NEW YORK — Financial regulators' approach to regulating shadow banking may not be swift, but is an appropriate way of combating systemic risks posed by financial firms outside the traditional banking sector, Federal Reserve Gov. Daniel Tarullo said Friday.
In a speech to students at Columbia Law School, Tarullo said that the process of identifying systemically risky activities that take place outside the regulatory perimeter of the banking sector and addressing those risks one-by-one can be painstaking, citing the Securities and Exchange Commission's years-long efforts to change the rules surrounding money market funds.
But it results in a more reasonable regulatory apparatus than it might if regulators went after shadow banking more aggressively. That approach does, however, require ongoing vigilance by regulators to identify when new risks become apparent.
"The virtue of this approach is that it allows for a very tailored regulatory response," Tarullo said. "But, as you can imagine, this approach necessarily involves a good bit of active oversight on an ongoing basis, both of measures previously taken and of new channels of nonbank intermediation as they arise."
By contrast, regulators could define shadow banking in broadly applicable terms and design a set of regulations that might apply to any firm that met the definition, Tarullo said. Such a move has notable drawbacks, he said, and may not be possible with existing financial regulatory authorities.
"To date, the attempts I have seen along these lines look likely to entail substantial overinclusion, substantial under-inclusion, or regulatory consequences that are inappropriately uniform," Tarullo said. "And, in the United States and other jurisdictions, it is not clear that authority exists to take this approach, either by an individual regulatory agency or even collectively."
Tarullo noted that "many shadow banking channels passed through prudentially regulated institutions" leading up to the crisis, and said that "the extent of shadow banking has significantly diminished since the crisis" — though he said there "is good reason to believe that it will grow in the future."
Tarullo's comments come amid a presidential campaign in which the role of shadow banking has played an outsized role. Democratic presidential nominee Hillary Clinton has made reining in the shadow banking system a focal point of her campaign, calling on Congress to strengthen the authorities of the Financial Stability Oversight Council in order to better regulate financial firms outside the banking sector. Fed Vice Chairman Stanley Fischer similarly said in recent comments that more should be done to address unknown risks posed by shadow banking.
Tarullo did say than a general "filter" that might be applied by regulators when examining an activity for systemic risk might be the susceptibility of the activity to runs, echoing the focus of FSOC's ongoing review of the asset management industry. But he noted that regulators can and do take different approaches to regulation; sometimes regulating individual firms, as FSOC has done with a handful of insurance firms, other times regulating certain business models or specific transactions. Each of these approaches — or multiple approaches — may be necessary in certain cases in order to ensure that the drift toward shadow banking does not imperil financial stability, he said.
"Institution-specific measures may be thought of as those needed to protect financial stability even though a firm is already subject to business model regulation," Tarullo said. "And a transaction-based measure may be thought of as one needed to protect financial stability regardless of whether all entities that might engage in such a transaction need to be regulated because of the risks associated with their business models."