Bernanke Sees Need for More Curbs on Shadow Banking

Federal Reserve Chairman Ben S. Bernanke
Ben S. Bernanke, chairman of federal reserve. Photographer: Andrew Harrer/Bloomberg

Federal Reserve Chairman Ben S. Bernanke called on regulators to stem risks from “shadow banking” operating beyond traditional oversight and favored steps to promote the “resiliency” of money market funds.

“An important lesson learned from the financial crisis is that the growth of what has been termed ‘shadow banking’ creates additional potential channels for the propagation of shocks through the financial system and the economy,” Bernanke said today in a speech in Stone Mountain, Georgia.

Bernanke also called for close tracking of financial innovation and backed curbs on intraday credit in tri-party repo markets. While not specifying what steps he supports to increase stability among money market funds, he referred to Securities and Exchange Commission proposals to require firms to maintain capital buffers or to redeem shares at the market value of underlying assets rather than at a fixed price of $1.

Congress under a 2010 regulatory overhaul known as Dodd-Frank mandated the Fed to safeguard stability partly by monitoring firms whose collapse may provoke turmoil across financial markets. The law is aimed at averting a repeat of the credit crisis that was triggered by the collapse of U.S. mortgage finance and deepened by the failure of Lehman Brothers Holdings Inc. in 2008.

“About three and a half years have passed since the darkest days of the financial crisis, but our economy is still far from having fully recovered from its effects,” Bernanke said in his only reference to the economy’s current condition. He didn’t refer to current monetary policy.

Stocks Declined

U.S. stocks fell today and yields on 10-year Treasuries slipped as job creation in the world’s biggest economy trailed estimates last week. The S&P 500 lost 1.1 percent to 1,382.20 in New York. The yield on the 10-year Treasury note fell to 2.047 percent from 2.054 percent on April 6.

Responding to audience questions, Bernanke said a regulation known as the Volcker rule, which bans banks from risking capital by trading for their own accounts, raises a “lot of complexities” and internationally “it is not going to be a completely level playing field in that area.”

The rule, named for its original champion, former Fed Chairman Paul Volcker, is aimed at reducing the odds that banks will make risky investments with their own capital and put depositors’ money at risk. Bernanke said on Feb. 29 that the central bank and other regulators won’t meet the July deadline to complete work on the Volcker rule. The Fed has received over 17,000 comment letters on the proposal.

Correct Balance

The Fed will seek an “appropriate balance” between a ban on proprietary trading and a rule that “allows appropriate market making,” Bernanke said.

International capital regulations known as Basel III will lead to “a very substantial increase in capital, and I think that is essential,” he said.

The higher level of required bank capital “probably will feed through” at least marginally to “the cost of credit” in the economy, Bernanke said. The costs of higher capital are small compared to the benefits from reducing the odds of a new financial crisis, he said.

“The cost-benefit test is very easily passed,” he said.

Bernanke said the Dodd-Frank Act had removed some of the Fed’s ability to make emergency loans, saying that “we can no longer lend to an individual firm as we did in the crisis.”

“Fortunately, I don’t think that they weaken our ability to provide backstop liquidity where necessary,” Bernanke said. The Fed is still able to lend through the discount window or to a broad class of borrowers in an emergency, he said.

Too Much Risk

Bernanke said that infrequent use of emergency programs as well as new abilities to supervise different types of firms should help reduce moral hazard, or excessive risking-taking by firms that expect a government bailout. “Anytime you have a safety net” regulators need a mechanism “to minimize moral hazard,” he said.

Following the collapse of the housing bubble, regulators will take steps to guard against another large decline in home prices, Bernanke said.

“Obviously, we have already taken steps and the Consumer Financial Protection Bureau will continue to take further steps to provide additional protections and try to avoid any similar event in the future,” Bernanke said.

Bernanke used his remarks at the 2012 Federal Reserve Bank of Atlanta Financial Markets Conference to summarize the Fed’s progress in implementing the Dodd-Frank Act and to highlight current challenges.

Warrant ‘Serious Consideration’

“Additional steps to increase the resiliency of money market funds are important for the overall stability of our financial system and warrant serious consideration,” he said.

The SEC is working on revamping rules for money market funds, as regulators have debated how to make the funds more stable since the 2008 collapse of the $62.5 billion Reserve Primary Fund, which triggered an industry-wide run by clients that helped freeze global credit markets.

The agency enacted changes two years later in an attempt to prevent runs, including new liquidity requirements, shorter maturity limits and enhanced disclosure mandates. SEC Chairman Mary Schapiro has called for further steps to fix “weaknesses” with the funds.

Bernanke, 58, also called on participants in the tri-party repo market to eliminate intraday credit, something an industry task force called on in 2010, he said.

‘Some Progress’

“Although some progress has been made, securities dealers and clearing banks have yet to fully implement that recommendation,” Bernanke said. “Through supervision and other means, we continue to push the industry toward this critical goal.”

The Fed has been seeking to strengthen the tri-party repurchase agreement market, which almost collapsed in 2008 amid the demise of Bear Stearns Cos. and bankruptcy of Lehman Brothers.

In February, the central bank said it will increase oversight of efforts to protect the market for borrowing and lending securities after an industry group, the Tri-Party Repo Infrastructure Task Force, said more time was needed for it to meet goals for reducing risk.

Repos are transactions used by the Fed’s primary dealers for short-term funding and typically involve the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to the lender, typically a money-market mutual fund.

In a tri-party arrangement, a third party, one of two clearing banks, functions as the agent for the transaction and holds the security as collateral.

Steve Matthews in Stone Mountain, Georgia at

Before it's here, it's on the Bloomberg Terminal. LEARN MORE