Board of Governors of the Federal Reserve System Governor Daniel K. Tarullo discussed the regulation of financial activities related to shadow banking. He focused on the risk of “runnable liabilities,” which are defined as short-term, “pay-on-demand” transactions that are not insured explicitly by the federal government (e.g., repo transactions). According to the “working definition” cited by Governor Tarullo, these transactions are considered “runnable” because their pay-on-demand feature implies that – in the event of stress caused by credit-risk concerns, wide swings in short-term interest rates, or deteriorations in market liquidity – investors may behave as though they are on bank runs: they might redeem shares, unwind transactions, or decide not to roll over positions.
In order to fashion a regulatory approach to these transactions, Governor Tarullo suggested, the following “key questions” should be answered:
- To what extent will the regulation apply uniformly to users of runnable funding, no matter what the characteristics of market actors and business models involved in the funding relationship might be?
- What agency or agencies would be the appropriate regulators?
- What form(s) would the regulation take (i.e., would it use methods such as outright prohibition, minimum margining requirements and practices, capital requirements, and taxation)?
- To what extent is the supply of short-term funding a response to the persistent demand for safer assets?
- To what extent must a comprehensive regulatory approach to shadow banking include mechanisms, which involve the government directly or indirectly, for the creation of genuinely safer assets, as well as limitations on runnable varieties that can precipitate or exacerbate financial stress?
Governor Tarullo emphasized that this fifth and final question “implicates some elements of monetary policy, as well as moral hazard issues and other recurring factors in financial regulation.”
Governor Tarullo delivered his remarks before the Center for American Progress and Americans for Financial Reform Conference in Washington, D.C.
Lofchie Comment: Governor Tarullo’s argument seems to be that, in one way or another, every participant in the financial markets is a bank; it is either regulated or shifts in the shadows. When he asks which agency should regulate all of these banks and shadow banks, the question practically answers itself: who better than the Federal Reserve?