Dennis Lockhart, President and CEO of the Atlanta Federal Reserve Bank, delivered a speech Friday, entitled, "Thoughts on Prudential Regulation of Financial Firms," where he shared concerns about shadow banking and, more specifically, money market funds. He said, "Today I would like to explore questions related to prudential regulation as it applies to banks and nonbank financial firms. More specifically, I'll contrast prudential regulation of banks and so-called shadow banks, or firms that play a role in the shadow banking system.... Another component of the shadow banking system that has received a lot of attention is the money market mutual fund industry. Money market funds have drawn attention because of the aggregate scale of the industry and the quasi-deposit nature of shareholder investments in these funds. The concern in the regulatory community -- including the Fed -- regarding money market funds relates to the industry's size and perceived vulnerability to runs in times of financial turbulence. Current regulation of money market funds by the U.S. Securities and Exchange Commission allows only a very limited range of investments and tenors. There is considerable correlation among constituent funds that results from this tight regulation. The industry has about $2.7 trillion of liabilities. Almost 40 percent of that is in funds that hold only government and government agency securities. And almost two-thirds of the $2.7 trillion in invested assets represents investments by institutional clients. There is some basis for concern about the industry's potential role in an episode of financial instability. In the fall of 2008, a prime fund -- the Reserve Primary Fund -- "broke the buck" due to holdings of Lehman Brothers commercial paper. In the week or so that followed, roughly $500 billion flowed out of prime money market funds into government money funds. Prime funds met redemptions through decreases in commercial paper holdings, prompting a crisis in that market for issuers. The Federal Reserve quickly stood up market support facilities to address the crisis in short-term markets. The money market fund sector remains a focus of regulators because of its potential to be both contributor to and victim of financial instability." He concludes, "At the beginning of my remarks, I argued that the experience of recent years has made the primary aim of prudential regulation to protect the financial system's ability to support the general economy. In my view, this should be the "true north" of any expansion of the regulatory overlay on shadow banking."

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