Daniel K Tarullo: Shadow banking and systemic risk regulation
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Americans for Financial Reform and Economic Policy Institute Conference,
Washington DC, 22 November 2013.
* * *
As illustrated, quite literally, by a chart that New York Fed staff produced a few years ago,
the term "shadow banking system" encompasses a wide variety of institutions that engage in
credit intermediation and maturity transformation outside the insured depository system.1 In
my remarks today, I want to concentrate on short-term wholesale funding and, especially, the
pre-crisis explosion in the creation of assets that were thought to be "cash equivalents." Such
assets were held by a range of highly risk-averse investors, who were in many cases not fully
cognizant that the "cash equivalents" in their portfolios were liabilities of shadow banks - the
institutions depicted in the memorable graphic.
In some cases, the perception of claims on shadow banks as cash equivalents was based on
explicit or implicit promises by regulated institutions to provide liquidity and credit support to
such entities. In other cases, the perception came about because market participants viewed
the instruments held on the balance sheets of shadow banking entities - notably highly rated,
asset-backed securities - as liquid and safe. While reliance on private mechanisms to create
seemingly riskless assets was sustainable in relatively calm years, the stress that marked the
onset of the financial crisis reminded investors that claims on the shadow banking system
could pose far more risk than deposits insured by the Federal Deposit Insurance Corporation
(FDIC). Once reminded of their potential exposure, investors engaged in broad-based and
sometimes disorderly flight from the shadow banking system.
This experience of the run on the shadow banking system that occurred in 2007 and 2008
reminds us that similar disorderly flights of uninsured deposits from banks lay at the heart of
the financial panics that afflicted the nation in the late nineteenth and early twentieth centuries.
The most dramatic of these episodes were the bank runs of the early 1930s that culminated in
the bank holiday in 1933. Just as it was necessary, though not sufficient, to alter the
environment that led to those successive deposit runs by introducing deposit insurance in order
to create a stable financial system in the early-twentieth century, today it is necessary, though
not sufficient, to alter the environment that can lead to short-term wholesale funding runs in
order to create a stable financial system for the early twenty-first century.
As I will describe in a few moments, the Federal Reserve has taken some steps toward this
end over the past few years. However, as I will also contend, completion of this task will
require a more comprehensive set of measures, at least some of which must cover financial
actors not subject to prudential regulatory oversight. Before turning to these points, I want to
develop briefly the comparison between deposit runs of the pre-FDIC period and
contemporary short-term wholesale funding runs in order better to explain the nature of the
regulatory challenge.
Vulnerabilities created by short-term wholesale funding
There are notable similarities between the bank runs that periodically afflicted the U.S.
banking system before the creation of federal deposit insurance and the dramatic short-term
wholesale funding runs that began in 2007. Each had a cascading, self-reinforcing quality,
fueled by questions concerning the solvency of borrowing entities - whether deposit-taking
banks or dealers seeking credit in repo markets. And, in each case, the opaqueness of the
balance sheets of the borrowing entities led lenders to fear that an institution holding assets
similar to, or interconnected through counterparty relationships with, another, troubled
institution might itself be in trouble. Significantly, though, in each case, at least some of the
lending actors were interested not just in eventually recovering the full amount of the funds
they had extended, but in having access to those funds more or less immediately. Some
depositors in 1932 needed their money in order to meet the requirements of daily life, while
many repo counterparties in 2008 needed their money to meet other short-term obligations.
Thus the issue was not just a matter of solvency - whether the firm would ultimately be able
to pay all the claims even after the run - but also a matter of the short-term liquidity of the
bank or broker.
The dynamic unleashed by short-term wholesale funding runs in 2007 and 2008 directly
exacerbated financial stress. Many assets funded through the shadow banking system were
traded assets, which could be liquidated rapidly, though often at distressed prices, to reduce
the funding needs of the borrowing firms. The resulting fire sales recalled the asset
liquidations by some trust companies during the Panic of 1907 and by some securities firms
in the 1930s. In 2008, these fire sales created adverse feedback loops of mark-to-market
losses, margin calls, and further liquidations. The unwinding of the risk illusion - that is, the
assumption that lending to shadow banks was essentially risk-free - helped transform a
dramatic correction in real estate valuations into a crisis that engulfed the entire economy.
