Banking

Many of the regulatory reform efforts—including the recently announced Basel III capital rules and the Dodd-Frank Act—have been aimed at large, regulated banking institutions, noted Federal Reserve Gov. Daniel Tarullo in a Sept. 17 speech. While there have been some important changes to the regulation of the shadow banking system, "more will need to be done in this area," he said. In particular, gaps still remain in critical areas such as money-market mutual funds, securitization, and repurchase transactions, also known as repos.

Speaking at the Brookings Panel on Economic Activity in Washington, D.C., Gov. Tarullo commented on a paper titled "Regulating the Shadow Banking System." The paper, by Yale University economists Gary Gorton and Andrew Metrick, proposes a new framework for the largely unregulated parts of the financial system.

Addressing information assymetry
One of the key problems contributing to the breakdown in the repo market was that participants lacked important information about the collateral they held. To help address that problem, the authors of the paper suggest the creation of narrow funding banks (NFB), which would be restricted to purchasing asset-backed securities (ABS) and very safe financial instruments such as U.S. Treasury bonds. The NFBs would be directly regulated by the government and limited as to the type of ABS that they could purchase.

Further, only NFBs would be allowed to buy securitized assets. Tarullo said the paper proposes that "the consequent franchise value would compensate NFBs for the costs they incur because they can hold only high-quality securities, are subject to supervision and prudential requirements, and have to operate in a highly transparent fashion."

Avoiding undue restrictions
Tarullo pointed to some of the drawbacks associated with the authors' proposal. For one, it would "significantly restrict all asset-backed securitization," he said. He also questioned the desirability of restricting all but NFBs from purchasing ABS and also pointed to the "not trivial" changes in bank regulatory policy that it would require, such as having the Fed extend loans to the NFBs through the discount window.

While there are potential complications associated with the proposal, it will nonetheless continue to "shape our understanding of the role and risks of the shadow banking system, as well as … add a specific proposal to our menu of possible responses," said Tarullo.

September 28, 2010