More must be done on shadow banking -Fed's Tarullo

Wed May 2, 2012 8:00am EDT

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May 2 (Reuters) - U.S. regulators should take steps soon to strengthen government oversight of money market funds and short-term bank funding markets so that the "shadow" banking system can be better policed, a top Federal Reserve official said on Wednesday.

Fed Governor Daniel Tarullo said that while regulators have taken many steps since the 2007-2009 financial crisis to better regulate banks once considered "too big to fail," less work has been done to make funding markets outside the traditional banking system less risky.

"Although some elements of pre-crisis shadow banking are probably gone forever, others persist," Tarullo said in remarks prepared to be delivered at the Council on Foreign Relations in New York. "Moreover, as time passes, memories fade, and the financial system normalizes, it seems likely that new forms of shadow banking will emerge."

Tarullo singled out money market and tri-party repo markets as areas where action should be taken in the "short-run."

Tarullo is the Fed's leading voice on regulation and his public support for stricter oversight gives weight to efforts by Securities and Exchange Commission Chairman Mary Schapiro to introduce new regulations for money markets.

Schapiro has so far been unsuccessful in gaining enough support within the commission for tougher reforms for the $2.6 trillion money market fund industry.

She has said further steps are needed to stop potential problems at money funds from spreading throughout the financial system, as happened in the 2008 credit crisis when the Reserve Primary Fund "broke the buck" with its net asset value falling below $1.

The agency is considering requiring that funds set aside capital against losses, restrict a portion of withdrawals or eliminate fixed share prices.

"Chairman Schapiro is right to call for additional measures," Tarullo said.

The tri-party agreements, or repos, are a prime source of short-term bank funding and are backed by Treasuries or riskier collateral, including mortgage-backed debt.

Fed officials, including Chairman Ben Bernanke, have pointed to problems in the repo market as a leading contributor to the financial crisis.

Earlier this year the New York Fed said it was considering restrictions on repo markets after becoming dissatisfied with an industry committee's efforts to address concerns about the loans' risks.

The industry effort "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."

Also on Wednesday, Tarullo is scheduled to meet in New York with the CEOs of several large banks to discuss results of the annual "stress tests" that were released in March.

The gathering should also give bank chiefs a chance to air grievances they have with a set of proposed rules the Fed was accepting comment on through April 30.

Large banks are complaining that the rules go too far and appear aimed at trying to make them smaller.

Wall Street giants should be comforted by at least one part of Tarullo's speech.

He said changes should be made to parts of an international agreement, known as Basel III, on the amount of liquid assets banks should have to hold in order to weather a crisis.

Banks want regulators to state clearly that if a crisis were to occur they could draw down their liquidity below the minimum levels laid out in the agreement.

Tarullo agreed, saying the current proposal could promote "liquidity hoarding."

The proposal "should be better adapted to a crisis environment as, for example, by making credibly clear that ordinary minimum liquidity levels need not be maintained in the midst of a crisis," he said.

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