On Friday, Federal Reserve Governor Daniel K. Tarullo gave a speech entitled, "Evaluating Progress in Regulatory Reforms to Promote Financial Stability. Tarullo, who has been one of money market funds' most outspoken critics, discussed "Vulnerabilities Exposed by the Crisis," and said, "Beginning in the 1970s, the separation of traditional lending and capital markets activities established by New Deal financial regulation began to break down under the weight of macroeconomic turbulence, technological and business innovation, and competition. During the succeeding three decades these activities became progressively more integrated, fueling the expansion of what has become known as the shadow banking system, including the explosive growth of securitization and derivative instruments in the first decade of this century."

He explained, "This trend entailed two major changes. First, it diminished the importance of deposits as a source of funding for credit intermediation, in favor of capital market instruments sold to institutional investors. Over time, these markets began to serve some of the same maturity transformation functions as the traditional banking systems, which in turn led to both an expansion and alteration of traditional money markets. Ultimately, there was a vast increase in the creation of so-called cash equivalent instruments, which were supposedly safe, short-term, and liquid. Second, this trend altered the structure of the industry, both transforming the activities of broker-dealers and fostering the emergence of large financial conglomerates."

Tarullo continued, "There was, in fact, a symbiotic relationship between the growth of large financial conglomerates and the shadow banking system. Large banks sponsored shadow banking entities such as Structured Investment Vehicles (SIVs), money market funds, asset-backed commercial paper conduits, and auction rate securities. These firms also dominated the underwriting of assets purchased by entities within the shadow banking system."

He said, "Though motivated in part by regulatory arbitrage, these developments were driven by more than regulatory evasion. The growth and deepening of capital markets lowered financing costs for many companies and, through innovations such as securitization, helped expand the availability of capital for mortgage lending. Similarly, the rise of institutional investors as guardians of household savings made a wide array of investment and savings products available to a much greater portion of the American public."

Tarullo added, "But these changes also helped accelerate the fracturing of the system established in the 1930s. While the increasingly outmoded regulation of earlier decades was eroded, no new regulatory mechanisms were put in place to control new risks. When, in 2007, questions arose about the quality of some of the assets on which the shadow banking system was based--notably, those tied to poorly underwritten subprime mortgages--a classic adverse feedback loop ensued. Investors formerly willing to lend against almost any asset on a short-term, secured basis were suddenly unwilling to lend against a wide range of assets, notably including the structured products that had become central to the shadow banking system."

He commented, "Severe repercussions were felt throughout the financial system, as short-term wholesale lending against all but the very safest collateral froze up, regardless of the identity of the borrower. Moreover, as demonstrated by the intervention of the government when Bear Stearns and AIG were failing, and by the aftermath of Lehman Brothers' failure, the universe of financial firms that appeared too-big-to-fail during periods of stress extended beyond the perimeter of traditional safety and soundness regulation."

The Fed Governor also writes, "In short, the financial industry in the years preceding the crisis had been transformed into one that was highly vulnerable to runs on the short-term, uninsured cash equivalents that fed the new system's reliance on wholesale funding. The relationship between large firms and shadow banking meant that strains on wholesale funding markets could both reflect and magnify the too-big-to-fail problem. These were not the relatively slow-developing problems of the Latin American debt crisis, or even the savings and loan crisis, but fast-moving episodes that risked turning liquidity problems into insolvency problems almost literally overnight."

Finally, Tarullo said, "As you can tell, there is not yet a blueprint for addressing the basic vulnerabilities in short-term wholesale funding markets. Accordingly, the risks of runs and contagion remain. For the present, we can continue to work on discrete aspects of these markets, such as through the diminution of reliance on intraday credit in triparty repo markets that is being achieved by Federal Reserve supervision of clearing banks and through the money market fund reforms that I expect will be pursued by the Securities and Exchange Commission. We might also think about less comprehensive measures affecting SFTs, such as limits on rehypothecation, when an institution uses assets that have been posted as collateral by its clients for its own purposes. But I do not think that the post-crisis program of regulatory reform can be judged complete until a more comprehensive set of measures to address this problem is in place."

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