Federal Reserve Governor Daniel Tarullo said large banks should be subject to higher capital requirements if they rely heavily on non-deposit funding, while also recommending regulators set a minimum safety margin level for all forms of collateralized lending.
The remarks are Tarullo’s most prescriptive to date on how to deal with more than $1 trillion in non-deposit funding used by banks and brokers that regulators are concerned is still vulnerable to runs by investors in a market panic.
Regulators must “alter the environment that can lead to short-term wholesale funding runs in order to create a stable financial system,” Tarullo said in a speech at the Economic Policy Institute in Washington. “Completion of this task will require a more comprehensive set of measures, at least some of which must cover” non-bank financial institutions.
For regulated institutions such as banks, Tarullo indicated he favored a regime of higher capital charges for firms that use securities financing transactions, which include repurchase agreements.
“The idea that seems most promising is to tie capital and liquidity standards together by requiring higher levels of capital for large firms that substantially rely on short-term wholesale funding,” Tarullo said.
The capital requirement would be calculated by a reference to a definition of short-term wholesale funding, such as total liabilities minus regulatory capital, insured deposits, and obligations “with a remaining maturity of greater than a specified term,” he said. Regulators could also weight the capital charges by taking account of the unique risks of different forms of funding.
With short-term funding and collateralized lending also occurring outside the regulated banking system, there is a need for “policy options in the form of regulatory tools that can be applied on a market-wide basis,” Tarullo said.
Such regulation would focus on “particular kinds of transactions, rather than just the nature of the firm engaging in the transactions,” he said
One strategy would be applying “numerical floors” on the safety margins or “haircuts” dealers demand for loans backed by securities, he said. Typically, dealers loan less than one-for-one against securities, imposing a “haircut” depending on the quality of the asset.
Tarullo identified three approaches to calculating the floors. The levels could be based on current haircuts in the repurchase-agreement market.
“These haircuts have increased significantly compared to pre-crisis levels,” Tarullo said. “Establishing numerical floors at around current levels could prevent the return of a less prudent set of practices as memories of the crisis fade.”
A second approach could base haircuts on asset-price volatility during times of stress, he said. A third could be calculated on the basis of the capital a bank would need to hold against the security if it were held in inventory.
Shadow banking, including money-market funds and off-balance sheet investment vehicles, grew $5 trillion last year to about $71 trillion, the Financial Stability Board, a global financial policy group based in Basel, Switzerland, said last week.
Supervisors consider shadow banking to include off balance sheet transactions as well as activities that give investors an opportunity to bypass lenders and the functions they traditionally fulfill on the markets. A hedge fund, for example, could in effect get loans against its securities from a non-bank broker.
Such activities grew by $41 trillion between 2002 and 2011, the FSB, which is made up of regulators and central bankers, said in a report last year.
During the financial crisis, short-term funding markets dried up for securitized mortgage pools, forcing banks to bring them back on their balance sheets. As mortgage defaults rose, even some banks and financial institutions had difficulty finding adequate financing for their assets.
Regulators are concerned that some of this financing, which takes the form of repurchase agreements or short-term commercial paper, could be subject to runs by investors in another market extreme market shock.
Tarullo in a speech last year called managing the risk of short-term funding markets “the most important remaining task of financial regulatory reform.”
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