Daniel K Tarullo: Shadow banking after the financial crisis
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Federal Reserve Bank of San Francisco Conference on "Challenges in global
finance: the role of Asia", San Francisco, California, 12 June 2012.
* * *
The three decades preceding the financial crisis were characterized in the United States by
the progressive integration of traditional lending and capital markets activities. This trend
diminished the importance of deposits as a source of funding for credit extension in favor of
capital market instruments sold to institutional investors. It also altered the structure of the
financial services industry, both transforming the activities of broker-dealers and fostering the
emergence of large financial conglomerates. Although the structure of foreign banking
systems was less noticeably changed, many foreign banks drew increasingly on the resulting
wholesale funding markets and made significant investments in the mortgage-backed
securities that had proliferated in the first decade of this century.
The financial crisis underscored the failure of the American regulatory system to keep pace
with these developments and revealed the need for two reform agendas. One must be aimed
specifically at the problem of too-big-to-fail institutions. The other must be directed at the
so-called shadow banking system, which refers to credit intermediation involving leverage
and maturity transformation that is partly or wholly outside the traditional banking system. As
I have noted on other occasions, most reforms to date have concentrated on too-big-to-fail
institutions, though many of these reforms have yet to be fully implemented. The shadow
banking system, on the other hand, has been only obliquely addressed, despite the fact that
the most acute phase of the crisis was precipitated by a run on that system. Indeed, as the
oversight of regulated institutions is strengthened, opportunities for arbitrage in the shadow
banking system may increase.
Today I want to focus on the development of a regulatory reform agenda for the shadow
banking system. As those who have been following the academic and policy debates know,
there are significant, ongoing disagreements concerning the roles of various factors
contributing to the rapid growth of the shadow banking system, the precise dynamics of the
runs in 2007 and 2008, and the relative social utility of some elements of this system.
Conclusions drawn from these debates will be important in eventually framing a broadly
directed regulatory plan for the shadow banking system. However, as it is neither necessary
nor wise to await such conclusions in order to begin implementing a regulatory response, I
will follow my discussion of the vulnerabilities created by shadow banking with some
suggestions for near- and medium-term reforms.
Fragility of the shadow banking system
It is not my purpose here today to discuss the history and complex nature of the shadow
banking system. There is a rich and growing academic literature devoted to this task.
However, I do want to identify some features of shadow banking that are reasonably
well-established and particularly salient for reform efforts.
First, and in many respects foremost, it bears noting that the use of the term "shadow
banking" refers not simply to the functions of credit intermediation and maturity
transformation. Shadow banking also refers to the creation of assets that are thought to be
safe, short-term, and liquid, and as such, "cash equivalents" similar to insured deposits in the
commercial banking system. Of course, as many financial market actors learned to their
dismay, in periods of stress these assets are not the same as insured deposits.
The years preceding the financial crisis saw a surge in the volume of dollar-denominated,
seemingly safe, seemingly liquid financial instruments. The causal interplay of factors leading
to this surge is still actively debated. But it seems reasonably clear that both a rise in the
demand by investors for safe, liquid assets as tools for precautionary or transactional liquidity
and a rise in demand for short-term financing by certain borrowers - notably financial
intermediaries looking to fund longer-term assets - played important, probably reciprocally
reinforcing roles.
Examples of investor demand for safe, liquid assets are not hard to identify. One source has
been foreign official investors, mostly emerging market countries, which invested about
$1.6 trillion in the United States in the four years preceding the crisis, largely in U.S. Treasury
and agency securities. Much of this activity arose from the investment of foreign exchange
reserves by countries running large current account surpluses. Some of these reserves were
undoubtedly built up as a precautionary measure in light of the financial problems in
emerging markets during the late 1990s, while others are attendant to policies of managed
exchange rates. This official sector demand for safe assets was largely if not entirely focused
on U.S. government securities, rather than cash equivalents. But this source of demand
absorbed roughly 80 percent of the increase in U.S. Treasury and agency securities over the
four-year period, potentially crowding out other investors and thereby increasing their
demand for cash equivalents that appeared to be of comparable safety and liquidity.
A second source of demand has been nonfinancial firms, which responded to the market
disruptions associated with defaults by Enron and other firms more than a decade ago by
boosting their holdings of cash. The pressure to hold large amounts of cash likely increased
when a major ratings agency began publishing liquidity risk assessments of nonfinancial
firms.
A third source of demand for cash equivalents resulted from the adoption of more elaborate
investment strategies by many institutional investors. For example, as more such investors
used derivatives or short-selling as part of their overall strategies, they needed cash or
cash-like instruments for margining and other collateral purposes. Moreover, of course, as
the amount of assets under professional management increased, the demand for safe, liquid
investments also inevitably increased, since intermediaries need a place to park funds that
are awaiting investment or needed to meet unexpected withdrawals.
