WASHINGTON (MNI) – The following are excerpts from Federal Reserve
Gov. Daniel Tarullo’s remarks Tuesday prepared for the Fed’s San
Francisco Bank conference on “Challenges in Global Finance:”

As those who have been following the academic and policy debates
know, there are significant, ongoing disagreements concerning the roles
of various factors contributing to the rapid growth of the shadow
banking system, the precise dynamics of the runs in 2007 and 2008, and
the relative social utility of some elements of this system. Conclusions
drawn from these debates will be important in eventually framing a
broadly directed regulatory plan for the shadow banking system. However,
as it is neither necessary nor wise to await such conclusions in order
to begin implementing a regulatory response, I will follow my discussion
of the vulnerabilities created by shadow banking with some suggestions
for near- and medium-term reforms.

Although the experiences of money market funds, triparty repos,
and securities lending vary in the details, they all share a common
underlying pathology: Offering documents with stern warnings
notwithstanding, explicit and implicit commitments combined with a
history of discretionary support to create an assumption, even among
sophisticated investors, that low-risk assets were free of credit and
liquidity risk . effectively cash, but with a slightly higher return.
This risk illusion led to pervasive underpricing of the risks embedded
in these money-like instruments and made them an artificially cheap
source of funding. The consequent oversupply of these instruments
contributed importantly to systemic risk.

Reliance on private mechanisms to create seemingly riskless assets
generally worked in the relatively calm years leading up to the
financial crisis and, to some extent, well into the crisis. But, in many
cases, discretionary support came into question at the time of acute
financial-market stress, precisely when it was needed most, as questions
arose about the ability or willingness of large financial institutions
to follow through on their implicit commitments. Investors were reminded
of their potential exposure, leading to wholesale and sometimes
disorderly flight. The unwinding of this risk illusion helped transform
a dramatic correction in real estate valuations — which itself would
have had serious consequences for the economy — into a crisis that
threatened the entire financial system.

We should continue to seek the analytic and policy consensus that
must precede the creation of a regulatory program that meets these
conditions. More work is needed on fundamental issues such as the
implications of private money creation and of intermediaries behaving
like banks but without bank-like regulation. These implications are
potentially quite profound for central banking and banking regulation,
considering that the shadow banking system has caused the volume of
money-like instruments created outside the purview of central bank and
regulatory control to grow markedly.

But regulators need not wait for the full resolution of contested
issues or the development of comprehensive alternatives, nor would it be
prudent for them to do so. We should act now to address some obvious
sources of vulnerability in the financial system. I believe that the
foregoing discussion of implicit support for various shadow banking
instruments helps identify areas where misunderstanding and mispricing
of risk are more likely, with the result that destabilizing runs are a
real possibility.

Let me then suggest three more-or-less immediate steps that
regulators here and abroad should take, as well as a medium-term reform
undertaking.

First, we should create greater transparency with respect to the
various transactions and markets that comprise the shadow banking
system. For example, large segments of the repo market remain opaque
today. In fact, at present there is no way that regulators or market
participants can precisely determine even the overall volume of
bilateral repo transactions.that is, transactions not settled using the
triparty mechanism. It is encouraging that the Treasury Departmentfs
new Office of Financial Research is working to improve information about
this market, while the Securities and Exchange Commission is considering
approaches to enhanced transparency in the closely related securities
lending market.

Second, the risk of runs on money market mutual funds should be
further reduced through additional measures to address the structural
vulnerabilities that have persisted even after the measures taken by the
SEC in 2010 to improve the resilience of those funds. The SEC is
currently considering several possible reforms, including a floating net
asset value, capital requirements, and restrictions on redemption.
Clearly, as suggested by Chairman Schapiro, action by the SEC to address
the vulnerabilities that were so evident in 2008, while also preserving
the economic role of money market funds, is the preferable route. But in
the absence of such action, there are several second-best alternatives,
including the recent suggestion by Deputy Governor Tucker of the Bank of
England that supervisors consider setting new limits on banksf reliance
on funding provided by money market funds.

A third short-term priority is to address the settlement process
for triparty repurchase agreements. Some progress has been made since
2008, but clearly more remains to be done. An industry-led task force
established in 2009 orchestrated the implementation of some important
improvements to the settlement process. The unwind, with its reliance on
vast amounts of discretionary and uncommitted intraday credit from the
two clearing banks, was pushed to later in the day, reducing the period
during which the intraday credit was extended. In addition, new tools
were developed for better intraday collateral management, and an
improved confirmation process was instituted.

Though these were useful steps, the key risk reduction goal of the
effective elimination of intraday credit has not yet been achieved. A
second phase of triparty reform is now underway, with the Federal
Reserve using its supervisory authority to press for further action not
only by the clearing banks, who of course manage the settlement process,
but also by the dealer affiliates of bank holding companies, who are the
clearing banksf largest customers for triparty transactions. But this
approach alone will not suffice. All regulators and supervisors with
responsibility for overseeing the various entities active in the
triparty market will need to work together to ensure that critical
enhancements to risk management and settlement processes are implemented
uniformly and robustly across the entire market, and to encourage the
development of mechanisms for orderly liquidation of collateral, so as
to prevent a fire sale of assets in the event that any major triparty
market participant faces distress.

In the medium term, a broader reform agenda for shadow banking will
first need to address the fact that there is little constraint on the
use of leverage in some key types of transactions. One proposal is for a
system of haircut and margin requirements that would be uniformly
applied across a range of markets, including OTC derivatives, repurchase
agreements, and securities lending. Work is ongoing to develop globally
uniform margin requirements for OTC derivatives, but there is not yet an
agreement to develop globally uniform margin requirements for securities
financing transactions. Such a margining system would not only limit
leverage, but.to the extent it is in fact uniform.also diminish
incentives to use more complicated and less transparent transactional
forms to increase leverage or reduce its cost. Some proponents suggest
that such systems of uniform haircut and margin requirements could also
dampen the observed procyclical character of many collateralized
borrowings that results from changes in margins and haircuts following
general economic or credit trends.

Conclusion

The shadow banking system today is considerably smaller than at the
height of the housing bubble six or seven years ago. And it is very
likely that some forms of shadow banking most closely associated with
that bubble have disappeared forever. But as the economy recovers, it is
nearly as likely that, without policy changes, existing channels for
shadow banking will grow, and new forms creating new vulnerabilities
will arise. That is why I suggest what is, in essence, a two-pronged
agenda: first, near-term action to address current channels where
mispricing, run risk, and potential moral hazard are evident; and,
second, continuation of the academic and policy debate on more
fundamental measures to address these issues more broadly and
proactively.

** MNI Washington Bureau: 202-371-2121 **

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