UPDATE 2-Fed's Dudley floats even broader revamp of U.S. wholesale funding

Fri Feb 1, 2013 11:14am EST

* Could expand central bank backstop to non-banks, he says

* Could also adopt laws that dissuade short-term funding

* Policymaker sees gradual improvement in global economy

By Jonathan Spicer

NEW YORK, Feb 1 (Reuters) - An influential Federal Reserve official on Friday suggested an even broader revamping of the worrisome U.S. wholesale funding market than is currently being considered.

New York Fed President William Dudley advocated expanding the central bank's backstop to firms doing "socially useful" business or forcing them to rely more on longer-term funding.

Dudley warned that extensive activity in the money markets and tri-party repo markets takes place without proper safeguards against runs and fire sales, and he urged U.S. lawmakers to take a closer look.

Without endorsing a particular path, he suggested the government could decide to extend access to the Fed's so-called discount window to non-banks, while at the same time bulking up supervision of those firms.

Alternatively, he said, laws could dissuade banks from using short-term wholesale funding.

Dudley, a close ally of Fed Chairman Ben Bernanke, did not comment on monetary policy in his breakfast speech to the New York Bankers Association. Though he noted that improvements on Europe, China and Japan was proof that the global economy is gradually healing.

The policymaker's comments on money markets and triparty repurchase agreements, however, could shake up a regulatory debate that has inched forward since the 2007-2009 financial crisis exposed deep flaws in the so-called wholesale system.

"The status quo - where we are today - should be unacceptable because we're sitting here with a latent risk," Dudley said in response to a question from a community banker.

If the Fed's emergency source of liquidity, known as the discount window, is expanded to more firms, those firms would have to pay for the benefit of the U.S. central bank's implicit backstop, he added. That would likely involve a higher interest rate and more Fed supervision.

"Regardless of where we come out on these questions, we must make the basic structure of the wholesale funding market as sound as possible," Dudley said at the landmark Waldorf Astoria hotel in Manhattan.

THORNY ISSUES

Both the triparty and money markets have been under regulators' microscope, though few big changes have been made.

The $2.6-trillion money market mutual fund industry threatened to freeze global markets in the crisis, capped by investors' rush to flee the well-known Reserve Primary Fund in the fall of 2008 because of its heavy holdings in the collapsed Lehman Brothers. The fund was unable to maintain its $1 per share value, known as "breaking the buck."

The industry and the Financial Stability Oversight Council, which includes officials from the central bank and the Securities and Exchange Commission, have been locked in debate over what changes to make since a sweeping SEC rule proposal was blocked last summer.

Also last summer, the New York Fed unveiled reforms for the $1.8 trillion U.S. triparty repurchase agreement market that would force banks to reduce their reliance on the short-term loans.

So-called repos are a prime source of short-term bank funding and are backed by Treasuries or riskier collateral, including mortgage-backed debt.

Dudley said that even after the reforms that are being considered, the sheer size of the banking business that takes place outside commercial banking entities - those with access to the Fed's discount window - suggests the issue must not be ignored.

"We need to consider whether our current architecture is satisfactory," Dudley said. If not, regulators could require that longer-term debt fund the wholesale market, or laws could be adopted to reduce the volume of activity in the market.

Dudley noted that a recent proposal by colleague Daniel Tarullo, a Fed governor, to cap banks' size could achieve that goal.

Alternatively, he said, any expansion of the Fed's "lender of last resort" privilege to nonbanks would require legislation that also expanded oversight. "Many thorny issues would have to be resolved," he added.

GRADUAL IMPROVEMENT IN GLOBAL ECONOMY

Turning to the economic situation, Dudley, who has a permanent vote on Fed policy, said the world is better now than it was six years ago.

The euro zone's smaller economies are on better footing, China's economic growth is accelerating, and the Japanese government's fresh push to battle deflation, Dudley said.

"Things aren't perfect. But things are definitely improving, and that will actually be helpful for the U.S. outlook," he said.

"If the rest of the world gets healthier, the demand for U.S. goods and services will increase and that will provide support to our own economy."

Dudley has consistently supported the Fed's unprecedented policy efforts, including rock-bottom interest rates and some $2.5 trillion in bond purchases, to support the slow U.S. recovery from recession over the last few years.