Bloomberg News

Fed’s Tarullo Concerned Momentum for Regulation Will Wane

May 02, 2012

Federal Reserve Governor Daniel Tarullo said regulators must press on with an overhaul of financial regulation, focusing especially on shadow banking and too-big-to-fail institutions.

“My concern has been that the momentum generated during the crisis will wane or be redirected to other issues before reforms have been completed,” Tarullo said today in a speech in New York. It’s “sobering” that “so much remains to be done” four years after the collapse of Bear Stearns Cos., he said.

U.S. banks have complained that tougher oversight enacted since the financial crisis, such as stricter capital standards, has forced them to impose tighter lending standards. Tarullo, the governor in charge of supervision, plans to meet today with chief executive officers of the largest U.S. banks, including JPMorgan Chase & Co. (JPM:US), to discuss their concerns, according to four people familiar with the meeting.

Bankers have complained the stress tests completed in March lack transparency and underestimate their underwriting abilities, resulting in higher losses on some asset classes than the lenders projected.

“If we do not complete rigorous implementation of this complementary set of reforms, we will have lost the opportunity to reverse the pre-crisis trajectory of increasing too-big-to- fail risks,” Tarullo said.

‘Basic Outlines’

Responding to audience questions, Tarullo said that while it will probably be “several years before the full implementation of the major sets of reforms we’re talking about would actually be in place,” it is “reasonable” to “expect that sometime next year the basic outlines” of those rules will be clear.

As part of those reforms, it is “widely agreed” that liquidity requirements are needed, such as the liquidity coverage ratio proposed by the Basel Committee on Banking Supervision, Tarullo said. The assumptions used to calculate the ratio should reflect “actual experience during the crisis,” he said, adding the ratio overstates the liquidity risks of commercial banking.

Regulators should also consider adapting that proposal to make it “credibly clear that ordinary minimum liquidity levels need not be maintained in the midst of a crisis,” he said. Otherwise, it “might have the unintended effect of exacerbating a period of stress by forcing liquidity hoarding,” he said.

Fragility of System

While regulators have come up with a “well-defined set” of rules to address too big-to-fail, “the same cannot be said” for the fragility of the shadow banking system, Tarullo said. The need for changes in money-market funds and the market for repurchase agreements “is compelling,” he said.

“In periods of high stress, with substantial uncertainty as to the value of important asset classes, questions about liquidity and solvency could still arise, even with respect to well-regulated institutions,” Tarullo said. “It cannot be overemphasized that this systemic effect can materialize even if no firms were individually considered too-big-to-fail.”

In February, the New York Fed said it would increase oversight of efforts to protect the market for borrowing and lending securities after an industry group, the Tri-Party Repo Infrastructure Task Force, said more time was needed for it to meet goals for reducing risk.

“An industry initiative to address the issue led to some important operational improvements to the tri-party market, but, to be frank, fell short of dealing comprehensively with this problem,” Tarullo said. “So it now falls to the regulatory agencies to take appropriate regulatory and supervisory measures to mitigate these and other risks.”

Short-Term Funding

Repos are transactions used by the Fed’s primary dealers for short-term funding and typically involve the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to the lender, typically a money-market mutual fund.

In a tri-party arrangement, a third party, one of two clearing banks, functions as the agent for the transaction and holds the security as collateral.

Tarullo said in response to an audience question about the future of the mortgage market that “we’re not likely to see the restart of a sustainable, well-developed, well-functioning, private securitization market until there’s more clarity on what role” government-sponsored enterprises are going to play.

Clarifying regulations is also necessary so that “private market actors” can also judge which securitization and financing activities will be profitable, he said.

“It’s going to be hard to see more than moderate increases” in securitization by private firms, he said.

To contact the reporters on this story: Caroline Salas Gage in New York at salas1@bloomberg.net

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net


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