Shift Toward Activities-Based Regulation Continues to Make Headway

WASHINGTON — Policymakers in the U.S. and abroad are increasingly favoring a regulatory approach that focuses more on an institution's activities than its charter type.

Federal Reserve Gov. Daniel Tarullo said this week that he envisions a move toward "prudential market regulation," which he described as essentially an application of some of the Dodd-Frank Act's rules to financial institutions outside of the banking sector depending on their line of business.

Any entity engaged in "particular business models or particular business activities" might come under the umbrella of such a regulatory regime, Tarullo said, but the purpose of an activities-based approach would be less to expand regulatory reach than to eliminate the potential for supervisory arbitrage. He was careful to say, however, that such an approach does not mean capturing all activities outside banking.

"Much of the activity outside of the regulated sector will be very healthy, and there's a risk that people, in a kind of knee-jerk fashion, say, 'Gee, if there's any kind of intermediation outside of the banks, it must be bad and we must regulate it,'" Tarullo said on Thursday. "I don't think we want to approach things that way."

Tarullo's comments come as the International Organization of Securities Commissions — a leading consortium of market regulators from around the globe — opted June 17 to indefinitely table its plans to publish a standard methodology for identifying and regulating systemically risky shadow banking firms.

The Securities Industry and Financial Markets Association — a major international market trade association — praised the move, calling the methodology effort "misguided" and saying that further analysis should be conducted by securities regulators with "relevant expertise."

"Given the characteristics of the asset management industry, it simply makes sense to review market activities rather than entities," SIFMA said.

IOSCO's chairman Greg Medcraft — who also serves as chairman of the Australian Securities and Investments Commission — expanded further in a press conference June 22 in Washington, D.C., saying that international regulators to date have been "too willing to draw conclusions about the nature and the scale of risks" posed by asset managers.

The move was seen as a significant step away from regulating institutions by charter type. Asset management firms have protested international and U.S. efforts to treat them as systemically risky, saying they do not pose a threat to the system.

Tarullo said earlier this month that he favored an activities-based approach to the asset management industry, but his Thursday comments expanded on those thoughts.

For example, he said that the criteria for the kinds of activities that might be subject to "macroprudential market regulation" would exhibit both excess leverage and a vulnerability of funds, such that in a financial stress event they would potentially be subject to runs. A nonbank engaged in activities that have those symptoms should be covered by some macroprudential rules, he said, regardless of whether it is a commercial bank or even if the assets under its control are not especially large.

That said, Tarullo acknowledged that it would be hard to determine exactly where to draw the line, and because markets are constantly adapting to new circumstances, the effort would have to adapt as well.

"I think that is going to be an ongoing challenge, because one has to take some care to differentiate between activities that are best left alone … as opposed to activities that do pose those kinds of risks," Tarullo said. "We have to recognize that this will be a dynamic undertaking because financial markets, as they are wont to do, are constantly adapting and changing, so regulators are going to have to make those judgments on an ongoing basis."

Other industry groups have already offered suggestions about what areas might be ripe for such a consideration. The CFA Institute, which represents Chartered Financial Analysts, conducted a survey of its members on what policy changes they would recommend.

The results, published in April, suggested generally that regulators should require greater transparency from market-based financial firms, mandate more collateral for their services and products, standardize the securitization markets worldwide and improve data collection for shadow banking activities.

It also called for regulators to phase out constant net asset value money market funds in favor of a variable net asset value model, thus eliminating the potential market disruption of "breaking the buck."

Additionally, CFA respondents outlined a number of improvements that can be made to the securities markets, including a standard distribution of risk across securities tranches; a standard structure for credit guarantees; and comparable legal terms. Securities issuers should also be restricted from using clients' posted collateral based on that client's existing leverage ratio; requiring securities transactions to be reported to trade repositories, as with the swaps market; and central clearing of repo transactions.

Rhodri Preece, head of the institute's capital markets policy group for Europe, the Middle East and Africa and author of the study, said in April that its recommendations pose a viable starting point for regulators to achieve the systemic safety they are looking for without going too far and quashing the services that shadow banking provide.

"Amid the myriad of shadow banking policy initiatives, the challenge facing regulators is to achieve coherence in the implementation of these measures and to minimize regulatory gaps and overlaps," Preece said. "Nonbank finance has the potential to deliver many benefits to the financial markets in Europe and indeed globally if the right measures are put in place to stimulate demand and justify investor confidence."