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From Banking and Finance Law Daily, November 18, 2015

Not all shadow banking needs equal regulation, Fed governor says

How shadow banking should be regulated depends on the specific financial activity in question, according to Federal Reserve Board Governor Daniel K. Tarullo. Calling shadow banking “a constantly changing and largely unrelated set of intermediation activities pursued by very different types of financial market actors,” Tarullo said in remarks prepared for the Brookings Institution that the risks and benefits of each activity must be analyzed so that neither too much, nor too little, regulation is imposed.

Tarullo made clear that he is uncomfortable with the term “shadow banking” because it is imprecise, implying the inclusion only of activities similar to those of commercial banks. As a result, the term may include some activities that do not pose significant risks to financial stability while excluding other, riskier activities. Regulation should be based on the risks and benefits of an activity, not on whether the activity looks like something that banks traditionally do, he emphasized.

Funding sources. One reason that risks might differ is the source of funding, according to the Fed governor. For example, nonbanks that lend to consumers or small businesses may present different levels of risk based on how they fund their loans. The financial crisis pointed out the risks from funding long-term loans through short-term liabilities.

Nonbank entities. Analyzing each activity’s risks and benefits might show that some nonbank financial intermediaries do not pose much risk, Tarullo suggested. Some asset managers with permissive redemption policies might pose redemption risks, he noted; on the other hand, conventional mutual funds might pose little risk because they usually are not heavily leveraged. As a result, perhaps not all asset managers need the same regulation.

Some financial intermediaries, such as insurance companies and pension funds, may pose no risks to financial stability at all, he suggested.

Benefits. Regulation also must avoid excessively burdening beneficial activities, Tarullo warned. For example, the creation of mutual funds may have reduced the funding available to commercial banks by offering consumers better savings options. However, that would not have been a good reason to limit the availability of mutual funds.

Nonbank lenders may be able to offer financial services to consumers that banks do not serve well, Tarullo said. Nonbank intermediaries also may expand the availability of capital to the economy as a whole. Striking the risks versus benefits balance requires considering an activity’s reliance on maturity or liquidity transformation, creation of assets seen as equivalent to cash, leverage, and interconnection with the banking sector.

Short-term wholesale funding. “While I favor assessment of the specific risks and costs associated with a particular form of nonbank intermediation, I also believe that the greatest risks to financial stability are the funding runs and asset fire sales associated with reliance on short-term wholesale funding, and thus I place particular emphasis on this factor,” Tarullo said. The financial crisis demonstrated the severity of this risk.

Regulators have taken a number of steps to reduce the risk this type of funding presents to the banking system, but these rules have done nothing to reduce the risk posed by nonbanks’ use of short-term wholesale funding, Tarullo warned. Some degree of bank-like regulation is needed to address this risk.

Institutional issues. Tarullo also pointed out two institutional considerations that affect the regulation of nonbanking financial intermediaries:

  1. If regulation is needed, what form should that regulation take? Most shadow banking companies will not qualify for regulation as systemically important financial institutions, yet risks posed by their activities might call for regulation. The needed regulation might be different from what a bank would require.
  2. Which regulator should make the risk-benefit analysis? While it might be simple to assign the analysis to the regulator with authority to act, that might not always be the best choice. A regulator responsible for one sector might be tempted to protect that sector through deregulation against what is perceived to be encroachment by companies in a second, less-regulated sector, Tarullo warned.

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