August 3, 2016

Financial Services Regulation

Federal Reserve Board Governor Tarullo Discusses Regulatory Approach to “Shadow Banking” and Stable Funding

Federal Reserve Board Governor Daniel Tarullo recently delivered a speech in which he warned of potential risks to financial stability due to so-called “shadow banking” activities and entities, focusing in particular on potential risks arising from the use of “runnable” short-term wholesale funding.1 Governor Tarullo argued that no regulatory regime to protect financial stability could be “deemed complete” without a “well-considered approach” to regulating certain short-term funding activities subject to runs, including funding activities conducted by “shadow banking” institutions that may not be subject to prudential regulation. He further suggested that developing and implementing this “well-considered” regulatory approach will require addressing five fundamental questions (discussed below) regarding its scope, structure, aims and possible consequences, some of which he suggested are not likely to be answered in the short term.

Without attempting a precise definition of “shadow banking,” Governor Tarullo identified runnable short- term wholesale funding as a subset of “shadow banking”-related activities and institutions that he believes are “most likely to pose risks to financial stability and to the economy more generally.” As the term “runnable” suggests, liabilities arising from these types of short-term funding transactions are more susceptible to runs during time of crisis.2 This, in turn, could lead to “fire sales” of the assets underlying, or serving as collateral for, short-term funding, potentially creating what he called a “classic adverse feedback loop.” Furthermore, Governor Tarullo questioned whether the very short-term nature of runnable funding may reduce the incentives of counterparties to evaluate those investments carefully, which could, in turn, lead to downward adjustments in asset prices only at the “moment at which negative information becomes so powerful that everyone wants out at once.”

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Although Governor Tarullo acknowledged that post-crisis regulatory reforms have resulted in lower levels of runnable funding, he stated this “does not necessarily mean they are at safe or optimal levels.” In addition, he noted that the risks of runnable funding may arise outside of prudentially regulated firms such as banks and bank holding companies and cautioned that “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.”

This concern about the impact of short-term wholesale funding in financial stability and its causative properties for the 2007-2009 financial crisis have been a central theme of Governor Tarullo’s remarks for some time. Similar concerns have been expressed by other Federal Reserve Governors.3 What is notable now is the focus on short-term wholesale funding by financial institutions outside the regulated banking sector. There have been a number of recent U.S. regulatory reforms that have sought to address the use of short-term wholesale funding by prudentially regulated institutions, but these have not generally been extended to other financial institutions. 4

Governor Tarullo also discussed the growing demand for “safe” assets among financial firms, pension funds, and foreign sovereigns and its potential impact on the role and risks of runnable funding, a theme he has also pursued in some of his prior remarks on this topic.5 He described “safe” assets as instruments that are both “reliable stores of value” and “readily available for use.” Governor Tarullo raised a key distinction between publicly created safe assets, such as currency, government-insured demand deposits, and obligations of highly creditworthy sovereigns, with “privately created” safe assets, which may not prove to be safe in periods of high stress, which could lead to runs on those assets.6 Governor Tarullo questioned whether the demand for putatively safe assets is driving the creation of runnable funding, which forms a key consideration in his analysis of the overarching issue.

The central part of the address comprised the five questions that, in Governor Tarullo’s view, must be answered in order to develop an effective regulatory regime to address the risks presented by runnable funding:

 First, Governor Tarullo outlined two broad alternatives for the scope of application and approach of a regulatory regime to address runnable funding. Governor Tarullo contrasted (i) “uniform regulation of users of runnable funding no matter what the characteristics of the market actors or their business models involved in the funding relationship” with (ii) a “continued reliance on a regulatory response tailored to different forms of financial intermediation and, perhaps, the relative market significance of the various actors.” Governor Tarullo acknowledged possible tradeoffs in these approaches: the first may minimize “at least one kind of regulatory arbitrage and the need for extensive and perhaps constant elaboration,” whereas the second may “allow more innovation in financial markets, particularly by non-established actors, and could well be more efficient.”  Second, which regulatory agency or agencies would be the appropriate regulators of runnable funding? Governor Tarullo acknowledged possible tradeoffs between, on the one hand, the “coherence of approach and linkage with other agency functions and expertise” and, on the other hand, “involvement of multiple agency perspectives and avoidance of too much concentration of authority in a single agency.”7

