Daniel K Tarullo: Thinking critically about nonbank financial
intermediation
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Brookings Institution, Washington DC, 17 November 2015.
* * *
The financial crisis highlighted two major vulnerabilities in the U.S. financial system. First was
the magnitude of the too-big-to-fail problem. Second was the size and fragility of the
socalled shadow banking system and the extent to which shadow banking activities not subject
to prudential regulation were integrated with the regulated banking sector. In the intervening
years, much has been done to address too-big-to-fail. With regard to shadow banking
concerns, the specific forms related to mortgage lending that linked the regulated and
unregulated sectors, such as the notorious structured investment vehicles (SIVs), collapsed
during the crisis. Changes in capital, accounting, and other regulatory standards make these
arrangements very unlikely to reappear. Moreover, the kind of very large nonbank financial
firms whose failures deepened the crisis are now subject to consolidated prudential
regulation and supervision. So, in a quite direct sense, the answer to the question posed by
this conference of whether we are safer than before the crisis is easy to answer in the
affirmative.
Of course, "safer" does not necessarily mean safe enough. With respect to the largest banks,
we continue to pursue the aim of promoting orderly resolution through evaluation of their
resolution plans and through a long-term debt requirement, as proposed a few weeks ago. In
addition, the banking agencies will be proposing a net stable funding ratio rule, aimed at
assuring adequate medium-term liquidity, in the next few months. And the Federal Reserve
is currently engaged in a review of its annual stress testing and capital planning exercises,
one goal of which is to reflect better the range of risks confronted by these institutions.
With respect to shadow banking, the subject of my remarks today, the circumstances are
somewhat different. While the specific pre-crisis linkages to the regulated sector have been
removed or better regulated, the possibility of other connections remains. More generally,
risks to financial stability may arise anew from activities mostly or completely outside the
ambit of prudentially regulated firms. Shadow banking is not a single, identifiable "system,"
but a constantly changing and largely unrelated set of intermediation activities pursued by
very different types of financial market actors. Indeed, the very rigor of post-crisis reforms to
prudential regulation may create new opportunities for such activities. The aphoristic warning
to avoid too much emphasis on fighting the last war, since wholly new risks may have arisen,
seems particularly applicable in this area.
Yet there is simultaneously the opposite danger that the regulatory response to shadow
banking will be too broad and too unidimensional. Indeed, the very term "shadow banking"
tilts in that direction. This afternoon, I will try to identify some of the considerations that could
help navigate between the perils of underappreciating the risks to financial stability arising
from, and the costs from overreacting to, new forms of nonbank financial intermediation.
Along the way I will make a few points. One is that, analytically, it is essential to disaggregate
the various activities that fall under the loose term shadow banking and to assess the risks
and benefits they present on a discrete basis. A second is that, notwithstanding the manifold
nature of nonbank intermediation, it remains useful to identify the relationship of specific
activities to the prudentially regulated sector. A third is that institutional considerations will be
important in defining the potential, and actual, regulatory responses to nonbank
intermediation.
The legacy of shadow banking
As you have probably noticed already, I have some misgivings about the continued use of
the term shadow banking as a shorthand for various forms of nonbank financial
intermediation that may need a regulatory response. The term conjures up a picture of
lending and borrowing that resembles activity associated with, but not conducted by,
commercial banks which is both over- and under-inclusive of actual risks to financial stability.
Before elaborating on this point, though, let me review how the phrase does capture well the
activities that played such a large part in precipitating and exacerbating the financial crisis.1
Before 2007, large banks provided credit and liquidity support, whether explicit or implicit, for
a range of intermediation entities, including finance companies, nonbank mortgage lenders,
SIVs, and asset-backed commercial paper conduits. All of these entities engaged in maturity
and liquidity transformation, frequently accompanied by significant leverage. Many created,
through securitization or otherwise, assets that were viewed as cash equivalents - safe,
short-term, and liquid. That is, at least in normal times, they were seen as comparable to
demand deposits created by the traditional banking sector. Thus, what we might refer to as
the prototypical form of shadow banking presented the kind of risk associated with traditional
banking prior to the creation of deposit insurance - that of destabilizing short-term creditor
runs that lead to defaults and asset fire sales.
