The Federal Reserve Board is working with other financial regulators to create a comprehensive set of regulatory data on hedge funds and private equity firms as part of the oversight of the shadow banking system, said Fed Chair Ben Bernanke in remarks at the Fed Bank of Atlanta Financial Markets Conference. The Fed takes its role of prudential regulator very seriously. In a very important statement, Chairman Bernanke said that financial stability policy has taken on greater prominence and now stands on an equal footing with monetary policy as a critical responsibility of central banks.
The Chair’s remarks were issued in the wake of final Financial Stability Oversight Council regulations implementing the criteria and process FSOC will use to designate hedge funds and other non-bank financial firms as systemically important. Once designated, these firms would be subject to consolidated supervision by the Federal Reserve and would be required to satisfy enhanced prudential standards established by the Fed under Title I of Dodd-Frank. FSOC regulations provide details on the framework the Council intends to use to assess the potential for a particular firm to threaten U.S. financial stability. The analysis would take into account the firm's size, interconnectedness, leverage, provision of critical products or services, and reliance on short-term funding, as well as its existing regulatory arrangements.
According to the Fed Chair, the FSOC regulations are an important step forward in ensuring that systemically critical hedge funds and other non-bank financial firms will be subject to strong consolidated supervision and regulation. More work remains to be done, however. In particular, although the basic process for designation has now been laid out, further refinement of the criteria for designation will be needed. For those firms that are ultimately designated, it will fall to the Federal Reserve to develop supervisory frameworks appropriate to each firm's business model and risk profile. As the FSOC gains experience with this process, it will make adjustments to its rule and its procedures as appropriate.
Chairman Bernanke also examined the regulatory approach to the shadow banking system, which refers to the intermediation of credit through a collection of institutions, instruments, and markets that lie at least partly outside the traditional banking system In his view, an important lesson learned from the financial crisis is that the growth of shadow banking creates additional potential channels for the propagation of shocks throughout the financial system and the economy.
Although the shadow banking system taken as a whole performs traditional banking functions, including credit intermediation and maturity transformation, unlike banks, it cannot rely on the protections afforded by deposit insurance and access to the Federal Reserve's discount window to help ensure its stability. Shadow banking depends instead upon an alternative set of contractual and regulatory protections, such as the posting of collateral in short-term borrowing transactions. It also relies on regulatory restrictions on key entities, such as the significant portfolio restrictions on money market funds required by SEC Rule 2a-7, which are designed to ensure adequate liquidity and avoid credit losses. During the financial crisis, however, these types of measures failed to stave off a self-reinforcing panic that took hold in parts of the shadow banking system and ultimately spread across the financial system.
An important feature of shadow banking is the involvement of commercial and clearing banks. For example, commercial banks sponsored securitization arrangements which, until recently, permitted those banks to increase their leverage by keeping the underlying assets off their balance sheets. Clearing banks also stand in the middle of tri-party repo agreements, managing the exchange of cash and securities while providing protection and liquidity to both transacting parties.
Because of these and other connections, noted the Chair, panics and other stresses in shadow banking can spill over into traditional banking, causing many traditional financial institutions to lose important funding channels for their assets. For reputational and contractual reasons, many banks supported their affiliated funds and conduits, compounding their own mounting liquidity pressures.
A first set of reforms relate to the accounting and regulatory capital treatment of shadow banking entities sponsored by traditional banks. In 2009, FASB required securitizations and other structured finance vehicles to be consolidated onto the sponsoring bank's balance sheet. Regarding regulatory capital, Basel 2.5 and Basel III addressed interconnectedness and other sources of systemic risk frequently associated with shadow banking by raising capital requirements for exposures to unregulated financial institutions, such as asset managers and hedge funds, and by strengthening the capital treatment of liquidity lines to off-balance-sheet structures. Basel III also includes quantitative liquidity rules that reflect contractual and other risks that arise from bank sponsorship of off-balance-sheet vehicles.
A second area of ongoing reform is money market funds. In an important step toward greater stability, in 2010 the SEC required money market funds to maintain larger buffers of liquid assets, which may help reassure investors and reduce the likelihood of runs. But despite new regulations, the Fed Chair said that the risk of runs created by a combination of fixed net asset values, extremely risk-averse investors, and the absence of explicit loss absorption capacity remains a concern, particularly since some of the tools that policymakers employed to stem the runs during the crisis are no longer available.
SEC Chair Mary Schapiro has advocated additional measures to reduce the vulnerability of money market funds to runs, including possibly requiring funds to maintain loss-absorbing capital buffers or to redeem shares at the market value of the underlying assets rather than a fixed price of $1. In the Fed’s view, additional steps to increase the resiliency of money market funds are important for the overall stability of the financial system and warrant serious consideration.
For its part, the Fed is developing a framework for monitoring systemic risk. The goal is to have the capacity to follow developments in all segments of the financial system, including parts of the financial sector for which data are scarce or that have developed more recently and are thus less well understood. Armed with proper data, the Fed will monitor measures of systemic importance that reflect firms' interconnectedness and their provision of critical services.
The Fed recognizes that data on hedge funds and other players in the shadow banking sector can be difficult to obtain. Thus, the Fed will engage in what the Chair called creative monitoring of risk by looking at broad indicators of risk to the financial system, such as risk premiums, asset valuations, and market functioning. The Fed is also developing new sources of information to improve the monitoring of leverage. For example, the Fed has begun a quarterly survey on dealer financing that collects information on the leverage that dealers provide to financial market participants in the repo and over-the-counter derivatives markets.
Noting that hedge funds and other shadow banking entities can create cross-border intermediation chains, Chairman Bernanke said that international regulatory groups have also been focused on addressing the financial stability risks of shadow banking. The G-20 leaders have directed the Financial Stability Board, whose membership includes the Federal Reserve, to develop recommendations to strengthen the regulation of the shadow banking system. The FSB currently has five major projects under way devoted to understanding the risks of shadow banking, including money market funds, securitization, securities lending and the repo market, banks' interactions with shadow banks, and other shadow banking entities.