But for a few idiosyncratic instances since the introduction of deposit insurance in 1933, bank
runs have been rendered a thing of the past. Deposits below the amount of the federal
insurance cap are fully and explicitly guaranteed. Access to the Federal Reserve's discount
window for depository institutions complements the deposit insurance system by helping to
relieve liquidity pressures in solvent banks. In practice, failing banks usually merge into
healthier ones, so that depositors do not lose access to their funds and deposits exceeding
the amount of the federal insurance cap are effectively protected. In the relatively few
instances of depositor payouts, the FDIC has reimbursed depositors expeditiously. Of
course, the explicit and de facto extension of federal guarantees created moral hazard
problems, which the safety-and-soundness regulation of insured depository institutions was
strengthened to address.
The similarities between deposit runs and short-term wholesale funding runs have suggested
to some that the policy responses should also be similar. Those taking this position argue for
providing discount window access to broker-dealers, guaranteeing certain kinds of wholesale
funding, or both. Others, myself included, are wary of any such extension of the government
safety net and would prefer a regulatory approach that requires market actors using or
extending short-term wholesale funding to internalize the social costs of those forms of
funding. Unlike deposit insurance, the savings of most U.S. households are generally not
directly at risk in short-term wholesale funding arrangements. And, also unlike insured
deposits, there is an argument in the short-term wholesale funding context that
counterparties should be capable of providing some market discipline in at least some of the
contexts in which such funding is provided.
In thinking about how to regulate shadow banking, we must be mindful that it is not really a
single system. It is immeasurably more complicated than the bank deposit system of either
the 1930s or today. Even with the reduction in activity following the crisis, the scale of
shadow banking activity remains very large. Banks and broker-dealers currently borrow
about $1.6 trillion, much of this from money market funds and securities lenders, through
triparty repos, leaving aside additional funds sourced from asset managers and other investors
through other channels.2 The banks and broker dealers, in turn, use reverse repo to provide
more than $1 trillion in financing to prime brokerage and other clients. While the volume of
this activity has fallen considerably since the crisis and the haircuts and other conditions
associated with current securities financing transactions are considerably more conservative
than during the pre-crisis period, there is every reason to believe that the amount of this
activity could increase, and the conservatism of the terms of the lending could be eroded, as
economic conditions improve.
Let me turn now to some of the specific vulnerabilities, steps that have been taken thus far to
address these vulnerabilities, and the work that remains.
Regulated institutions and shadow banking
While the term "shadow banking" implies activity outside the purview of regulatory oversight,
regulated institutions are in fact heavily involved in these activities, both in funding their own
operations and in extending credit and liquidity support to shadow banks beyond the
regulatory perimeter.
Support provided for shadow banking activities may be either explicit or implicit. In some
cases, there are explicit contractual provisions for credit enhancements and liquidity support.
In other cases, the support is implicit, based on a bank's historical pattern of providing
support or a belief among investors that a bank will provide support to maintain the value of
its franchise. In the lead-up to the crisis, explicit and implicit commitments by regulated
banking firms to shadow banks often combined to create the assumption that the liabilities of
such entities were risk-free. This perception led to an underpricing of the risks embedded in
these money-like instruments, making them an artificially cheap source of funding and
creating an oversupply of these instruments that contributed to systemic risk.
Contractually committed credit and liquidity support lends itself more readily to regulation
than does implicit support. Basel III reforms have strengthened the regulatory requirements
for situations in which there is contractual support for shadow banking activities. For
example, the Basel III capital requirements increase from 0 percent to 20 percent the credit
conversion factor for commitments with an original maturity of one year or less that are not
unconditionally cancellable. In addition, the Basel III Liquidity Coverage Ratio (LCR) assigns
a 100 percent drawdown rate to undrawn amounts of credit and liquidity facilities extended
by banks to a special purpose entity (SPE), effectively requiring a bank to hold $100 in
highquality liquid assets (HQLA) for every $100 it commits to a SPE.
