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Governor Tarullo Delivers Speech Regarding Shadow Banking and Systemic Risk Regulation

Federal Reserve Governor Daniel K. Tarullo gave a speech at the Americans for Financial Reform and Economic Policy Institute Conference discussing the "shadow banking system" and its impact on systemic risk regulation. The speech focused in particular on the issues presented by short-term wholesale funding, and especially the pre-crisis rise in the creation of assets that were thought to be "cash equivalents." Governor Tarullo described the short-term wholesale funding runs that began in 2007 as events that had a "cascading, self-reinforcing quality" that directly exacerbated financial stress, comparing those runs to the periodic deposit runs on banks that took place before the advent of federal deposit insurance. He acknowledged that the similarities between deposit runs and short-term wholesale funding runs have suggested, at least to some, that policy responses should be similar. Nevertheless, he argued that a regulatory approach requiring market actors to internalize the social costs of short-term wholesale funding would be preferable, and that a more comprehensive reform agenda is needed.

Governor Tarullo went on to discuss specific vulnerabilities presented by the shadow banking system, such as the difficulty in measuring the amount of "implicit support" that regulated institutions provide to shadow banking activities, and the concomitant difficulty in crafting an appropriate regulatory response. He surveyed two types of policy options to be considered in response to the vulnerabilities inherent in firms with large amounts of short-term wholesale funding: the first, to tie capital and liquidity standards together by requiring higher levels of capital for large firms that substantially rely on short-term wholesale funding, and the second, to address the macroprudential concerns arising from large matched books of securities financing transactions. He noted that these options would be directly applicable only to firms already subject to prudential regulation, and for that reason, those options would have to be supplemented by regulatory tools that could be applied on a market-wide basis; such regulation would focus on particular kinds of transactions, rather than the nature of the firm engaging in those transactions.

See: Governor Tarullo's Speech.

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