WASHINGTON — A top Federal Reserve official on Tuesday urged regulators to embrace a set of reforms that could be taken to minimize risk in the shadow banking system.
"We should act now to address some obvious sources of vulnerability in the financial system," said Fed Gov. Daniel Tarullo in prepared remarks. "Regulators need not wait for the full resolution of contested issues or the development of comprehensive alternatives, nor would it be prudent for them to do so."
Tarullo suggested three immediate steps both U.S. and foreign regulators could take in the short-term, beginning with greater transparency in the shadow banking system covering various transactions and markets, like the repo-market, for example.
"At present there is no way that regulators or market participants can precisely determine even the overall volume of bilateral repo transactions — that is, transactions not settled using the triparty mechanism," said Tarullo.
Both the Treasury Department's Office of Financial Research and the Securities and Exchange Commission are taking steps in this area.
Secondly, he said regulators should reduce the risk of runs on money market mutual funds by addressing structural problems that have persisted despite earlier reform efforts by the SEC. The agency is currently considering a host of reforms including floating net asset value, capital requirements and restrictions on redemption.
Tarullo endorsed SEC Chairman Mary Schapiro's goal of addressing the vulnerabilities, while also preserving the economic role of money market funds, saying it was "the preferable route."
Lastly, he said regulators should work to address the settlement process for triparty repurchase agreements.
"Some work has been made since 2008, but clearly more remains to be done," said Tarullo, namely eliminating intraday credit.
The Fed, he said, is pressing for further action not only by the clearing banks, who manage the settlement process, but also from the dealer affiliates of the bank holding companies, which are clearing banks' largest customers for triparty transactions.
But this approach alone would not "suffice," Tarullo said.
"All regulators and supervisors with responsibility for overseeing the various entities active in the triparty market will need to work together to ensure that critical enhancements to risk management and settlement processes are implemented uniformly and robustly across the entire market, and to encourage the development of mechanisms for orderly liquidation of collateral, so as to prevent a fire sale of assets in the event that any major triparty market participant faces distress," said Tarullo.
The central banker also suggested that under a broader reform effort for shadow banking, regulators will need to first address the minimal constraint on the use of leverage in some key types of transactions.
One remedy that has been offered is a system of haircut and margin requirements that would be applied uniformly across a range of markets, like over-the-counter derivatives, repurchase agreements, and securities lending, he said.
"Such a margining system would not only limit leverage, but — to the extent it is in fact uniform — also diminish incentives to use more complicated and less transparent transactional forms to increase leverage or reduce its cost," said Tarullo.