Federal Reserve governor Daniel Tarullo used a speech in New York on Friday to call on academics to appraise post-financial crisis regulations and consider areas for improvement and alternatives, in particular addressing short-term funding dependencies and asset correlations.
He said there were numerous shortcomings in the way rules targeted primarily the banking system before the 2008 meltdown. Such areas should be "central to the further development and refinement of a regulatory system that takes account of the financial system as a whole," said Mr. Tarullo in remarks prepared for an event on financial regulation at Columbia University's Law School.
They "should be fertile ground for legal and economic scholarship." For example, he said from a purely microprudential perspective, the Basel II changes to capital requirements for large banks were "ill-conceived."
Mr. Tarullo called special attention to two things that concern him: the vulnerability of firms to runs in short-term wholesale funding, on which banks heavily rely, and the potential for rapid redemptions from investment funds. These can lead to firms being forced to hastily mark down the value of their assets and dump them in what became known in the crisis as asset "fire" sales.
"My own sense is that the greatest risks to financial stability lie in activities with vulnerability to funding runs and asset fire sales," he said. Short-term wholesale funding sources "may dry up quickly under stressed conditions," he said, and efforts to fight them will be all the more difficult where there is substantial leverage.
Another important area for scholars to research are channels of non-bank capital that have arisen since the financial crisis. The hallmarks of the Fed's postcrisis response are tailored stress testing, resolution planning, redesigned capital requirements on banks and the addition of liquidity rules, but the "sometimes nonexistent" rule set for intermediaries operating outside the traditional banking system, now called shadow banks, was worrisome.
"While the extent of shadow banking has significantly diminished since the crisis, there is good reason to believe that it will grow in the future," said Mr. Tarullo. "Indeed, the very rigor of new regulations applicable to firms within the prudential perimeter may well incentivize more innovation outside that perimeter."
He said some of those firms may shake up traditional banking activities such as payments and suggested that some of their efforts may have far reaching effects, including the potential for a '"shadow payments system" at the retail level.
Defining shadow banking is challenging, and he said efforts to date risk substantial over-inclusion, or under-inclusion. The 2008 crisis was not a bank solvency crisis, but a financial crisis on account of the spectacular crises at American International Group and Lehman Brothers Holdings Inc., both non-traditional banks, he said.
"The whole concept of runnable liabilities-whether uninsured deposits, repo, commercial paper or other forms-was left largely untouched, even for commercial banks, much less for broker-dealers like Lehman Brothers or insurance holding companies like AIG," said Mr. Tarullo.
As regulators primarily target firms considered to have large enough footprints that they could destabilize the banking system, Mr. Tarullo said there was a "good argument for a less-demanding regime for smaller institutions whose contribution to systemic contagion would almost surely be somewhere between modest and inconsequential."
In September, the Fed proposed easing "stress-test" requirements for banks with less than $250 billion in assets, providing potential relief for U.S. regional banks.
In a question-and-answer session following the speech, Mr. Tarullo said bank capital levels were being rethought because they are a "lagging indicator" of a firm's financial health; that's why firms also need other identifiable instruments that "won't have been eroded in the run-up to a stressed period." He said the data show that "what looks like a nice capital position" at a bank can often "accelerate dramatically" before it fails.
Mr. Tarullo's call on teachers and scholars to do more work in these policy areas is fitting: Before joining the Fed's board of governors in 2009, he was a law professor at Georgetown University. He said if he were to teach on financial regulation again, the course he taught in the fall 2008 semester would have to "differ markedly." An emphasis in studying the liability side of the balance sheet, he said, was crucial.
Earlier this year, The Wall Street Journal called Mr. Tarullo the most "powerful man in banking."
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