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 Third, “what form or forms would the regulation take?” Governor Tarullo provided a non-exhaustive list of possible responses with respect to the use of short-term wholesale funding: “outright prohibition, minimum margining requirements and practices, capital requirements and taxation.”  Fourth, “to what extent is the supply of short-term funding a response to a persistent demand for more safe assets?” Governor Tarullo expressed concern that, if the relationship between supply of short-term funding and demand for safe assets is “considerable,” then further regulation of currently used safe assets may lead to the creation of even riskier assets.  Fifth, to what extent should a comprehensive regulatory response to “shadow banking” and runnable funding include mechanisms for the creation of more “genuinely” safe assets? Governor Tarullo acknowledged that 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,” and “implicates some elements of monetary policy, as well as moral hazard issues and other recurring factors in financial regulation.”

Significantly, Governor Tarullo concluded his remarks by noting that “[s]ome of the ideas” on this topic “move in quite different directions” and questioned whether there could be answers in the “near term that can command a working agreement among policymakers,” thereby suggesting that, as a practical matter, the development and ultimate implementation of a comprehensive regulatory regime to address runnable short-term wholesale funding – applicable to both banking and non-banking entities – is likely to be a long-term endeavor, at least absent another financial crisis.

OBSERVATIONS AND IMPLICATIONS Governor Tarullo’s speech indicates that, although the ultimate structure, scope and timing of future regulation of “shadow banking” and runnable funding remain unclear at this point, the Federal Reserve (and Governor Tarullo in particular) continues to believe that the post-financial crisis regulatory reform efforts must include additional measures addressing the intersection of highly-regulated banking institutions and less regulated “shadow banking” entities and runnable funding. Further, the Federal Reserve (perhaps to be joined by other regulators) is considering wide-ranging, and perhaps unorthodox, approaches to the regulation of runnable funding, for example, by focusing on a defined universe of activities, transactions or markets, rather than individual institutions (which is the primary method in banking regulation).

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ENDNOTES 1 Daniel K. Tarullo, Member, Bd. of Govs. of the Fed. Reserve Sys., Opening Remarks at the Center for American Progress and Americans for Financial Reform Conference: Exploring Shadow Banking: Can the Nation Avoid the Next Crisis? (July 12, 2016), available at https://www.federalreserve.gov/newsevents/speech/tarullo20160712a.htm. 2 As a working definition of “runnable liabilities,” Governor Tarullo referenced the definition of “runnables” contained in Jack Bao, Josh David & Song Han, The Runnables, FEDS Notes (September 3, 2015), available at http://www.federalreserve.gov/econresdata/notes/feds- notes/2015/the-runnables-20150903.html. 3 For examples of remarks by Governor Tarullo and other Federal Reserve Governors on this topic, see, e.g., Stanley Fischer, Vice Chairman, Bd. of Govs. of the Fed. Reserve Sys., Financial Stability and Shadow Banks: What We Don’t Know Could Hurt Us, Remarks at “Financial Stability: Policy Analysis and Data Needs,” 2015 Financial Stability Conference (Dec. 3, 2015), available at https://www.federalreserve.gov/newsevents/speech/fischer20151203a.htm; Daniel K. Tarullo, Member, Bd. of Govs. of the Fed. Reserve Sys., Thinking Critically About Nonbank Financial Intermediation, Remarks at the Brookings Institution (Nov. 17, 2015), available at https://www.federalreserve.gov/newsevents/speech/tarullo20151117a.htm (hereinafter Tarullo, Thinking Critically); Oversight of Financial Stability and Data Security: Hearing Before the S. Comm. on Banking, Hous. and Urban Affairs on Examining Regulatory Efforts to Improve Financial Stability and Data Security Regulatory Standards, Updating the Finalization of the “Volcker Rule”, and Receiving a Progress Report on Other Rules Required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, 113th Cong. 37–44 (2014) (statement of Daniel K. Tarullo, Member, Bd. of Govs. of the Fed. Reserve Sys.); Daniel K. Tarullo, Member, Bd. of Govs. of the Fed. Reserve Sys., Shadow Banking and Systemic Risk Regulation, Remarks at the Americans for Financial Reform and Economic Policy Institute Conference (Nov. 22, 2013), available at http://www.federalreserve.gov/newsevents/speech/tarullo20131122a.htm; Daniel K. Tarullo, Member, Bd. of Govs. of the Fed. Reserve Sys., Evaluating Progress in Regulatory Reforms to Promote Financial Stability, Remarks at the Peterson Institute for International Economics (May 3, 2013), available at http://www.federalreserve.gov/newsevents/speech/tarullo20130503a.htm; Wall Street Reform: Oversight of Financial Stability and Consumer and Investor Protections: Hearing on Examining the Agencies’ Overall Implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act Before the S. Comm. on Banking, Hous. and Urban Affairs, 113th Cong. 41–45 (2013) (statement of Daniel K. Tarullo, Gov., Bd. of Govs. of the Fed. Reserve Sys.); Daniel K. Tarullo, Member, Bd. of Govs. of the Fed. Reserve Sys., Shadow Banking After the Financial Crisis, Remarks to the Federal Reserve Bank of San Francisco Conference on Challenges in Global Finance (June 12, 2012), available at http://www.federalreserve.gov/newsevents/speech/tarullo20120612a.htm (hereinafter Tarullo, Shadow Banking). For a more detailed discussion of Governor Tarullo’s May 3, 2013 remarks, see our memorandum to clients titled Bank Regulation: Federal Reserve Board Governor Tarullo Outlines Potential Regulatory Initiatives (May 10, 2013), available at https://www.sullcrom.com/siteFiles/Publications/SC_Publication_Federal_Reserve_Board_Gover nor_Tarullo_Outlines_Potential_Regulatory_Initiatives.pdf. 4 These recent regulatory reforms include the proposed establishment of a net stable funding ratio for large banks (see Net Stable Funding Ratio: Liquidity Risk Measurement Standards and Disclosure Requirements, 81 Fed. Reg. 35,124 (proposed June 1, 2016) (to be codified at 12 C.F.R. pts. 50, 249 & 329), the establishment of risk-based capital surcharges for global systemically important bank holding companies (G-SIBs) (see Regulatory Capital Rules: Implementation of Risk-Based Capital Surcharges for Global Systemically Important Bank Companies, 80 Fed. Reg. 49,082 (Aug. 14, 2015) (codified at 12 C.F.R. pts. 208 & 217)) and the implementation of a liquidity coverage ratio requirement for large banks (see Liquidity Coverage Ratio: Liquidity Risk Measurement Standards, 79 Fed. Reg. 61,440 (Oct. 10, 2014) (codified at 12 C.F.R. pts. 50, 249 & 329)). For example, as part of “Method 2” for determining the G-SIB -4- Financial Services Regulation August 3, 2016

