Fed Governor Tarullo Beats the Drum on Shadow Banking: We Break Down his Speech for Clues on Future Regulatory Action

Federal Reserve Governor Tarullo gave a speech on June 12th entitled “Shadow Banking After the Financial Crisis”. It got a lot of press, but not much analysis past the sound bites. That said, Tarullo certainly is taking Shadow Banking seriously. We’ll take a look at some of the interesting bits of his speech and put our two cents in.

Tarullo sets up the speech by noting that post-crisis, there are two reforms agendas: Too Big To Fail (TBTF) and Shadow Banking. The latter has not been adequately addressed. He defines Shadow Banking as “credit intermediation involving leverage and maturity transformation that is partly or wholly outside the traditional banking system” and the “creation of assets that are thought to be safe, short-term, and liquid, and as such, ‘cash equivalents’ similar to insured deposits in the commercial banking system.” This is important as it includes money market funds fully under the Shadow Banking umbrella; this is not the same definition that we used to evaluate Shadow Banking in our April 2012 report on the matter (a link is here). It is also not the same definition used by the Financial Stability Board in their big October 2011 report setting up the regulatory investigation (a link is here)

Tarullo notes that about 80% of the increase in US Treasury and Agency securities issued in the four years before the crisis was bought by foreigners investing their trade surpluses. This surge in investment may have crowded out some investors of “safe assets”, pushing them into investing in what looked like cash equivalents created by the shadow banking system. The other source of demand was non-financials, who looked to invest larger cash cushions post-Enron. If we were being cheeky, we would wonder if the Fed Governor just blamed the Chinese and Enron for the financial crisis.

The demand was met with new supply. One example was ABCP issued by SIVs in a huge maturity transformation scheme – buy long complicated assets, issue short vanilla’ish liabilities. Many of the SIV’s bank sponsors were foreign financials, creating an extra layer of risk when the ABCP demand vaporized and natural dollar funding, which had to come from somewhere (read: the bank sponsors), turned out to be a very shallow pool. US and foreign banks did another own version of the trade when they bought the super senior tranches of RMBS and other structured assets, bought CDS protection, financed the paper in tri-party repo, and figured taking the funding spread vs. the curve + insured instrument credit risk was a “no brainer”. I think we know all this already.

Tarullo got into the meat of the speech when he focuses on money market funds, repo, and securities lending and regulatory responses.

  • He reminds us that between 1989 and 2003 sponsors had voluntarily supported their money market funds when they “broke the buck” no less than 100 times. The cost to prop the funds up was less than the perceived damage to their franchise should the funds pass the losses on to shareholders. That changed when the Reserve Primary Fund opted not to dig into their own pockets to make up (as Tarullo put it) the “relatively small losses”.
  • The second area Tarullo addresses is tri-party repo and the risk on the “unwind/rewind”. Our readers will be well acquainted with this risk. The systemic risk taken on by the clearing agents has been a huge focus at the Fed, as has been their impatience about getting it fixed once and for all.
  • Finally, Tarullo looks at sec lending. Collateral reinvestment losses have been written about ad nauseam. He does include in a nice footnote that AIG has been often held up as the poster child of bad sec lending practices, including flawed cash reinvest. The footnote says AIGs issues were “more specific and fundamental” than just questionable cash reinvest.

Where does the speech differ from the history lessons everyone has heard for a couple years? Tarullo draws some common themes: he says that there were expectations among investors that money fund sponsors would prop up funds if they “broke the buck”, even though there were no legal obligations to do so….until they didn’t. He says that cash investors in tri-party repo expected the clearing banks to execute the morning unwind religiously, even if there were indications that one of the cash borrowers might not be able to roll over or pay off their borrowings…until they didn’t. Tarullo says that while sec lenders provided indemnification to their lending clients to return the assets they lent, and there was no equivalent obligation to make whole on the cash reinvest side, many beneficial owners thought they were protected on cash reinvest too…until, well you get it.  In other words, “safe assets” weren’t all they were cracked up to be and the investors didn’t read the documents.  

What to do now? In repo, Tarullo asks for greater transparency, especially in bilateral trades where there is no accurate volume data (we agree…we’ve looked). A trade repository is a good idea. On money funds, he is advocating for the same structural reform as put forth by the SEC including a floating NAV, capital requirements, and gating mechanisms. We are fine with the floating NAV (it removes the fiction of the $1 stable price) and maybe the capital requirements but think that gates on investor withdrawals would lead to a mass exodus from money funds. Finally, Tarullo bangs the drum for fixing tri-party unwind/rewind. If the clearers can’t get this done quickly, does he have a government-sponsored utility in mind?

The speech didn’t present anything really new, although it did bring some context that was interesting. However by saying “…But regulators need not wait for the full resolution of contested issues or the development of comprehensive alternatives, nor would it be prudent for them to do so. We should act now to address some obvious sources of vulnerability in the financial system…” it is clear their patience is running paper thin.  

A link to the speech text is here.

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