Fed Governor Proposes Research on Shadow Banking System

Federal Reserve Governor Daniel Tarullo said in a speech this morning at the Brookings Institution that there remains one significant task in the reform of the financial system:

[T]he most important remaining task of financial regulatory reform [is] determining the most effective and efficient ways to deal with short-term funding markets, often characterized as the shadow banking system, that are inherently subject to runs.

To accomplish that task, Tarullo argues for additional research and against a return to the Glass-Steagall Act which forbade a single institution from being both a consumer and a commercial bank. It was the repeal of that Act that allowed financial firms like JPMorgan Chase & Co. (NYSE: JPM), Morgan Stanley (NYSE: MS), Citigroup Inc. (NYSE: C), and Wells Fargo & Co. (NYSE: WFC) to grow to the point that they present a systemic to the financial system and are, indeed, “too big to fail.”

Tarullo suggests that capping non-deposit liabilities at the TBTF banks offers a solution because these liabilities “are highly correlated with the systemic risk measures” the Fed uses to determine the financial stability of proposed mergers. The other side of the coin, of course, is who sets the cap and what an appropriate cap might be.

Requiring TBTF banks to maintain a minimum level of long-term debt “at the top holding company level” might serve to lessen the effect of bankruptcies such as those that felled Bear Stearns and Countrywide. From Tarullo’s perspective, he sees little in the way of “unfavorable unintended consequences” to requiring minimum long-term debt, and suggests that it should be considered as a “near-term policy priority.”

The full text of Tarullo’s remarks is available here.

Paul Ausick