Fed's Tarullo on "Shadow Banking"
Fed Governor Dan Tarullo spoke Friday on "Shadow Banking and Systemic Risk Regulation". He says, "As illustrated, quite literally, by a chart that New York Fed staff produced a few years ago, the term "shadow banking system" encompasses a wide variety of institutions that engage in credit intermediation and maturity transformation outside the insured depository system. In my remarks today, I want to concentrate on short-term wholesale funding and, especially, the pre-crisis explosion in the creation of assets that were thought to be "cash equivalents." Such assets were held by a range of highly risk-averse investors, who were in many cases not fully cognizant that the "cash equivalents" in their portfolios were liabilities of shadow banks--the institutions depicted in the memorable graphic. In some cases, the perception of claims on shadow banks as cash equivalents was based on explicit or implicit promises by regulated institutions to provide liquidity and credit support to such entities. In other cases, the perception came about because market participants viewed the instruments held on the balance sheets of shadow banking entities--notably highly rated, asset-backed securities--as liquid and safe. While reliance on private mechanisms to create seemingly riskless assets was sustainable in relatively calm years, the stress that marked the onset of the financial crisis reminded investors that claims on the shadow banking system could pose far more risk than deposits insured by the Federal Deposit Insurance Corporation (FDIC). Once reminded of their potential exposure, investors engaged in broad-based and sometimes disorderly flight from the shadow banking system. This experience of the run on the shadow banking system that occurred in 2007 and 2008 reminds us that similar disorderly flights of uninsured deposits from banks lay at the heart of the financial panics that afflicted the nation in the late nineteenth and early twentieth centuries. The most dramatic of these episodes were the bank runs of the early 1930s that culminated in the bank holiday in 1933. Just as it was necessary, though not sufficient, to alter the environment that led to those successive deposit runs by introducing deposit insurance in order to create a stable financial system in the early-twentieth century, today it is necessary, though not sufficient, to alter the environment that can lead to short-term wholesale funding runs in order to create a stable financial system for the early twenty-first century."