ENDNOTES (CONTINUED) surcharge, a G-SIB must calculate its “short-term wholesale funding score,” a measure of the G- SIB’s reliance on short-term wholesale funding. See 12 C.F.R. § 217.406 (2016). For a discussion of the Board of Governors’ final equity surcharge rules for U.S. global systemically important banks, see our memorandum to clients titled Bank Capital Requirements: Federal Reserve Board Approves Final Common Equity Surcharge for U.S. Global Systemically Important Banks (July 29, 2015), available at https://www.sullcrom.com/siteFiles/Publications/SC_Publication_Bank_Capital_Requirements_7_ 29_2015.pdf. In addition, Governor Tarullo discussed recent regulatory initiatives related to short-term funding in Tarullo, Thinking Critically, supra note 3. 5 E.g., Tarullo, Thinking Critically, supra note 3. 6 For a more detailed elaboration of Governor’s Tarullo’s views on the relationship between “shadow banking” and the creation of safe assets, see Tarullo, Shadow Banking, supra note 3. In those remarks, Governor Tarullo described three types of instruments enjoying “tacit credit support” that “contributed importantly to systemic risk,” alongside possible regulatory strategies to address risks from these instruments: (i) money market funds, (ii) triparty repurchase agreements, and (iii) securities lending. In addition, Governor Tarullo also described risks arising from assets with explicit contractual provisions for liquidity support, such as asset-backed commercial paper. 7 Both regulators and banks may face particular challenges arising from multi-agency rulemakings or regulatory regimes. For example, for a discussion of the interagency coordination challenges posed by the Volcker Rule, which lacks a mechanism for banking organizations to seek coordinated guidance from the five agencies that have authority over its administration and enforcement, please see our memorandum to clients titled Volcker Rule: U.S. Agencies Approve Final Volcker Rule, Detailing Prohibitions and Compliance Regimes Applicable to Banking Entities Worldwide (Jan. 27, 2014), available at https://www.sullcrom.com/siteFiles/Publications/SC_Publication_Volcker_Rule.pdf.

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