By Steven K. Beckner
(MNI) – Federal Reserve Governor Daniel Tarullo said Friday that,
notwithstanding the revamping of bank regulation, there is still a lot
of work to do to improve supervision of payments, clearing and
settlement systems.
Tarullo also observed that repurchase agreement (repo) funding of
non-agency mortgage backed securities and other private assets remains
“substantially below” levels that prevailed before Lehman Brothers
collapsed in September 2008.
Tarullo, appearing on a panel at the Brookings Institution in
Washington, questioned a proposal to create so-called Nattow Funding
Banks that would invest only in asset-backed securities (ABS) and very
high quality instruments such as Treasury securities.
Tarullo said financial instability can arise either through
problems at a large financial institution or through “the breakdown of a
significant market in which large numbers of leveraged actors depend
upon similar sources of liquidity and, importantly, backup liquidity in
periods of stress.”
Or, as in the last few years, a combination of the two problems can
cause a financial crisis. Tarullo suggested that only the first has
been fully addressed.
“To date, reform in financial regulation and supervision has
focused mainly on large regulated institutions,” said Tarullo, citing as
examples the just-announced “Basel III” capital rules, the Dodd-Frank
financial reform act, and the Fed’s revamping of its large holding
company supervision.
Tarullo said a start has been made on strengthening “prudential
supervision” of payments, clearing, and settlement systems, but said
“more will need to be done in this area, particularly as new constraints
applicable to large regulated institutions push more activity into the
unregulated sector.”
He was commenting on a paper by Yale University economists Gary
Gorton and Andrew Metrick who trace the financial crisis partially to
the enormous growth of the so-called “shadow banking system” and the
repo market, which they say depended on the engineering of securities
rated triple-A by government sanctioned rating agencies.
“When the value of whole classes of the underlying collateral was
drawn into serious question, initially by the collapse of the subprime
housing market, participants’ lack of information about the collateral
they held led to a shattering of confidence in all the collateral,”
Tarullo said.
“In the absence of the regulation and government backstop that have
applied to the traditional banking system since the Depression, a run on
assets in the entire repo market ensued,” he continued. “The resulting
forced sale of assets into an illiquid market turned many illiquid
institutions into insolvent ones.”
Tarullo said “the fallout has been such that, to this day, the
amount of repo funding available for non-agency, mortgage-backed
securities, commercial mortgage-backed securities, high-yield corporate
bonds, and other instruments backed by assets with any degree of risk
remains substantially below its pre-Lehman levels.”
Gorton and Metrick propose to remedy the “information problem” in
the repo market through the creation of a statutory franchise value for
Narrow Funding Banks or NFBs — “narrow” in the sense that their only
assets would be ABS, Treasuries and other “very high quality
instruments.”
NFBs would make their money from the income streams associated with
the ABS. They would raise the funds to purchase ABS through debt
issuance and through the repo market, using their own liabilities as
collateral.
Under the proposal, the government would regulate the NFBs, set
limits on what the NFB could buy and give them access to the discount
window.
Tarullo was skeptical.
Noting that the Gorton-Metrick proposal “would significantly
restrict all asset backed securitization,” he commented, “While it is
obvious that too much credit was created through ABS and associated
instruments in the years preceding the crisis, it seems at least
reasonable to question whether the best policy response is this dramatic
a change in the regulatory environment.”
“One wonders, for example, if it is desirable to forbid anyone but
NFBs from buying ABS, particularly if there are investors interested in
holding these assets regardless of their utility in repo arrangements,”
he added.
Tarullo also warned, “Limiting securitization purchases to NFBs
will surely result in some tailoring of ABS to the business models of
NFBs, an outcome that might not be identical to a securitization market
tailored to the funding needs of lenders providing credit to businesses
and consumers.”
And he cautioned that if “the new system encountered major
difficulties, there might be materially reduced adaptive capacity in
other financial actors, possibly for a considerable period.”
Tarullo also expressed concern that NFBs might become oligopolies
or even monopolies, which could prove costly.
“Regardless of the eventual structure of the industry, NFBs
essentially would be monolines, with highly correlated risk exposures,”
he went on. “They could be particularly vulnerable to funding
difficulties in times of deteriorating credit conditions. Yet by the
terms of the G-M proposal, they apparently would not be able to hedge
interest rate or other risks.”
Tarullo was also troubled with giving the proposed NFBs access to
the Fed’s discount window to forestall liquidity problems and runs on
the NFBs. He said the Fed “does not make binding commitments to lend to
any institution and actively discourages reliance on the window for
regular funding.” Granticing access to the discount window could prove
“problematic,” he added.
** Market News International **
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