Fed Focuses on Shadow Banking as It Gauges Financial Risk

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Shadow Banking
Worldwide, shadow banking assets have grown, while banking assets stagnated, according to a report by the Financial Stability Board, a global group of regulators. Photographer: Brent Lewin/Bloomberg

Federal Reserve officials, fresh from the latest round of tests designed to ensure the safety of the biggest banks, are now peering into the darker corners of the financial system as they assess the risks of another crisis.

One source of concern: tighter regulation of banks is prompting more borrowers to seek funding through the $25 trillion shadow banking system -- money-market mutual funds, hedge funds, brokerages and other entities that face fewer restrictions.

“These institutions are a significant and growing source of credit in the economy,” Dennis Lockhart, president of the Atlanta Fed, said in a March 20 speech. “They are part of an interconnected financial system that, in extreme circumstances, is prone to contagion.”

Lockhart will draw more attention to the issue next week when he hosts a conference in Stone Mountain, Georgia. The event will bring together current and former Fed policy makers, money managers and academics to discuss how central banks can best identify and limit the biggest sources of risk to the financial system.

A key player in that effort is the Fed’s financial stability committee, headed by Vice Chairman Stanley Fischer, who will deliver a speech at next week’s forum.

“To say that the non-bank sector today appears less vulnerable than it did during the global financial crisis is not to say that authorities in the United States have tamed the non-bank sector,” he told an audience in Frankfurt on Friday.

Mapping Shadows

Fischer’s committee is mapping different parts of the shadow banking system and trying to figure out which regulator has authority over each portion.

Among the measures under consideration by Fed officials: stricter margin requirements for broker-dealers that can serve to limit the amount of borrowed money that firms such as hedge funds use to finance investments.

“Some activities have moved into the shadow banking sector, and the question is do we have regulatory or other means of controlling, mitigating, the possible negative impacts of those things,” Fischer said in response to questions following a speech to bankers and economists in New York this week. “We need to get some coherence about who does what and how those decisions are made.”

The focus is shifting to shadow banks after the Fed claimed success in its efforts to build up capital buffers at the nation’s largest banks in a bid to avoid a repeat of the financial crisis, which saw taxpayer funded bailouts of firms including Citigroup Inc. and Bank of America Corp.

Stress Tests

All 31 big banks tested had sufficient capital to absorb losses during a sharp and prolonged economic downturn, the Fed said on March 5. It was the first time since the central bank started stress tests in 2009 that no firm fell below any of the main capital thresholds.

Worldwide, shadow banking assets have grown, while banking assets stagnated, according to a report by the Financial Stability Board, a global group of regulators.

Non-bank financial intermediation grew almost 7 percent to $75 trillion in 2013, the latest year for which figures are available, while banking assets declined less than 1 percent to $139 trillion.

In the U.S., shadow banking -- also known as market finance -- grew almost 9 percent to $25.2 trillion in 2013, while banking assets increased almost 5 percent to $20.2 trillion.

Financial Grease

“One of the oft-cited examples regarding the prowess of the U.S. financial system is our reliance on market finance,” said Lawrence Goodman, president of the New York-based Center for Financial Stability, a non-profit research group. “It helps grease the wheels of the financial system.”

The grease can also magnify risks. That was the case during the financial crisis, when massive withdrawals from money-market mutual funds, beginning with the $62.5 billion Reserve Primary Fund, helped deepen the credit freeze.

One challenge for the Fed is that its regulatory reach is limited. The Securities and Exchange Commission, for example, oversees the $2.6 trillion money-market fund industry. For the SEC, the focus is protecting investors rather than preventing a financial meltdown.

The 2010 Dodd-Frank overhaul of financial regulation sought to address the issue by creating the Financial Stability Oversight Council, a panel of regulators headed by the Treasury secretary that also includes the Fed, the SEC and the Federal Deposit Insurance Corp.

Systemically Important

The council has used its authority to designate some insurers, such as Prudential Financial Inc., as systemically important non-bank financial firms, subjecting them to tougher Fed oversight. It has backed away from designating mutual-fund companies.

New York-based BlackRock Inc. has said repeatedly that asset managers don’t pose a systemic risk. At the same time, BlackRock, the world’s largest asset manager, supports the idea of stress tests of mutual and private funds because they would help ensure “robust portfolio liquidity risk management,” it told FSOC in the summary of a letter released this week.

One area where the Fed claims some success is in the tri-party repo market, where broker-dealers borrow, often overnight, from investors including money-market funds, and hand over securities as collateral. The amount of securities financed through tri-party repo averaged $1.62 trillion as of Feb. 10, according to data compiled by the Fed.

Managing Collateral

The Fed has worked with the market’s two big clearing banks, JPMorgan Chase & Co. and Bank of New York Mellon Corp., to improve controls in managing and transferring collateral, the FSOC said in its annual report released in May 2014.

Fed Governor Daniel Tarullo, the Fed’s point person on regulation, has said the changes helped make short-term wholesale funding markets less risky.

The Fed also plans to issue a rule implementing an agreement by global regulators to impose minimum margin requirements -- the amount of collateral borrowers must put up - - for repurchase agreements and securities lending.

Tarullo has said he hopes margin requirements can combat the buildup of debt and reduce the risk that lenders will act in unison during a crisis to require higher collateral from borrowers.