Bank sponsorship contributed to the illusion that the shadow banks' short-term liabilities were
virtually as good as cash. Large banks also relied on short-term wholesale funding provided
by the shadow banking sector as a source of cheap financing. Then, questions arose about
the quality of the mortgage loans and other assets underlying the liabilities of SIVs and
asset-backed commercial paper conduits and, simultaneously, about the continued
willingness and capacity of their sponsors to support them. Suddenly, asset-backed
commercial paper was no longer seen as a cash equivalent, and a run ensued. Large
investment banks also experienced dramatic runs on their short-term, secured wholesale
funding. Another powerful run occurred, this time on money market mutual funds, after
Lehman Brothers' shadow banking activities caused it to fail and the Reserve Primary Fund
broke the buck.
As noted earlier, some key elements of pre-crisis shadow banking such as SIVs have
vanished, and some key actors of that earlier period have been brought within the bounds of
prudential regulation. Today, the shadow banking sector is smaller and the traditional
banking sector is more resilient. Nonetheless, abundant global liquidity continues to seek out
safe assets, and some financial market participants will continue to accept maturity and
liquidity mismatches in order to earn incrementally higher yields. The risks associated with
short-term wholesale funding in particular have more receded than disappeared. Accordingly,
the prototype of the precarious shadow banking model can generate new variants that
should command regulatory attention. Before returning to this issue, though, I want to speak
more directly to why and how we should analyze the risks and benefits associated with
specific forms of nonbank financial intermediation, rather than make regulatory decisions
based upon the fact that a particular form of intermediation bears some resemblance to the
borrowing or lending activities traditionally associated with commercial banks.
Analyzing nonbank intermediation
Switching from a focus on "shadow banking" to a consideration of the varieties of nonbank
intermediation reinforces the importance of assessing specific risks rather than merely
categorizing activities as either shadow banking or something else. In this way, the potential
over-inclusiveness for financial stability purposes of the tag "shadow banking" can be better
avoided. Even nonbank intermediaries that engage in lending to consumers or small
businesses are not monolithic, insofar as the sources of their funding - and thus attendant
run risks - may differ markedly.
On the other hand, financial stability risks are not limited to entities or activities that seem to
replicate the kind of lending conventionally associated with commercial banks. This is where
the potential under-inclusiveness of the shadow banking category arises. Here again,
though, it is important not to leap to the conclusion that where some risks do exist, they
should be addressed in a uniform manner. For example, some classes of asset managers,
such as bond funds that hold relatively illiquid assets while offering their investors the right to
withdraw funds on very short notice, may pose redemption risks. But intermediaries such as
many conventional mutual funds do not pose bank-like risks, since they generally are not
leveraged. So, if further analysis supports the conclusion that redemption risks are real, the
optimal regulatory response would surely not be one that treats all asset managers as
quasibanks that need to have capital and similar bank regulatory constraints.2
An emphasis on actual risks can lead to the conclusion that some nonbank financial entities
or activities do not pose material threats to financial stability at all. Pension funds, for
example, are surely an important form of intermediation. If, over time, they do not have
assets sufficient to meet their promises to plan participants, whether because they have
been underfunded in the traditional sense or because they have lost money through
illconsidered investments, hardship will undoubtedly follow. If enough pension plans fell short
of expectations, there might be macroeconomic consequences. And if they provide
shortterm funding in order to increase returns on the assets they need to keep liquid, they might
contribute to the risks assumed by other kinds of intermediaries. But, in themselves, they are
unlikely to pose financial stability risks. Similar reasoning would apply to traditional insurance
activities.
Even as the risks associated with specific forms of nonbank intermediation are evaluated, it
is important also to bear in mind the specific economic benefits of those activities. Nonbank
intermediaries can increase the diversity of the economy's capital providers. For example,
the creation and eventual proliferation of equity mutual funds offered a variety of savings
options to American households for which ownership of a diversified portfolio of equities is
either practically burdensome or financially impossible. This development posed a challenge
for the liability side of banks' balance sheets, as households reduced the share of their
savings in traditional bank deposits. But it is hard to argue that this challenge would have
merited limiting the availability of mutual funds.
