Friday, Federal Reserve Governor Daniel Tarullo delivered a speech entitled, "Advancing Macroprudential Policy Objectives," which discussed short-term funding and systematic risk issues. Tarullo stated, "I have on past occasions described at some length my concerns with short-term wholesale funding -- especially, though not exclusively, funding associated with assets thought to be cash equivalents. We are, of course, addressing these risks within prudentially regulated firms through various types of liquidity regulation and supervision, as well as changes in practice by the firms that clear tri-party repo transactions. But, as demonstrated in the years preceding the crisis, short-term wholesale funding can support a form of shadow banking outside the regulatory perimeter." Tarullo's speech continued, "Both the short-term wholesale funding and asset management examples point to the broader objective for macroprudential policy of developing what we might term "prudential market regulation" -- that is, a policy framework that builds on the traditional investor protection and market functioning aims of securities regulation by incorporating a system-wide perspective. Like the reforms to banking regulation that followed the crisis, this new form of regulation might start by strengthening some of the firm- or fund-specific measures associated with those traditional regulatory aims, but then move forward to take into account such considerations as system-wide demands on liquidity during stress periods and correlated risks among asset managers that could exacerbate liquidity, redemption, and firesale pressures.... In her important speech last month, Securities and Exchange Commission (SEC) Chair Mary Jo White provided a roadmap for beginning to develop just such a regulatory approach for the asset management industry." He added, "In thinking about short-term wholesale funding and some forms of asset management, we encounter a background circumstance that complicates the task of developing effective macroprudential tools. Demand for safe short-term assets is both real and substantial, emanating from multiple sources, including sovereign nations that wish to self-insure against exchange rate pressures; non-financial corporations that have increased their cash holdings in the wake of the market disruptions associated with defaults by Enron and other companies; and institutional investors protecting themselves against redemption demands or other unexpected cash needs. While it is important to adopt measures that protect against runs and that counteract the illusion that cash equivalents are actually cash, it is equally important to realize that the demand for relatively safe, short-term assets will not disappear. Indeed, there is some risk that, as regulation makes some forms of such assets more costly, this demand will simply turn elsewhere. Thus the ultimate effectiveness of what I have termed prudential market regulation will depend on policymakers taking into account in their regulatory approaches the sources of, and motivation for, demand for short-term, liquid, and relatively safe assets beyond the debt of very creditworthy sovereigns."
