Federal Reserve Governor Jeremy Stein said banks that rely on deposits for funding have an advantage over counterparts that rely on the shadow banking system, such as repurchase agreements, to finance investments in illiquid assets.
"Shadow banking money is much more run prone than bank money," Stein said in a speech today in Philadelphia. "Given its relatively stable nature, the banking model is better suited to investing in assets that are illiquid and subject to interim price volatility that is, to fire-sale risk."
More than five years after the collapse of Lehman Brothers Holdings Inc., U.S. regulators are still grappling with how to reduce the risks from the loosely regulated so-called shadow banking system and lower the likelihood that taxpayers will need to bail out too-big-to-fail banks in a crisis.
"A stable deposit franchise gives a bank the ability to ride out transitory valuation changes of the sort that might come from noise-trader shocks or fire sales, without being forced to liquidate assets at temporarily depressed prices," Stein said.
"As a result, traditional banks with stable funding have an advantage relative to their shadow banking counterparts in holding those assets where transitory repricing risk is high for a given level of underlying fundamental cash flow risk," Stein said.
In his remarks to a joint luncheon of the American Economic Association and the American Finance Association, Stein didn't discuss monetary policy or the U.S. economic outlook. Fed Chairman Ben S. Bernanke is scheduled to speak today also in Philadelphia.
Stein, a former Harvard University economist who specializes in banking and finance, joined the Fed in May 2012 for a term lasting through January 2018.