The growing demand for safe and liquid assets was met largely by the shadow banking
system's creation of assets that were seemingly safe and seemingly liquid.1 New varieties of
shadow-banking activities were created, some pre-existing types grew larger, and the
shadow banking system became much more internationalized. For example, the volume of
asset-backed commercial paper, or ABCP, grew enormously. Many ABCP vehicles issued
short-term, highly rated liabilities and bought longer-term, highly rated securities, often
mortgage-backed securities. Many of the vehicles were sponsored abroad, especially by
European banks, which issued dollar-denominated ABCP in the U.S. market and bought
dollar-denominated assets in the U.S. market. The overall volume of this activity was very
large, although the net flows between the U.S. and Europe were not, leaving European bank
sponsors of such ABCP vehicles with a huge exposure when market participants stopped
believing that ABCP was risk-free.
It now seems clear that the tail risk associated with many shadow-banking instruments was
not understood by many market actors, including both sellers and buyers. An important
contributing factor on the buyers' side that helped set the stage for the 2007-2008 financial
crisis was the widespread acceptance that risk-free assets could be created by augmenting
what was already thought to be a low-risk asset with a promise from a large financial
institution to provide liquidity or bear credit losses in the unlikely event that such support
might be needed. When, in stressed conditions, the credibility of the promise came into
question, the susceptibility to runs increased dramatically.
In some cases, there were explicit contractual provisions for liquidity support or credit
enhancements, such as were provided to ABCP vehicles by their sponsoring banks. In other
cases, the support was more implicit, and was conveyed in the marketing of the assets or
through an historical pattern of providing support. Forms of implicit credit support were
present in a variety of important funding channels and, to a considerable degree, persist
today. Three examples are money market funds, the triparty repo market, and securities
lending.
Money market funds aim to maintain a stable net asset value of one dollar per share and to
meet redemption requests upon demand. As such they are the very model of a nonbank
"deposit" or cash equivalent.2 Unlike other mutual funds, money market funds are allowed to
round their net asset values to one dollar per share so long as the underlying value of each
share remains within one-half cent of a dollar. But a drop in the unrounded net asset value of
more than one-half of one percent causes a money fund to "break the buck", a scenario in
which losses, at least in theory, would be passed along to the fund's investors.
However, fund sponsors historically have absorbed losses whenever necessary to prevent
funds from breaking the buck, with only two exceptions. Even though they had no legal
obligation to do so, sponsors voluntarily supported their funds more than 100 times between
1989 and 2003, presumably because allowing a fund to break the buck would have damaged
the sponsor's reputation and franchise. This tendency was well understood by investors.
Indeed, a standard reference book on money markets states that a "money fund run by an
entity with deep pockets, while it may not have federal insurance, certainly has something
akin to private insurance . . . likely to prove adequate to cover any losses sustained by the
fund".3
Many money funds sustained significant capital losses when the market for asset-backed
commercial paper collapsed in the summer and fall of 2007. As in previous decades, losses
at money funds were absorbed by the funds' sponsors. Indeed, money funds were seen as
highly safe in 2007 and received large net inflows as concerns about other portions of the
financial system increased.
But when, in 2008, the Reserve Primary Fund did not provide support for the relatively small
losses at its money market fund, the illusion that money funds were effectively as safe as
insured bank accounts was shattered. A general run on money funds ensued. Within two
days, investors withdrew nearly $200 billion from prime money market funds, about
10 percent of their assets. This contributed to severe funding pressures for issuers of
commercial paper. The run ultimately prompted - and was stopped by - unprecedented
interventions by the Treasury and the Federal Reserve to provide insurance and liquidity
support to the industry.
A second example is the triparty repo market, which had grown to about $2.8 trillion of
outstanding financing by early 2007. In general, a repo, or "repurchase agreement", is the
sale of a security with an agreement to repurchase the security at a later date; the economics
of repos are similar to that of short-term loans collateralized by longer-term assets. So-called
triparty repos, typically used by broker-dealers to raise financing from cash-rich institutions
such as money market funds, insurance companies, and some central banks, utilizes a
particular settlement mechanism. The third party in this triparty market is a clearing bank,
which handles settlement through accounts held at that institution by the broker-dealers who
are cash borrowers and the cash lenders. Because the composition and size of
broker-dealers' inventories can change rapidly with the levels of trading activity,
broker-dealers find the very flexible and inexpensive short-term financing offered by triparty
repos to be extremely attractive. To the extent that this borrowing appeared riskless to
lenders, broker-dealers were potential suppliers through triparty repos of the safe, liquid
assets that were in such demand.
Broker-dealers who borrow in the triparty repo market want to have access to their securities
for routine trading purposes - for example, to make deliveries to clients during the day. To
allow for that, the market developed a critical operational feature called the "daily unwind".
