Bernanke Warns of Risks from Shadow Banking System

CHICAGO — Federal Reserve Board Chairman Ben Bernanke said further reforms of the shadow banking system are warranted to confront threats to financial stability.

"While the shadow banking sector is smaller today than before the crisis and some of its least stable components have either disappeared or been reformed, regulators and the private sector need to address remaining vulnerabilities," Bernanke said Friday at the Federal Reserve Bank of Chicago's annual banking conference.

Bernanke, who made his eight consecutive appearances at the prestigious banking conference, highlighted efforts by the central bank to monitor threats and weaknesses in four areas: systemically important financial institutions, shadow banking, asset markets and the nonfinancial sector.

"The Federal Reserve is moving toward a more systemic approach that also pays close attention to the vulnerabilities of the financial system as a whole," Bernanke said.

Specifically, he said further reforms were necessary to get rid of hazards in the short-term wholesale funding markets and the money mutual fund market to eliminate the susceptibility to runs, as witnessed during the financial crisis.

Bernanke said that, despite progress in shrinking the amount of intraday credit extended by the clearing banks, which should be largely nonexistent by the end of 2014, more work is needed.

"Important risks remain in the short-term wholesale funding markets," Bernanke said. "One of the key risks is how the system would respond to the failure of a broker-dealer or other major borrower."

Fed Gov. Daniel Tarullo, who is responsible for bank supervision and regulation at the central bank, has raised similar concerns. Tarullo has said that without further regulatory reforms in this area "victory" cannot be declared.

He has suggested the possibility of raising capital requirements even higher in order to reduce banks' potential overreliance on short-term wholesale funding markets.

"This is the major problem that remains, and I would suggest that additional reform measures be evaluated by reference to how effective they could be in solving it," Tarullo said on May 3 at the Peterson Institute for International Economics.

Tarullo offered a number of prescriptions to the problem, hinting that regulators might ask institutions to hold higher capital and more liquidity to ensure banks are not susceptible to damaging runs in the wholesale funding market.

Under Dodd-Frank, policymakers were given tools to deal with this kind of vulnerability, including the ability to resolve a broker-dealer or a broker-dealer holding company whose failure could pose a systemic risk.

The Fed and the Office of Financial Research, an arm of the Financial Stability Oversight Council, are working together to construct data sets on triparty and bilateral repo transactions, Bernanke said.

In its annual report, the FSOC recommended additional efforts to prepare investors and other market participants to deal with the potential consequences of a default by a large participant in the repo market.

During a question-and-answer session, Bernanke once again rebutted critics who say "too big to fail" persists. Policymakers should wait until the rules are completed to see if further reforms are necessary, he said.

He argued that regulatory reform efforts under the Dodd-Frank Act and Basel III "constitute important steps" in tackling the "too big to fail" problem.

"We will see if we are comfortable when that is all done, if 'too big to fail' is solved," Bernanke said.

The Fed chairman suggested that one way to solve the issue — if it still is an issue — is by raising capital requirements even higher rather than attempting to put a size cap on the largest institutions. A capital increase could help reduce their funding advantage, he said.