Fed’s Tarullo Says Asset Managers Could Pose Fire-Sale Risks

Federal Reserve Governor Daniel Tarullo said asset managers could pose potential risks in a future crisis if they are forced into fire sales, and said new regulations might be warranted to promote stability.

“Under some circumstances, a fund might respond by rapidly selling assets, with resulting contagion effects on other holders of similar assets,” Tarullo said today in a speech in Arlington, Virginia. Regulators also should consider further addressing “the risks associated with short-term wholesale funding,” he said.

Tarullo, the Fed’s point person on regulatory matters, advocated a broader focus on what he called “prudential market regulation” that moves beyond the overhaul of financial rules implemented after the 2008 crisis.

Tarullo said he expects the Fed to propose a rule to implement an agreement among global regulators to impose minimum margin requirements to limit the “build-up” of leverage in security-financing transactions.

Regulators should take into account the “system-wide demands on liquidity during stress periods and correlated risks among asset managers that could exacerbate liquidity, redemption and fire-sale pressures,” he said.

Product Focus

After discussing in October 2013 whether asset managers BlackRock Inc. and Fidelity Investments should be designated as systemically important, a U.S. council of regulators led by Treasury Secretary Jacob J. Lew decided instead on an approach focused on the firms’ products and activities. At the same time, the Securities and Exchange Commission is working on sweeping rules to target mutual funds.

Tarullo referred to measures outlined last month by SEC Chair Mary Jo White. Among the rules being developed is a plan to limit funds’ investments in harder-to-sell assets and derivatives, she said.

Asset managers, which are now overseen by the SEC, argue that they differ from banks because their funds aren’t backed by U.S. government guarantees and fund companies don’t make big trades with their own assets. Clients also direct their own investments and can withdraw them at any time.

The use of leverage by investment funds, including in derivatives, “could create interconnectedness risks between funds and key market intermediaries,” Tarullo said.

Demand for Safety

While it’s important to adopt measures “that protect against runs,” regulators should keep in mind that “the demand for relatively safe, short-term assets will not disappear,” he said. “Indeed, there is some risk that, as regulation makes some forms of such assets more costly, this demand will simply turn elsewhere.”

Tarullo reiterated his concern about short-term wholesale funding, which he said “can support a form of shadow banking outside the regulatory perimeter.” He also said tougher standards might be needed to ensure the stability of entities that clear financial transactions including derivatives. He questioned whether a requirement that systemically important clearinghouses hold funds to cover defaults by their two largest members is adequate to avoid “significant market disruption.”

Tarullo, noting that large banks must submit plans showing how they would wind themselves down if they fail, said that to meet the requirements, lenders will have to make some “significant changes” in how they are structured or their activities.

In its aim to prevent a repeat of the 2008 crisis, the 2010 Dodd-Frank Act required the most complex financial firms to plan for their own demise. The companies must send annual “living wills” to the Federal Deposit Insurance Corp. and the Fed that walk the agencies through a hypothetical liquidation that won’t damage the wider financial system or require taxpayer intervention.

Tarullo was speaking at a conference held by the Financial Stability Oversight Council and its research arm, the Office of Financial Research. The FSOC, led by Lew, also includes the heads of the Fed, FDIC and SEC.

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