Repos and shadow banking system still need reform

While the new Financial Stability Oversight Council tries to identify and then supervise systemically important financial institutions, as required by the Dodd-Frank Act, two other important issues still need attention, said Federal Reserve Board member Daniel K. Tarullo in a March 31 speech at the 2011 Credit Markets Symposium held in Charlotte, North Carolina, by the Federal Resserve Bank of Richmond.

The two issues are: Regulation of capital flows in the shadow banking system, including the repurchase market, and studies on the usefulness to society of very large, complex financial institutions.

From the speech:

It is noteworthy that while the term “shadow banking system” has taken its place in the lexicon of policymakers alongside “systemic risk” and “financial stability,” comparatively little has been done to regulate the channels of capital flows in which one or both transacting parties lie outside the perimeter of prudentially supervised institutions.

This despite the often considerable degree of leverage and maturity transformation associated with many of these channels.

In part, the relative lack of reform directed at the shadow banking system is a result of the fact that it was substantially disrupted by the financial crisis, and that some of its more unstable parts have fortunately disappeared.

Yet there are certainly significant pieces that have survived and that serve important purposes in financial markets. I have already mentioned money market funds as one example.

Although many broker-dealers are parts of bank holding companies, the breadth and significance of the repo market suggest that it may be another.

Tarullo spoke about the repo market and potential reforms September 17, in his discussion of  Yale economists Gary Gorton and Andrew Metrick’s proposal for “Regulating the shadow banking system.” From that speech:

In the absence of the regulation and government backstop that have applied to the traditional banking system since the Depression, a run on assets in the entire repo market ensued. The resulting forced sale of assets into an illiquid market turned many illiquid institutions into insolvent ones.

The fallout has been such that, to this day, the amount of repo funding available for non-agency, mortgage-backed securities, commercial mortgage-backed securities, high-yield corporate bonds, and other instruments backed by assets with any degree of risk remains substantially below its pre-Lehman levels.

Tarullo concluded March 31:

Even when the crisis was at its apex, students of  history recognized that the momentum for reform of the financial system that was then so strong could fade quickly. Legislators and officials move on to other issues, as does the public. There is some reason to believe this waning of interest and support has  already occurred. The reform agenda that variously includes Basel III, administrative implementation of the Dodd-Frank Act, and other initiatives continues, to be sure.

 But, particularly with respect to the shadow financial system, there is much that remains to be done.