Nonbank intermediaries can also provide credit to borrowers that are underserved or
unserved by traditional banks. It could be argued that one example of such nonbank activity
is online marketplace lending that uses new sources of data and new technologies to lower
the fixed costs of making credit decisions, rendering lending to some individuals and small
businesses more cost-effective. Of course, it matters a great deal whether this competition to
traditional banks arises because risks are genuinely lower or useful new products have been
created, on the one hand, or because well-grounded prudential or consumer regulations
have been successfully avoided, on the other.3
A key implication of the fact that the activities often grouped under the heading shadow
banking are not monolithic is that the level of a particular activity is less important than the
degree of vulnerability that it creates. Not all of what some might call shadow banking activity
represents a market failure that creates excessive risk to financial stability, and so it would be
wrong to assume that all shadow banking ought to be regulated to safeguard financial
stability. This view is reflected in the Global Shadow Banking Monitoring Report for 2015,
which has just been issued by the Financial Stability Board. The report begins by including all
activities that could arguably be included in the very broad category of shadow banking, but
then classifies these activities by economic function and risks. The result is about a
70 percent decrease in the amount of intermediation otherwise captured by the broader
definition.4
Thus, assessing whether regulation is appropriate for specific forms of nonbank
intermediation requires a balancing of the resulting increase in socially beneficial credit,
capital, or savings options against any associated increase in risks to the safety and stability
of the financial system as a whole. The chief relevant factors to consider include the extent of
reliance on maturity or liquidity transformation, the creation of cash equivalent assets, the
use of leverage, and the degree of interconnection with the traditional banking sector.
When growth in nonbank intermediation reflects a migration of traditional banking activities to
less-regulated entities, a number of similar considerations are relevant to an evaluation of the
costs and benefits of the migration and the potential need for a regulatory response. Here,
where the activity is probably quite bank-like, I am going to revert to the use of the term
shadow bank.
First, to what extent does the activity, as practiced by shadow banks, entail reliance on
leverage or on maturity or liquidity transformation that could lead to a bank-like creditor run
dynamic? Bank regulation is primarily aimed at preventing the occurrence of such
destabilizing runs or minimizing their ill effects, and so the need for bank-like regulation is
greater in the presence of material run risk.
Second, are banks still informally or indirectly at risk despite the migration to nonbank
entities? This could be the case if banks sponsor the shadow banks and implicitly or explicitly
provide them with a liquidity backstop or credit support, and it would call for greater
regulatory attention either to the shadow banks conducting the activity or to the banks'
connection with those shadow banks.
Third, is the activity at issue primarily migrating out of the most systemic banks - global
systemically important banking organizations (GSIBs) - or smaller banks? Migration of
activity out of GSIBs might on net be beneficial for financial stability because it would leave
the GSIBs less systemic, even if the activity migrates to less-regulated shadow banks,
though I would caution that an especially careful analysis would be needed before reaching
this conclusion.
In this regard, I would note that one way to limit the growth of shadow banking that simply
arbitrages bank regulation is to make sure that the regulated sector itself is not unnecessarily
burdened. This aim lies behind our efforts to tailor banking regulation by reference to the
risks posed to the economy and the financial system by banks of different sizes, scopes, and
business activities.
In addition, it suggests a couple of additional considerations for evaluating specific forms of
shadow banking. Here, though, the relevance of these considerations is for determining
whether to adjust banking regulation, as much as it is for determining whether regulation of
the shadow banks would be warranted. One such consideration is whether the activity is
high-risk, and whether banks have a good track record in addressing the attendant risks.
Migration may be of less concern where banks historically have done a poor job of managing
the risks of the activity. Another salient consideration is whether the activity at issue has
significant synergies with core banking activities. If so, then migration out of the traditional
banking sector could damage the efficiency of banks and increase their vulnerability.
