Federal Reserve Governor Daniel Tarullo said setting policies to contain the risk of fire sales in short-term funding markets should be the “highest priority” as policy makers consider additional steps to reduce the danger of another financial crisis.
Short-term wholesale funding such as repurchase agreements served as an “accelerant” in the financial crisis, Tarullo, the Fed governor responsible for financial regulation, said today in a speech laying out five proposals to guide policies aimed at reducing systemic risk.
“Specific policies to counteract the structural vulnerabilities created by short-term wholesale funding are a priority, not just for the stability of our large prudentially regulated institutions, but for the financial system as a whole,” Tarullo said in prepared remarks at Yale University in New Haven, Connecticut.
He did not speak about monetary policy or his economic outlook in the text of his remarks.
Tarullo said regulators are still trying to come up with tools that they could adjust through economic cycles in response to building risks. For now, such “time-varying” tools have a “fair number of significant issues,” he said. For one, he said, regulators would have to have reliable measures of when systemic risk was rising or falling.
Because these tools are still in development, regulators might have to resort more to capital surcharges and supervisory oversight, measures that don’t vary with the economic cycle, Tarullo said. “It might be necessary to have through-the-cycle constraints that strengthen financial stability at greater cost to economic activity,” he said.
He also ruled out monetary policy, the raising and lowering of interest rates, as an effective variable response to increased or waning risks.
“Monetary tightening will surely not be the correct response to most instances of increasing leverage or asset prices that raise macroprudential concerns,” Tarullo said.
The Fed and other U.S. financial regulators are working to implement the Dodd-Frank Act three years after it became law. President Barack Obama urged quicker progress on implementing the industry overhaul in an Aug. 19 meeting with Fed Chairman Ben S. Bernanke and the leaders of other financial regulators.
The Dodd-Frank Act, signed into law by Obama in July 2010, expanded the central bank’s power to oversee the largest financial institutions and gave regulators new tools aimed at preventing a repeat of the 2007-2009 financial crisis. It imposed new rules on derivatives, limits the ability of banks to trade on their own account and new rules for mortgages.
Tarullo, 60, has led the Fed’s effort to implement the Dodd-Frank Act, the biggest overhaul of financial regulation since the 1930s, and pushed to raise capital standards for the largest banks, subject them to annual stress tests and boost scrutiny of their lending and trading practices.
Tarullo previously was a professor at the Georgetown University Law Center in Washington and an aide to President Bill Clinton. He was nominated by Obama and has served on the Fed board since 2009. His term ends in 2022.