Implicit support presents more of a regulatory challenge. Identifying implicit forms of support
requires a supervisory judgment that, despite sometimes stern warnings in offering
documents, a banking organization bears some of the risk associated with that investment.
Regulators must decide how much of the risk the banking organization retains and make
context-sensitive judgments about the financial stability implications of various remedies.
These challenges notwithstanding, regulators have made some progress in addressing
instances of implicit support that played a major role in the last crisis. Let me mention two
examples.
The first involves the implicit support associated with the provision of intraday credit by
clearing banks in the tri-party repo market. In a repurchase agreement or "repo," the cash
borrower agrees to sell a security to a cash lender, and to repurchase the security from the
cash lender at a later date. In a tri-party repo transaction, a clearing bank handles
settlements through accounts held at that financial institution by the parties to the
transaction. To allow broker-dealers who borrow in the tri-party repo market to have access
to their securities for routine trading purposes, the market developed an operational feature
known as the "daily unwind." Before the crisis and for some time afterwards, the clearing
banks unwound all tri-party repo trades each day - even those with a significant term, which
in theory represented longer-term financing commitments - returning securities to borrowers
and cash to lenders. However, because the securities still required financing during the day,
cash borrowers relied on uncommitted secured credit, backed by their overall portfolio of
securities and provided by the clearing bank. Transactions were re-wound at the end of the
day, with specific securities allocated as collateral to each lender at that time.
Cash lenders in the tri-party repo market thus came to expect that the two clearing banks
would always unwind their maturing trades in the morning, returning cash to their account,
despite the absence of a contractual provision requiring them to do so. As a result, they grew
comfortable in the belief that they held a cash-equivalent asset that was perfectly safe and
liquid. But as the crisis deepened, cash lenders became aware of the fact that the clearing
banks were not contractually obligated to unwind repo trades and that the dealers that were
the primary borrowers in the tri-party repo market could fail, leaving lenders with collateral
that they had little or no capacity to manage at a juncture when its value and liquidity was
open to doubt. This resulted in several distinct episodes during the crisis when cash lenders,
despite holding collateral, quickly withdrew financing from dealers perceived to be facing
potential financial distress. The tri-party repo market might have suffered a full-scale run in
the absence of public-sector intervention.
Since the crisis, the Federal Reserve has led an effort to reduce reliance on intraday credit in
the tri-party repo market. Work to date has reduced the amount of intraday credit provided by
the clearing banks from 100 percent of the tri-party repo market to approximately 30 percent,
and commitments by market participants suggest that this amount will fall to 10 percent by
the end of next year. This operational change, in addition to enhancing the resiliency of the
settlement process, should help limit the likelihood that tri-party repo lenders return to
believing that lending in the tri-party repo market is a risk-free proposition. As a result,
triparty repo lenders are likely to conduct more thorough due diligence on their counterparties
and exercise more care in considering the types of collateral that they will lend against than
was the case before the crisis.3
The second example involves the implicit support provided by bank sponsors of certain
securitization SPEs. Before the crisis, the interplay between bank capital requirements and
accounting rules created a significant incentive for banks to shift assets off-balance sheet
through the use of various SPEs. Under the capital requirements that applied at the time, a
bank that sold assets to a conduit or other SPE it sponsored was required to hold capital only
against its contractual exposure to the SPE. Yet because a bank that failed to support SPEs
it sponsored might irreparably damage the value of its franchise, banks often provided credit
and liquidity support in excess of contractually obligated amounts to asset-backed
commercial paper (ABCP) programs, credit card securitizations, and other structured finance
vehicles. Recognizing this incentive, pre-crisis lenders were willing to hold commercial paper
and other liabilities issued by bank-sponsored SPEs at yields only slightly higher than those
on liabilities issued directly by the bank. In effect, the bank was able to hold less capital and
reduce its funding costs without decreasing its economic exposure.
Post-crisis reforms have reduced the opportunity for banks to exploit this regulatory
arbitrage. In 2009, the Financial Accounting Standards Board (FASB) adopted FAS 166 and
167 to modify the accounting treatment of structured finance transactions involving certain
SPEs. Under the new accounting guidance, a company is required to consolidate those
SPEs for which the company has the power to direct matters that most significantly impact
the entity as well as the obligation to absorb losses or the right to receive benefits.
