involving leverage and maturity transformation that is partly or wholly outside the traditional banking system. As I have noted on other occasions, most reforms to date have concentrated on too-big-to-fail institutions, though many of these reforms have yet to be fully implemented. The shadow banking system, on the other hand, has been only obliquely addressed, despite the fact that the most acute phase of the crisis was precipitated by a run on that system. Indeed, as the oversight of regulated institutions is strengthened, opportunities for arbitrage in the shadow banking system may increase."

He explained, "The growing demand for safe and liquid assets was met largely by the shadow banking system's creation of assets that were seemingly safe and seemingly liquid. New varieties of shadow-banking activities were created, some pre-existing types grew larger, and the shadow banking system became much more internationalized. For example, the volume of asset-backed commercial paper, or ABCP, grew enormously. Many ABCP vehicles issued short-term, highly rated liabilities and bought longer-term, highly rated securities, often mortgage-backed securities. Many of the vehicles were sponsored abroad, especially by European banks, which issued dollar-denominated ABCP in the U.S. market and bought dollar-denominated assets in the U.S. market. The overall volume of this activity was very large, although the net flows between the U.S. and Europe were not, leaving European bank sponsors of such ABCP vehicles with a huge exposure when market participants stopped believing that ABCP was risk-free."

Tarullo told a San Francisco audience, "It now seems clear that the tail risk associated with many shadow-banking instruments was not understood by many market actors, including both sellers and buyers. An important contributing factor on the buyers' side that helped set the stage for the 2007-2008 financial crisis was the widespread acceptance that risk-free assets could be created by augmenting what was already thought to be a low-risk asset with a promise from a large financial institution to provide liquidity or bear credit losses in the unlikely event that such support might be needed. When, in stressed conditions, the credibility of the promise came into question, the susceptibility to runs increased dramatically."

He commented, "In some cases, there were explicit contractual provisions for liquidity support or credit enhancements, such as were provided to ABCP vehicles by their sponsoring banks. In other cases, the support was more implicit, and was conveyed in the marketing of the assets or through an historical pattern of providing support. Forms of implicit credit support were present in a variety of important funding channels and, to a considerable degree, persist today. Three examples are money market funds, the triparty repo market, and securities lending."

Tarullo said, "Money market funds aim to maintain a stable net asset value of one dollar per share and to meet redemption requests upon demand. As such they are the very model of a nonbank "deposit" or cash equivalent. Unlike other mutual funds, money market funds are allowed to round their net asset values to one dollar per share so long as the underlying value of each share remains within one-half cent of a dollar. But a drop in the unrounded net asset value of more than one-half of one percent causes a money fund to "break the buck," a scenario in which losses, at least in theory, would be passed along to the fund's investors."

He explained, "However, fund sponsors historically have absorbed losses whenever necessary to prevent funds from breaking the buck, with only two exceptions. Even though they had no legal obligation to do so, sponsors voluntarily supported their funds more than 100 times between 1989 and 2003, presumably because allowing a fund to break the buck would have damaged the sponsor's reputation and franchise. This tendency was well understood by investors. Indeed, a standard reference book on money markets states that a "money fund run by an entity with deep pockets, while it may not have federal insurance, certainly has something akin to private insurance ... likely to prove adequate to cover any losses sustained by the fund."

Tarullo told the "shadow banking" event crowd, "Many money funds sustained significant capital losses when the market for asset-backed commercial paper collapsed in the summer and fall of 2007. As in previous decades, losses at money funds were absorbed by the funds' sponsors. Indeed, money funds were seen as highly safe in 2007 and received large net inflows as concerns about other portions of the financial system increased."

He explained, "But when, in 2008, the Reserve Primary Fund did not provide support for the relatively small losses at its money market fund, the illusion that money funds were effectively as safe as insured bank accounts was shattered. A general run on money funds ensued. Within two days, investors withdrew nearly $200 billion from prime money market funds, about 10 percent of their assets. This contributed to severe funding pressures for issuers of commercial paper. The run ultimately prompted--and was stopped by--unprecedented interventions by the Treasury and the Federal Reserve to provide insurance and liquidity support to the industry."

Later, he commented, "Although the experiences of money market funds, triparty repos, and securities lending vary in the details, they all share a common underlying pathology: Offering documents with stern warnings notwithstanding, explicit and implicit commitments combined with a history of discretionary support to create an assumption, even among sophisticated investors, that low-risk assets were free of credit and liquidity risk -- effectively cash, but with a slightly higher return. This risk illusion led to pervasive underpricing of the risks embedded in these money-like instruments and made them an artificially cheap source of funding. The consequent oversupply of these instruments contributed importantly to systemic risk."

Tarullo said, "Let me then suggest three more-or-less 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 Securities and Exchange Commission is considering approaches to enhanced transparency in the closely related securities lending market."

He continued, "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. The SEC is currently considering several possible reforms, including a floating net asset value, capital requirements, and restrictions on redemption. Clearly, as suggested by Chairman 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 Tucker of the Bank of England that supervisors consider setting new limits on banks' reliance on funding provided by money market funds."

Finally, Tarullo said, "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 have 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."

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