Daniel K Tarullo: Opening remarks on the theme of shadow banking
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Center for American Progress and Americans for Financial Reform
Conference, Washington DC, 12 July 2016.
* * *
Having been given the privilege of opening this conference, let me start at the very beginning
with the term "shadow banking." The very phrase evokes the sense of something hidden,
furtive even - a sort of film noir backdrop for extending credit, in contrast to the well-lit setting
of the local insured depository institution. In the pre-crisis years, there did indeed develop
modes of financial intermediation in which certain features of a counterparty relationship
were, if not quite obscured, then at least ambiguous, and thus "shadowy." Most notable were
arrangements in which guarantees of capital preservation or liquidity provision were
understood to exist and to have been previously honored, even in the absence of contractual
obligations for those guarantees. But as asset values were falling to points unknown, the
withdrawal of many of these implicit guarantees by financial entities that were themselves
under stress amplified the growing liquidity crunch.
Damaging as these arrangements were, however, they do not define the range of issues
associated with the term shadow banking. A broader definition would embrace all forms of
lending outside of prudentially regulated institutions. While such a definition might be a useful
starting point for purposes of consumer protection, for example, it seems both over- and
under-inclusive for purposes of regulation to protect financial stability and the resilience of
the economy as a whole. There are certainly forms of nonbank lending that do not raise
prudential concerns. On the other hand, financial stability concerns can arise where credit
extension is only indirectly involved, as might be the case with certain bond funds, or where
credit is not involved at all, as might be the case with firms writing large amounts of variable
annuities with minimum return guarantees.
Rather than dwell on definitions, much less attempt to develop a taxonomy of shadow
banking, I think it more productive to focus on the characteristics of shadow banking-related
financial activities and institutions that are most likely to pose risks to financial stability and to
the economy more generally.1 Front and center among these risks is that of runnable
liabilities.2 As has been frequently observed, the recent financial crisis began, like most
banking crises, with a run on short-term liabilities by investors who had come to doubt the
value of the assets they were funding through various kinds of financial intermediaries. The
difference, of course, was that the run was not principally on depository institutions, as in the
1930s, but on asset-backed commercial paper programs, broker-dealers, money market
1
Some of the issues mentioned in these brief opening remarks are addressed at greater length in Daniel K.
Tarullo (2015), "Thinking Critically about Nonbank Financial Intermediaries," remarks at the Brookings
Institution, Washington, November 17. Return to text
2
A working definition of runnable liabilities is provided by Jack Bao, Josh David, and Song Han in "The
Runnables," FEDS Notes, September 3, 2015, www.federalreserve.gov/econresdata/notes/feds-
notes/2015/the-runnables-20150903.html:
We define "runnables" as "pay-on-demand" transactions which embed defaultable promises made by private
agents or state and local governments without explicit insurance from the federal government. A transaction is
considered "pay-on-demand" if its term to maturity is short or the claimholder of the long-term debt has a put
option that can be exercised on short notice. In general, the pay-on-demand feature implies that in the event
of stress - caused by credit-risk concerns, large swings in short-term interest rates, or deteriorations in market
liquidity - investors may exhibit bank-run-like behavior by redeeming their shares, unwinding their
transactions, or deciding not to roll over their positions.
funds, and other intermediaries that were heavily dependent on short-term wholesale
funding.
Lacking enough liquidity to repay all the counterparties who declined to roll over their
investments, these intermediaries were forced into fire sales that further depressed asset
prices, thereby reducing the values of assets held by many other intermediaries, raising
margin calls, and leading to still more asset sales. Those financial market actors who did
have excess liquidity tended to horde it, in light of their uncertainty as to whether their
balance sheets might come under greater stress and their reluctance to catch the proverbial
falling knife by purchasing assets whose prices were plummeting with no obvious floor.
Runs and panics are the defining characteristic of a financial crisis, transforming debt
problems that might themselves have produced a drag on the economy into a classic
adverse feedback loop with more devastating consequences. It is important to note that the
short-term funding or immediately redeemable investments that can run when a shock hits
are likely to have contributed to the vulnerability of relevant asset classes to those shocks.
The very short-term nature of the transaction reduces the incentives of counterparties to
evaluate carefully the loan or investment they are making. If you can refuse to roll over your
repo tomorrow, why be too concerned about whether the underlying collateral may prove to
be overvalued a few months later? Consequently, funds may flow into asset classes with less
sensitivity to information relevant to the value of the assets, driving asset values up and
lending standards down, until the moment at which negative information becomes so
powerful that everyone wants out at once.
Thus, in deciding where - from a prudential viewpoint - to concentrate analysis and policy
initiatives within the broad universe of activities that can be described by the term shadow
banking, it seems to me that the presence of runnable funding is the key, though perhaps not
the only consideration.3 To be sure, this kind of funding remains at levels well below those
prevailing before the crisis, as many of the more damaging mechanisms of that period - such
as the infamous structured investment vehicles (SIVs) - have disappeared. Moreover, the
largest broker-dealers, both domestic and foreign, that were so dependent on short-term
funding in the pre-crisis period have now either converted to, or been absorbed into, bank
holding companies subject to prudential capital and liquidity regulation. New regulatory
requirements have placed some constraints on the relationships between shadow banking
and prudentially regulated banking organizations. The Securities and Exchange Commission
has taken some steps to strengthen its regulation of money market funds and other asset
managers whose business models involve substantial amounts of liquidity transformation.
