U.S. regulators should take steps soon to strengthen government oversight of money market funds and short-term bank funding markets so that the "shadow" banking system can be better policed, a top Federal Reserve official said on Wednesday.
Fed Governor Daniel Tarullo said that while regulators have taken many steps since the 2007-2009 financial crisis to better regulate banks once considered "too big to fail," less work has been done to make funding markets outside the traditional banking system less risky.
"Although some elements of pre-crisis shadow banking are probably gone forever, others persist," Tarullo said at the Council on Foreign Relations.
"Moreover, as time passes, memories fade, and the financial system normalizes, it seems likely that new forms of shadow banking will emerge."
Tarullo singled out money market and tri-party repo markets as areas where action should be taken in the "short-run."
Tarullo is the Fed's leading voice on regulation and his public support for stricter oversight gives weight to efforts by U.S. Securities and Exchange Commission Chairman Mary Schapiro to introduce new regulations for money markets.
Schapiro has so far been unsuccessful in gaining enough support within the commission for tougher reforms for the $2.6 trillion money market fund industry.
She has said further steps are needed to stop potential problems at money funds from spreading throughout the financial system, as happened in the 2008 credit crisis when the Reserve Primary Fund "broke the buck" with its net asset value falling below $1.
The agency is considering requiring that funds set aside capital against losses, restrict a portion of withdrawals or eliminate fixed share prices.
"Chairman Schapiro is right to call for additional measures," Tarullo said.
The shadow-banking sector handles credit and leverage outside traditional banking, and includes money market funds, and securities lending and repo markets, which use collateral to underpin short-term financing for banks and brokers.
The Financial Stability Board (FSB), a global regulatory body, is set to complete work on policy recommendations for shadow-bank regulation by November, when leaders of the Group of 20 nations meet. The European Commission will propose shadow bank regulation for the European Union next year.
REPO MARKET STILL NEEDS WORK
Tri-party agreements, or repos, are a prime source of short-term bank funding and are backed by Treasurys or riskier collateral, including mortgage-backed debt.
Fed officials, including Chairman Ben Bernanke, have pointed to problems in the repo market as a leading contributor to the financial crisis.
Earlier this year the New York Fed said it was considering restrictions on repo markets after becoming dissatisfied with an industry committee's efforts to address concerns about the loans' risks.
The industry effort "fell short of dealing comprehensively with this problem," Tarullo said. "So it now falls to the regulatory agencies to take appropriate regulatory and supervisory measures to mitigate these and other risks."
Asked how long it would take various U.S. regulators to give clear details on a raft of planned financial reforms — from Basel III capital standards to the Volcker Rule's ban on proprietary trading — Tarullo said it was reasonable to expect those "some time next year."
Also on Wednesday, Tarullo is scheduled to meet in New York with the chief executives of several large banks to discuss results of the annual "stress tests" that were released in March.
The gathering should also give bank CEOs a chance to air grievances over a set of proposed Fed rules the banks say go too far and appear aimed at trying to make them smaller.
Still, Wall Street giants should be comforted by at least one part of Tarullo's speech.
He said changes should be made to parts of an international agreement, known as Basel III, on the amount of liquid assets banks should have to hold in order to weather a crisis.
U.S. financial institutions are making good progress gearing up for Basel III, Tarullo said. "As a whole, we're quite confident that our banks are well ahead of even our accelerated expectations."
Banks want regulators to state clearly that if a crisis were to occur they could draw down their liquidity below the minimum levels laid out in the agreement.
Tarullo agreed, saying the current proposal could promote "liquidity hoarding."
The proposal "should be better adapted to a crisis environment as, for example, by making credibly clear that ordinary minimum liquidity levels need not be maintained in the midst of a crisis," he said.
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