Fed Governor Tarullo: Increased oversight of shadow banking necessary for stability

Daniel Tarullo

Daniel Tarullo

Federal Reserve Governor Daniel K. Tarullo said during a hearing last week that as regulators shore up oversight of the regulated banking system, it will become increasingly important to ramp up oversight of the shadow banking system.

“While strengthening the regulation and improving the resolvability of banking firms is of paramount importance, we should not forget that one of the key elements of the recent financial crisis was the precipitous unwinding of large amounts of short-term wholesale funding that had been made available to highly leveraged and maturity-transforming financial firms, many of which were clearly outside of the traditional banking sector,” Tarullo said in prepared testimony. “Nonbank financial intermediaries can provide substantial benefits to an economy, but a complete financial reform program must address financial stability risks that emanate from the shadow banking system. Particularly as we tighten the oversight of the regulated banking system, it will become more and more essential that we are able to monitor and constrain the build-up of systemic risks in the nonbank financial sector.”

Tarullo noted the authority given to the Financial Stability Oversight Council to “bring systemically important financial firms that are not already bank holding companies within the perimeter of Federal Reserve supervision and regulation.”

Last month, the FSOC proposed designations for nonbank financial firms, and earlier last week confirmed the proposed designations for two of the firms. Tarullo said, however, that short-term wholesale funding markets and certain classes of nonbank firms pose a threat to financial stability.

“Many of the key problems related to shadow banking and their potential solutions are still being debated domestically and internationally, but some of the necessary steps are already clear,” Tarullo said.

In order to address the problems posed by the shadow banking industry, Tarullo said regulators need to increase the industry’s transparency, reduce the risk of runs on money market mutual funds and ensure that initiatives designed to bolster the triparty repo market are successfully implemented.

“Completing these three reforms would represent a strong start to the job of reducing systemic risk in the short-term wholesale funding markets that are key to the functioning of securities markets,” Tarullo said.

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