Federal Reserve Governor Daniel Tarullo called on regulators to curb risks in lightly regulated nonbank funding and credit markets that he said may grow as supervisors strengthen bank oversight.
So-called shadow banking, in which nonbank institutions create loans or raise funds, “has been only obliquely addressed,” Tarullo said today in a speech to a San Francisco Fed conference on global finance. “As the oversight of regulated institutions is strengthened, opportunities for arbitrage in the shadow banking system may increase.”
Shadow banks typically lack deposit insurance and don’t have access to the Fed’s discount window. Consequently, the firms can be subject to runs if investors refuse to roll over commercial paper or to buy assets held by a shadow bank. During the financial crisis, the Fed created emergency programs to save some lightly supervised parts of finance from collapse. The Primary Dealer Credit Facility, for example, financed Wall Street bond brokers after funding in repo markets broke down.
Tarullo called for more transparency in repo markets, and for reforms to address “structural vulnerabilities” in money market mutual funds. “A third short-term priority is to address the settlement process for tri-party repurchase agreements,” he said.
Regulators need to watch for new kinds of risk that may emerge in shadow banking, even though their first task is to ensure sound oversight in established markets like money market mutual funds, Tarullo said in response to an audience question.
“A set of effective regulations in one area can produce arbitrage opportunities, which lead people to create new instruments or look for new channels to engage in similar kinds of activities that may produce similar kinds of risks,” Tarullo said. “Indeed, the possibility of such arbitrage has increased as the regulation of already-regulated financial institutions has strengthened in the wake of the crisis.”
The KBW Bank Index, which tracks 24 large U.S. and regional banks, rose 1.3 percent today as of 1:18 p.m. in New York, while the Standard & Poor’s 500 Index increased 0.7 percent to 1,317.91.
U.S. central bankers plan to meet June 19-20 amid signs of sputtering economic growth. Payrolls climbed by 69,000 last month, the least in a year, after a revised 77,000 gain in April that was smaller than initially estimated. Tarullo, the governor in charge of bank supervision and regulation, didn’t comment on monetary policy in the text of his remarks.