Securitization sponsors have generally interpreted the new guidance as requiring a sponsor
to consolidate a SPE under circumstances in which the sponsor retains loan-servicing
obligations and exposure to the equity tranche of the securitization.
Following the publication of FAS 166 and 167, the federal banking agencies adopted new
rules requiring banking organizations to hold risk-based and leverage capital against assets
of the newly consolidated SPEs.4 These rules eliminated a provision in the bank capital
requirements that permitted a banking organization to exclude from the calculation of its
riskweighted assets the assets of an ABCP program that the banking organization sponsored
and was required to consolidate. As a result, bank sponsors of ABCP conduits and certain
other securitizations must now hold levels of regulatory capital commensurate with the
exposure arising from the implicit support they provide.
Collateralized borrowing arrangements and financial stability
Turning now to financial stability concerns raised by short-term wholesale funding more
generally, I want to focus on collateralized borrowing arrangements. These collateralized
borrowing arrangements consist largely of securities financing transactions (SFTs), a term
that generally refers to repo and reverse repo, securities lending and borrowing, and
securities margin lending. Lenders are willing to extend credit on a secured basis because
these transactions are usually short-term, over-collateralized, backed by reasonably liquid
securities, subject to daily mark-to-market and re-margining requirements, and exempt from
the automatic stay in insolvency proceedings. In the most common practice, a broker-dealer
uses SFTs to finance either securities inventory or a back-to-back SFT loan to another
financial firm (SFT matched book).
The financial stability risks associated with a dealer's use of short-term SFT funding to
finance its inventory are relatively straightforward. If a broker-dealer loses access to
financing and is forced to sell securities at a depressed price, fire sale externalities may
result because other market participants may be less able to borrow against the same
securities. And if the broker-dealer fails due to runs by short-term SFT lenders, post-default
fire sales by the firm's creditors or contagious runs on other financial intermediaries may
ensue. Because broker-dealers generally do not internalize the externalities that arise in
these cases, they may use more than the economically efficient level of short-term funding.
The financial stability risks associated with SFT matched books are somewhat less obvious.
Even if the outflows and inflows associated with a dealer's SFT positions are perfectly
maturity-matched, reputational considerations may inhibit a dealer from reducing the amount
of SFT credit that it provides its customers, exposing the dealer to considerable liquidity
stress. If the dealer does reduce the amount of credit that it provides to its customers, those
customers may be forced to engage in asset fire sales of their own. Particularly in situations
in which the customers are highly leveraged, maturity-transforming entities that lack access
to a liquidity provider of last resort may pose a significant risk of contagion.
Post-crisis financial regulatory reform has taken some steps to address the financial stability
risks associated with a dealer's use of short-term SFT funding to finance inventory. For
example, the liquidity coverage ratio requires firms to hold a buffer of high-quality liquid assets
when they use SFT liabilities that mature in less than 30 days to fund many types of securities.
New risk-based capital rules have substantially increased the amount of capital that dealers
are required to hold against assets in the trading book. But these reforms are limited: The LCR
does not require firms to hold any liquidity buffer against SFT liabilities that mature in more
than 30 days or that are backed by very liquid assets. There continues to be a need for
standardized capital requirements for market risk to back up model-derived risk weights.
Moreover, the current regulatory framework does not impose any meaningful regulatory
charge on the financial stability risks associated with SFT matched books. The Basel III
riskbased capital rules require banking organizations to hold relatively little capital against SFT
assets, which are assumed to pose little microprudential risk. Because leverage
requirements do not take into account the fact that SFTs are collateralized transactions,
leverage requirements have the potential to impose higher charges on SFT assets. But
leverage requirements have traditionally been calibrated at non-binding levels and, to the
extent they do bind in the future, are unlikely to bind evenly across firms. As a result, the
leverage ratio may simply cause SFT assets and liabilities to migrate to those firms with
stronger leverage ratios.
Similarly, the LCR and, at least at this stage of its development, the Net Stable Funding Ratio
(NSFR), both assume that a firm with a perfectly matched book is in a stable position. The
LCR assumes a bank can call in reverse repos and other SFT assets that mature in less than
30 days or reuse the collateral that secures those assets for purposes of its own borrowing.