But just because the levels of runnable funding are significantly lower than before the crisis
does not necessarily mean they are at safe or optimal levels. And it seems quite reasonable
to expect that new forms of financial intermediation based substantially on runnable funding
could develop in the future. As liquidity standards, stress testing, and resolution planning
evolve, regulators will continue to work on this issue with prudentially regulated firms. But the
conditions for destructive runs that threaten financial stability could exist even where no
institutions that might be perceived as too-big-to-fail are immediately involved. So I continue
to believe that the post-crisis work to create a solid regime to protect financial stability cannot
be deemed complete without a well-considered approach to regulating runnable funding
outside, as well as inside, the regulatory perimeter.
Again, taking advantage of my spot at the opening of the conference, let me note some key
questions to be answered in fashioning such an approach.
First, to what degree will it rely on uniform regulation of users of runnable funding no matter
what the characteristics of the market actors and business models involved in the funding
relationship? The alternative would be continued reliance on a regulatory response tailored
to different forms of financial intermediation and, perhaps, the relative market significance of
the various actors. The advantages of the former are that it minimizes at least one kind of
regulatory arbitrage and the need for extensive and perhaps constant elaboration. The
advantages of the latter are that it might allow more innovation in financial markets,
particularly by non-established actors, and could well be more efficient.
Second, what agency or agencies would be the appropriate regulators? The answer to this
question would obviously be related to the answer to the first, though some different
considerations do apply. The choice of a single agency versus multiple agencies involves the
well-known tradeoff between relative coherence of approach and linkage with other agency
functions and expertise, on the one hand, versus involvement of multiple agency
perspectives and avoidance of too much concentration of authority in a single agency, on the
other.
Third, what form or forms would the regulation take? A non-exhaustive list of possibilities
includes outright prohibition, minimum margining requirements and practices, capital
requirements, and taxation. Again, the answer to this question may both affect, and be
affected by, the considerations implicated by the first two.
My fourth and fifth questions are quite different from the first three, and I will defer for a
moment actually stating them, in order to provide some context. To this point, my remarks
have reflected the familiar perspective that identifies a set of market practices carrying
significant risk of negative externalities - in this case, with some collective action problems
thrown in - and then asks how to fashion an appropriate regulatory response. An additional,
important consideration here is that at least some of the short-term funding instruments
implicated in this analysis respond not just to the desire of their creators for funding that is
cheaper than equity or longer-term debt, but also to the demand of many entities - from
other financial firms to pension funds to foreign sovereigns - for "safe" assets. As the term
implies, these assets must be reliable stores of value that are readily available for use -
features sometimes characterized as "money-like."
Obvious forms of safe assets include currency itself (though that has its well-known
limitations for large-value transacting), government-insured demand deposits, and
obligations of highly creditworthy sovereigns such as U.S. Treasuries. But numerous
commentators have observed that, for a variety of reasons, demand for safe assets in recent
decades has been growing substantially faster than the supply of these most obvious and
truly safe forms of government-backed assets.4 In these circumstances, they note, the
demand for privately created safe assets has increased. One problem, of course, is that the
privately created assets may be treated as safe in normal times but, as seen in 2008, not in
periods of high stress. Hence the phenomenon of runs. Another consideration is that the
private creation of putatively safe assets is, at least to some degree, the creation of money
outside of the operations of central banks or of depository institutions subject to reserve
requirements and other regulations.
With that background, here are my last two questions. Fourth, as a factual matter, to what
extent is the supply of short-term funding a response to a persistent demand for more safe
assets? If the answer is "considerable," then further constraints on the creation of currently
used safe assets might result in further financial engineering in search of assets that
approximate the attributes of truly safe assets even less well, but are the best the demanders
of these assets can do.
And so, fifth, to what extent does a comprehensive regulatory approach to shadow banking
need to include mechanisms - involving the government directly or indirectly - for the
creation of more genuinely safe assets, as well as limitations on the runnable varieties that
can precipitate or exacerbate financial stress? This is clearly a big question that runs well
beyond the scope of even the most far-reaching financial regulatory debates and initiatives of
the post-crisis period. It implicates some elements of monetary policy, as well as moral
hazard issues and other recurring factors in financial regulation.
Consideration of the question of whether government policy should seek to create, or create
the conditions for private creation of, safe assets has already produced numerous interesting
analyses and proposals. Some of these ideas move in quite different directions, perhaps an
indication that it is not realistic to think we will have an answer in the near term that can
command a working agreement among policymakers.5 But, even if that is so, the implications
of these questions must be confronted when devising policy responses to the very real risks
of runnable liabilities.
There are the questions. Now I bring the opening of the conference to a close, and look
forward to hearing what answers emerge during the rest of the day.