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. If there is one lesson to be drawn from
the financial crisis, it is that the rapid withdrawal of funding by short-term credit providers can
lead to systemic problems as consequential as those associated with classic runs on
traditional banks.5 When financial intermediaries must rapidly liquidate a substantial amount
of longer-term assets that they can no longer fund, the impact can reverberate throughout
the financial system. The resulting declines in asset prices can trigger margin calls on other
investors, who themselves may need to de-lever by selling their own holdings, adding to the
fire sale-induced price impact on these, and potentially other, assets. In the worst case, the
result can be the kind of generalized asset price decline and liquidity freeze observed at the
height of the financial crisis.
The total amount of short-term wholesale funding within the financial system is lower today
than immediately before the crisis, but volumes are still large relative to the size of the
financial system. For example, nearly half of the liabilities of broker-dealers consist of
shortterm wholesale funding, an amount that is nearly the same as it was during the crisis.6
Numerous regulatory reforms have addressed the use of short-term wholesale funding by
prudentially regulated institutions. The Board has finalized the liquidity coverage ratio7 and is
developing the net stable funding ratio to diminish large banks' vulnerability to abrupt
changes in short-term wholesale markets. The Board's annual Comprehensive Liquidity
Analysis and Review provides an opportunity for supervisors to assess and, where
necessary to contain risks, require changes to the specific funding practices of large banking
organizations.8 Finally, in order to increase the resilience of firms that continue to use
significant amounts of such funding, we have also incorporated a measure of a firm's
reliance on short-term wholesale funding into the calibration of both the capital surcharge for
U.S. GSIBs and our proposed long-term debt requirement for those firms.9
These measures, applicable as they are only to prudentially regulated banking organizations,
do nothing to address the risks of short-term wholesale funding by nonbank intermediaries.
Indeed, constraints imposed on banking organizations may prompt more short-term
wholesale funding to migrate outside the regulated sector. In the past, bank backstops were
generally needed for shadow banks to obtain substantial amounts of such funding. But it is
not so far-fetched to think that, with time and sufficient economic incentive, the financial,
technological, and regulatory barriers to the disintermediation of prudentially regulated
banking firms could be overcome. Indeed, we have observed some investment funds
exploring the possibility of disintermediating dealers by lending cash against securities
collateral to other market participants. While it would be inadvisable to apply bank-style
regulation to all entities that make use of short-term wholesale funding, a degree of
consistent regulatory treatment is desirable to address bank-like risks in the shadow banking
sector and to forestall regulatory arbitrage.
The Board has advocated for international measures to forestall the development of highly
volatile funding structures outside the regulated sector. Consistent with this position, we will
be developing a regulation that would establish minimum haircuts for securities financing
transactions (SFTs) on a market-wide basis, rather than just for specific classes of market
participants. SFTs include repo, reverse repo, securities lending and borrowing, and
securities margin lending - transactions that are the lifeblood of many kinds of shadow
banks. SFTs are a key component of the healthy functioning of the securities market. But, in
the absence of sensible regulation, they also carry the potential for prompting the fire sale
dynamic described earlier. While the haircuts and other conditions associated with SFTs
today are considerably more conservative than during the period leading up to the crisis,
there is good reason to believe that this conservatism could be eroded as economic
conditions continue to improve and credit growth accelerates.
A system of numerical haircut floors for SFTs would require any entity that wants to borrow
against a security to post a minimum amount of excess margin to its lender, with the amount
varying depending on the asset class of the collateral. Like the minimum margin
requirements that U.S. regulators have imposed on derivatives contracts, numerical floors for
SFT haircuts would serve as a mechanism for limiting the build-up of leverage in the financial
system. They could also mitigate the risk to financial stability posed by pro-cyclical margin
calls during times of financial stress, since putting a regulatory floor under SFT haircuts
during good times would reduce the amount by which they would increase during periods of
stress.
Institutional considerations
While the analytics of shadow banking, or nonbank intermediation more generally, lean
toward a case-by-case balancing of risks and economic benefits, significant institutional
issues also need to be addressed. Today I will mention only two.