Thus, reverse repos and other SFT assets generally are treated as completely liquid
instruments. Under the initial version of the NSFR, firms would not need to hold any stable
funding against reverse repos, securities borrowing receivables, or other loans to financial
entities that mature in less than one year. Again, this may be a reasonable position from a
microprudential perspective, geared toward more or less normal times. But here is where we
need an explicitly macroprudential perspective that forces firms to internalize the tail-event
financial stability risks associated with SFT matched books.
Policy options
There are two kinds of policy options that can be considered, individually or together, in
responding to the financial stability vulnerabilities inherent in firms with large amounts of
short-term wholesale funding - whether loaned, borrowed, or both. The first would impose a
regulatory charge calculated by reference to reliance on SFTs and other forms of short-term
wholesale funding, whether the firm uses that funding to finance inventory or an SFT
matched book. The second would directly increase the very low charges under current and
pending regulatory standards attracted by SFT matched books.
Among the first set of options, 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. The additional capital requirement would
be calculated by 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. There might be a kind of weighting system to take account
of the specific risk characteristics of different forms of funding. The capital requirement would
then be added to the Tier 1 common equity requirement already mandated by the minimum
capital, capital conservation buffer, and globally systemic bank surcharge standards.
However, this component of the Tier 1 common equity requirement would be calculated by
reference to the liability side, rather than the asset side, of the firm's balance sheet.
The rationale behind this policy option is that, while solid requirements are needed for both
capital and liquidity, the relationship between the two also matters. For example, a firm with
little reliance on short-term funding is less susceptible to runs and, thus, to the need for
engaging in fire sales that can depress capital levels. A capital surcharge based on
shortterm wholesale funding usage would add an incentive to use more stable funding and, where
a firm concluded that higher levels of such funding were nonetheless economically sensible,
the surcharge would increase the loss absorbency of the firm. Such a requirement would be
consistent with, though distinct from, the long-term debt requirement that the Federal
Reserve Board will be proposing to enhance prospects for resolving large firms without
taxpayer assistance.
The second kind of policy option is to address head-on the macroprudential concerns arising
from large matched books of securities financing transactions. A capital surcharge is in some
respects an indirect response to the problem of short-term wholesale funding runs and, as
earlier noted, current versions of capital and liquidity standards do not deal with matched
book issues. One might choose either to increase capital charges applicable to SFT assets
or to modify liquidity standards so as to require firms with large amounts of these assets to
hold larger liquidity buffers or to maintain more stable funding structures. It is not clear how
much appetite there may be internationally for revisiting agreements that have been
completed, such as the LCR and the Basel III capital rules. However, with the NSFR still
under discussion, and with the Basel Committee in the process of reconsidering the
standardized banking book risk weights and capital regulations associated with traded
assets, there are opportunities to pursue these options.
Requirements building on any of the foregoing options would by definition be directly
applicable only to firms already within the perimeter of prudential regulation. The obvious
questions are whether these firms at present occupy enough of the market that standards
applicable only to them would be reasonably effective in addressing systemic risk and, even
if that question is answered affirmatively, whether the imposition of such standards would
lead to a significant arbitrage through increased participation by those outside the regulatory
perimeter. It does not seem far-fetched to think that, with time and sufficient economic
incentive, the financial, technological, and regulatory barriers to the disintermediation of
prudentially regulated dealers could be overcome. Indeed, there have already been reports
of some hedge funds exploring the possibility of disintermediating dealers by lending cash
against securities collateral to other market participants.
For this reason, there is a need to supplement prudential bank regulation with a third set of
policy options in the form of regulatory tools that can be applied on a market-wide basis. That
is, regulation would focus on particular kinds of transactions, rather than just the nature of the
firm engaging in the transactions. To date, over-the-counter derivatives reform is the primary
example of a post-crisis effort at market-wide regulation.5 Given that the 2007-2008 financial
crisis was driven more by disruptions in the SFT markets than by disruptions in the
over-thecounter derivative markets, comparable attention to SFT markets is surely needed. Over the
past two years, the Financial Stability Board (FSB) has been evaluating proposals for a
system of haircuts and margin requirements for SFTs. In its broadest form, a system of
numerical floors for SFT haircuts would require any entity that wants to borrow against any
security to post a minimum amount of excess margin that would vary depending on the asset
class of the collateral. Like minimum margin requirements for derivatives, numerical floors for
SFT haircuts would be intended to serve as a mechanism for limiting the build up of leverage
at the security level, and could mitigate the risk of procyclical margin calls.
