Why it matters

In addressing the impact of the so-called shadow banking industry with the financial markets, Daniel K. Tarullo, a member of the Board of Governors of the Federal Reserve System, advocated for regulation of the industry based on the nature of the financial activity involved. The "constantly changing and largely unrelated set of intermediation activities pursued by very different types of financial market actors," as Tarullo defined the industry, requires regulation based on the specific benefits and risks of the given activity, and not on whether the activity looks like something banks traditionally do, he recently told an audience at the Brookings Institution. Nonbank lenders may be better positioned to offer financial services to consumers that banks cannot, while other nonbank intermediaries can expand the availability of capital—benefits that may outweigh some of the risks, Tarullo explained. Considering the possibility of regulation, he considered what form it should take and which regulator should make the necessary risk-benefit analysis.

Detailed discussion

Should the shadow banking industry be regulated? And if so, how? One of the lessons from the financial crisis was the major vulnerability of the shadow banking system and the extent to which such activities were not subject to prudential regulations integrated with the regulated banking sector, Tarullo explained. While many steps have been taken to address the causes of the financial crisis and specific forms of shadow banking. "[T]he answer to the question … of whether we are safer than before the crisis is easy to answer in the affirmative," Tarullo told his audience. "Of course, 'safer' does not necessarily mean safe enough."

Although the circumstances are different, the possibility of other systemic or risk related problems with shadow banking remains. Defining the industry as "a constantly changing and largely unrelated set of intermediation activities pursued by very different types of financial market actors," Tarullo said the very rigor of post-crisis reforms may create new opportunities within the shadow banking industry.

And yet, he appears to caution against moving too quickly or drastically against the industry, advocating for a balanced perspective. To do that, he emphasized three points, beginning with the premise that "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." Also, "notwithstanding the manifold nature of nonbank intermediation, it remains useful to identify the relationship of specific activities to the prudentially regulated sector," and "institutional considerations will be important in defining the potential, and actual, regulatory responses to nonbank intermediation."

Tarullo acknowledged misgivings about the use of the term "shadow banking," contending that it is both over- and under-inclusive of actual risks to financial stability. Recognizing the varieties of nonbank intermediation "reinforces the importance of assessing specific risks rather than merely categorizing activities as either shadow banking or something else," he explained.

As the risks associated with specific forms of nonbank intermediation are evaluated, he reiterated the importance of bearing in mind the specific economic benefit of the activities, such as increasing the diversity of the economy's capital providers and providing 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," Tarullo said. "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."

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," Tarullo said. "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."

He noted that when nonbank intermediation reflects a migration of traditional banking activities to less regulated entities, additional considerations may be necessary. Does the activity entail reliance on leverage or maturity or liquidity transformation that could lead to a bank-like creditor-run dynamic, are banks still informally or indirectly at risk, and is the activity migrating from systemic or smaller banks are all relevant questions, Tarullo told listeners.

If the activity at issue has "significant synergies" with core banking activities, migration out of the traditional banking sector could damage the efficiency of banks and increase their vulnerability, he warned. Alternatively, migration may be of less concern where banks have historically done a poor job of managing the risks of the activity.

Tarullo added that although he favors the specific risk and benefit analysis for nonbank intermediaries, he also believes "that the greatest risks to financial stability are the funding runs and asset fire sales associated with reliance on short-term wholesale funding." Though the total amount of short-term wholesale funding is lower today than precrisis, the volume is still large relative to the size of the financial system.

Measures by the Board to address the issue—such as the finalized liquidity coverage ratio—do nothing to address the risks of short-term wholesale funding by nonbank intermediaries, he said. "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," Tarullo said. Consistent with that position, he said the Board 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."

Finally, Tarullo turned to two institutional considerations: what form of regulation is appropriate once analysis suggests that a response is needed and the question of which regulators would make the assessment and policy decisions.

Designation by the Financial Stability Oversight Council of nonbanks as systemically important institutions places some firms under the supervision of the Federal Reserve Board, he noted. However, with the "vast majority" of firms engaged in such activities not satisfying the statutory test for designation, Tarullo pushed for a tool targeted to actual risks: prudential market regulation.

"[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" 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," he said, using the example of SFT minimum haircuts.

As for which regulator should make the call, the natural answer would be "the regulator with authority to act," Tarullo said, although that raises potential issues of regulators relaxing regulations for their firms to create disadvantages for firms in a different sector.

While the growth of shadow banking in recent years has been relatively modest, "the grace period we are now experiencing may not last forever," Tarullo concluded. "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."

To read Tarullo's prepared remarks, click here.