Each day, the clearing banks "unwind" all repo trades, returning securities to borrowers and
cash to lenders, even for longer-dated term transactions. However, the securities still require
financing during the day. To this end, borrowers rely on intraday overdrafts at the two major
clearing banks. At the end of the day, the transactions are "re-wound". Thus, the risks
associated with the portfolios of securities are fully transferred twice each day.
The lenders in this market widely believed that the two clearing banks would always unwind
their maturing trades in the morning, returning cash to their account, despite no contractual
provision requiring that the clearing banks do so. The fact that lenders believed they were
protected in this way by the clearing bank helped perpetuate the illusion that, particularly
when lending overnight, they were invested in a money-like asset that would always be
highly liquid and safe, even though in reality the borrower was usually an entity that could go
bankrupt.
This illusion faded as the financial crisis progressed. Significant strains were created by
concerns about the financial strength of the broker-dealers, uncertainty about the value of the
underlying collateral, and belated recognition that the clearing banks were not contractually
obligated to unwind maturing trades. Only when the prospect of dealer failures became very
real - for example, in the case of Countrywide's broker-dealer affiliate in August 2007 and
Bear Stearns in March 2008 - did the lenders appear to see these risks clearly. In addition,
the presumed stabilizing function of collateral was weakened, since a default by a dealer or
clearing bank could leave lenders with securities posted as collateral that they had no desire,
operational capacity, or even, in some cases, legal authority to hold, or at least liquidate in an
orderly way. The response at that point was to flee, ignoring the protection putatively
afforded by collateral.
Only because of unprecedented official-sector action did the triparty repo market not suffer
the same kind of disastrous run as did money market funds. A broad run on triparty repos
would have severely impacted all major broker-dealers and thus the U.S. securities industry
as a whole. The Primary Dealer Credit Facility - instituted on an emergency basis
immediately after the failure of Bear Stearns - provided emergency lending to dealers,
injected liquidity into the system, and provided a backstop that reassured markets. This
public-sector support prevailed where implicit private-sector support had come into question,
and helped stabilize the triparty repo market.
My third example of a funding channel characterized by tacit credit support is the securities
lending market, which is driven in large part by demand for securities by financial institutions
wanting to establish short positions or needing collateral to support other transactions.
Securities lenders in this market are typically owners of large pools of securities such as
pension plans, endowments, and insurance companies. The securities borrower posts
collateral, usually cash in the United States, which a custodian bank then typically invests on
behalf of the securities lender in supposedly safe and liquid investments, including money
market funds, triparty repos, and other short-term instruments. The gains from these
reinvestment activities provide a significant amount - in some cases, all - of the
compensation to the securities lender associated with participating in the lending program.4
The custodian banks all but universally provided a contractual indemnification to the
securities lender that required them to absorb any losses to the securities lenders if the
securities were not returned. But the investment returns, and risk of loss on the reinvestment
of cash collateral that would have to be returned to the borrowers of securities, generally
were not covered by such indemnifications. Nonetheless, a number of securities lenders
seemed to believe otherwise, and in many cases their expectations were fulfilled as
custodian banks agreed during the financial crisis to bear at least some of the losses from
cash collateral reinvestment programs.
Although the experiences of money market funds, triparty repos, and securities lending vary
in the details, they all share a common underlying pathology: Offering documents with stern
warnings notwithstanding, explicit and implicit commitments combined with a history of
discretionary support to create an assumption, even among sophisticated investors, that
low-risk assets were free of credit and liquidity risk - effectively cash, but with a slightly
higher return. This risk illusion led to pervasive underpricing of the risks embedded in these
money-like instruments and made them an artificially cheap source of funding. The
consequent oversupply of these instruments contributed importantly to systemic risk.
Reliance on private mechanisms to create seemingly riskless assets generally worked in the
relatively calm years leading up to the financial crisis and, to some extent, well into the crisis.
But, in many cases, discretionary support came into question at the time of acute
financial-market stress, precisely when it was needed most, as questions arose about the
ability or willingness of large financial institutions to follow through on their implicit
commitments. Investors were reminded of their potential exposure, leading to wholesale and
sometimes disorderly flight. The unwinding of this risk illusion helped transform a dramatic
correction in real estate valuations - which itself would have had serious consequences for
the economy - into a crisis that threatened the entire financial system.
Shaping a regulatory response
Ideally, a regulatory response to the shadow banking system would be grounded in a full
understanding of the dynamics that drove its rapid growth, the social utility of its
intermediation activities, and the risks they create. Such a response would be
comprehensive, meaning that it would cover in an effective and efficient manner any
activities that create these vulnerabilities, without regard to how the activities were
denominated, what transaction forms were used, or where they were conducted. Of course,
many of the key issues are still being debated, and even those who agree on the desirability
of a comprehensive response may differ on its basic form.