In August, the FSB released a proposal that would represent a first step in the direction of
such a framework. However the FSB's proposal has some significant limitations. First, with
respect to counterparty scope, the FSB's proposal would apply only to SFTs in which
regulated entities provide financing to unregulated entities; the proposal would not cover
SFTs between a regulated lender and a regulated borrower, between an unregulated lender
and a regulated borrower, or between an unregulated lender and an unregulated borrower.
Second, the proposal would apply only to lending against collateral other than sovereign
obligations. And finally, with respect to calibration, the FSB's proposed numerical floors are
set at relatively low levels - levels that are, for example, significantly below the haircuts that
currently prevail in the tri-party repo market.
An alternative to the FSB's proposal would be to apply a system of numerical floors to SFTs
regardless of the identity of the parties to the transaction. Such an approach would at least
partially offset the incentive that will otherwise exist to move more securities financing activity
completely into the shadows. Regarding calibration, there are at least three conceptually
plausible bases for setting the level of the numerical floors above the low backstop levels
contemplated in the current FSB proposal.
One approach would be to base the calibration of the numerical floors on current repo market
haircuts. These haircuts have increased significantly compared to pre-crisis levels.
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 would be to set
haircuts for a given asset class based on asset price volatility or haircut levels observed
during times of stress or long-term periods that include times of stress. While minimum
haircut levels should not be set as high as the haircuts lenders demanded at the depths of
the crisis, setting numerical floors in proportion to those levels might be reasonable. A third
alternative would be to set numerical floors for SFT haircuts at levels that are commensurate
with the amount of capital a banking organization would need to hold against the security if it
held the security in inventory. Such an approach could be viewed as an indirect way of
extending bank capital requirements to the shadow banking system, and would reduce the
current bank regulatory incentive to lend against a security rather than hold it directly.
Finally, it is worth noting that, while a framework of universal margin requirements for SFTs
could not be evaded through the disintermediation of regulated entities, it might be evaded
through the use of alternative transactional structures. If margin requirements for cash SFT
transactions are significantly higher than margin requirements for creating the same
economic exposures using synthetic SFT transactions, a framework of minimum margins for
SFTs could push market participants to rely more heavily on derivatives that are the
functional equivalent of cash SFTs. Moreover, market participants might attempt to arbitrage
margin floors through arrangements whereby the lender effectively lends the SFT borrower
the minimum excess margin amount. These and similar issues will need to be addressed as
options for minimum margins are further developed.
Conclusion
If we think back to the rapid growth of the shadow banking system in the pre-crisis period, we
are reminded of some glaring vulnerabilities: Large firms that could themselves be
considered shadow banks and that relied on the shadow banking system for a significant
proportion of their funding - a group that included the "free-standing" investment banks -
were outside the perimeter of prudential regulation. The breaking of the buck by the Reserve
Primary Fund following Lehman's collapse triggered a run on the shadow banking system
that required unprecedented support by the Treasury Department and the Federal Reserve.
The process established by the Dodd-Frank Wall Street Reform and Consumer Protection
Act for designation of systemically important non-bank firms has provided a means for
ensuring that the perimeter of prudential regulation can be extended as appropriate to cover
large shadow banking institutions. The proposals of the Securities and Exchange
Commission on money market fund regulation are a response to continuing vulnerabilities as
well as to the run in the fall of 2008. These are important initiatives that will contribute to a
safer system of funding throughout the financial system. Yet the risk of contagious runs
would persist even in the absence of individually systemic institutions. And with less
vulnerable money market funds, other cash-rich entities could emerge as a source of
inexpensive funding for the shadow banking system. Finally, as I have noted, the systemic
risks associated with short-term wholes