First is the issue of what form of regulation is appropriate once analysis suggests that a
response is needed. By authorizing the Financial Stability Oversight Council (FSOC) to
designate nonbanks as systemically important institutions, the Dodd-Frank Wall Street
Reform and Consumer Protection Act fills the gap that existed in the pre-crisis period, when
firms like Bear Stearns, Lehman Brothers, and AIG largely escaped the perimeter of
prudential regulation. Designation by FSOC places firms under the regulation and
supervision of the Federal Reserve Board. While the Board can shape the particulars of its
oversight to the nature of each designated firm, the statute requires liquidity standards, risk
management standards, resolution plans, and concentration limits, with the additional strong
presumption of capital standards.
As important as the designation authority is to preclude the Lehmans or AIGs of the future, it
is almost surely not the optimal regulatory approach for most activities that can be
characterized as shadow banking or that are conducted by nonbank intermediaries so as to
raise financial stability concerns. The vast majority of firms engaged in such activities will not
satisfy the statutory test for designation. In any case, it is unclear that all of the statutory
prudential requirements for designated firms would be necessary or appropriate in dealing
with the risks to financial stability posed by the activities of these firms. In many instances,
and especially where funding vulnerabilities are at the heart of a business model, it is the
activity itself that needs to be regulated in some way, whether there are a few large firms
involved or many smaller ones.
A tool that might be better targeted to actual risks, while avoiding unnecessary "bank-like"
regulation would be what I have previously termed "prudential market regulation" - that is, a
policy framework that builds on the traditional investor-protection and market-functioning
aims of market regulation by incorporating a system-wide financial stability perspective. This
approach would take into account such considerations as system-wide demands on liquidity
during stress periods and correlated risks that could exacerbate liquidity, redemption, or fire
sale pressures. The specific policies associated with prudential market regulation might be
transaction-specific or apply to certain kinds of business models.
One example of such a measure is the SFT minimum haircut idea I mentioned earlier.
Generally, though, prudential market regulation would be a tool more available to market
regulators, since it would apply to activities on a market or transactional basis. In her
important speech last year, Securities and Exchange Commission (SEC) Chair Mary Jo
White provided a roadmap for just such a regulatory approach for the asset management
industry.10 The SEC has since begun to develop that approach.11
The second institutional issue is the question of which regulators would make the
assessment and policy tradeoffs that I contemplate in addressing financial stability risks
associated with nonbank financial intermediation. The natural answer would be the regulator
with authority to act. While this may well be the best answer from a policy perspective, it
does raise some potential issues on its own. For example, if regulators with responsibility for
one sector believe that the failure of regulators with responsibility for another sector to act on
financial stability concerns is creating debilitating disadvantages for firms in the first sector,
they might be tempted to relax regulation on their firms, even though they might agree that
the best outcome would be to retain their existing regulations but have the other sector
subject to some constraints as well. This seems to me not a bad description of what
happened in banking for a good part of the three decades beginning in the mid-1970s, when
the banking agencies pursued a variety of deregulatory measures in part because they
believed that the franchise of commercial banking was being eroded by various capital
market activities that were not subject to appropriate prudential requirements.
Conclusion
The Financial Stability Board study to which I referred earlier notes that the growth of shadow
banking in the United States in recent years has been relatively modest. With the regulated
financial sector so much more resilient than in pre-crisis days, the financial system as a
whole is obviously safer. Moreover, much of the innovation occurring in lending and
payments arenas today carries the promise of genuinely increased efficiency, and does not
appear to be just an arbitrage against the stronger post-crisis regulatory regime.
But if history is any guide, the grace period we are now experiencing will not last forever.
New forms of intermediation may carry new risks, or older forms may acquire new risks as
they expand and adapt to new circumstances. If we are to pursue a policy of case-by-case
assessment that permits healthy forms of nonbank intermediation while protecting the
financial system, financial regulators will need to develop effective and supple mechanisms
for what I have termed prudential market regulation.