We should continue to seek the analytic and policy consensus that must precede the
creation of a regulatory program that meets these conditions. More work is needed on
fundamental issues such as the implications of private money creation and of intermediaries
behaving like banks but without bank-like regulation. These implications are potentially quite
profound for central banking and banking regulation, considering that the shadow banking
system has caused the volume of money-like instruments created outside the purview of
central bank and regulatory control to grow markedly.
But regulators need not wait for the full resolution of contested issues or the development of
comprehensive alternatives, nor would it be prudent for them to do so. We should act now to
address some obvious sources of vulnerability in the financial system. I believe that the
foregoing discussion of implicit support for various shadow banking instruments helps identify
areas where misunderstanding and mispricing of risk are more likely, with the result that
destabilizing runs are a real possibility.
Let me then suggest three more-or-less immediate steps that regulators here and abroad
should take, as well as a medium-term reform undertaking.
First, we should create greater transparency with respect to the various transactions and
markets that comprise the shadow banking system. For example, large segments of the repo
market remain opaque today. In fact, at present there is no way that regulators or market
participants can precisely determine even the overall volume of bilateral repo transactions -
that is, transactions not settled using the triparty mechanism. It is encouraging that the
Treasury Department's new Office of Financial Research is working to improve information
about this market, while the Securities and Exchange Commission is considering approaches
to enhanced transparency in the closely related securities lending market.
Second, the risk of runs on money market mutual funds should be further reduced through
additional measures to address the structural vulnerabilities that have persisted even after
the measures taken by the SEC in 2010 to improve the resilience of those funds. The SEC is
currently considering several possible reforms, including a floating net asset value, capital
requirements, and restrictions on redemption. Clearly, as suggested by Chairman Schapiro,
action by the SEC to address the vulnerabilities that were so evident in 2008, while also
preserving the economic role of money market funds, is the preferable route. But in the
absence of such action, there are several second-best alternatives, including the recent
suggestion by Deputy Governor Tucker of the Bank of England that supervisors consider
setting new limits on banks' reliance on funding provided by money market funds.
A third short-term priority is to address the settlement process for triparty repurchase
agreements. Some progress has been made since 2008, but clearly more remains to be
done. An industry-led task force established in 2009 orchestrated the implementation of
some important improvements to the settlement process. The unwind, with its reliance on
vast amounts of discretionary and uncommitted intraday credit from the two clearing banks,
was pushed to later in the day, reducing the period during which the intraday credit was
extended. In addition, new tools were developed for better intraday collateral management,
and an improved confirmation process was instituted.
Though these were useful steps, the key risk reduction goal of the effective elimination of
intraday credit has not yet been achieved. A second phase of triparty reform is now
underway, with the Federal Reserve using its supervisory authority to press for further action
not only by the clearing banks, who of course manage the settlement process, but also by
the dealer affiliates of bank holding companies, who are the clearing banks' largest
customers for triparty transactions. But this approach alone will not suffice. All regulators and
supervisors with responsibility for overseeing the various entities active in the triparty market
will need to work together to ensure that critical enhancements to risk management and
settlement processes are implemented uniformly and robustly across the entire market, and
to encourage the development of mechanisms for orderly liquidation of collateral, so as to
prevent a fire sale of assets in the event that any major triparty market participant faces
distress.
In the medium term, a broader reform agenda for shadow banking will first need to address
the fact that there is little constraint on the use of leverage in some key types of transactions.
One proposal is for a system of haircut and margin requirements that would be uniformly
applied across a range of markets, including OTC derivatives, repurchase agreements, and
securities lending. Work is ongoing to develop globally uniform margin requirements for OTC
derivatives, but there is not yet an agreement to develop globally uniform margin
requirements for securities financing transactions. Such a margining system would not only
limit leverage, but - to the extent it is in fact uniform - also diminish incentives to use more
complicated and less transparent transactional forms to increase leverage or reduce its cost.
Some proponents suggest that such systems of uniform haircut and margin requirements
could also dampen the observed procyclical character of many collateralized borrowings that
results from changes in margins and haircuts following general economic or credit trends.
Conclusion
The shadow banking system today is considerably smaller than at the height of the housing
bubble six or seven years ago. And it is very likely that some forms of shadow banking most
closely associated with that bubble have disappeared forever. But as the economy recovers,
it is nearly as likely that, without policy changes, existing channels for shadow banking will
grow, and new forms creating new vulnerabilities will arise. That is why I suggest what is, in
essence, a two-pronged agenda: first, near-term action to address current channels where
mispricing, run risk, and potential moral hazard are evident; and, second, continuation of the
academic and policy debate on more fundamental measures to address these issues more
broadly and proactively.