NEW YORK – The shadow banking system contributed greatly to the economic downturn and needs to be regulated, Federal Reserve Board Governor Daniel Tarullo said Tuesday.

“The shadow banking system today is considerably smaller than at the height of the housing bubble six or seven years ago. And it is very likely that some forms of shadow banking most closely associated with that bubble have disappeared forever,” he told a Federal Reserve Bank of San Francisco conference, according to prepared text of his remarks, released by the Fed. “But as the economy recovers, it is nearly as likely that, without policy changes, existing channels for shadow banking will grow, and new forms creating new vulnerabilities will arise.”

He defined the shadow banking system as “credit intermediation involving leverage and maturity transformation that is partly or wholly outside the traditional banking system.”

While too-big-to-fail, the other contributor to the downturn, has been addressed, shadow banking “has been only obliquely addressed, despite the fact that the most acute phase of the crisis was precipitated by a run on that system,” he said.

Tarullo’s three-pronged short-term approach to regulating the system includes; increasing transparency in the transactions and markets of the shadow banking system, including repos; taking measures to shore up “structural vulnerabilities” in money market mutual funds, which could include the SEC’s plans for “a floating net asset value, capital requirements, and restrictions on redemption”; and addressing “the settlement process for triparty repurchase agreements.”

Longer term, Tarullo said, “a broader reform agenda for shadow banking will first need to address the fact that there is little constraint on the use of leverage in some key types of transactions. One proposal is for a system of haircut and margin requirements that would be uniformly applied across a range of markets, including OTC derivatives, repurchase agreements, and securities lending. Work is ongoing to develop globally uniform margin requirements for OTC derivatives, but there is not yet an agreement to develop globally uniform margin requirements for securities financing transactions. Such a margining system would not only limit leverage, but—to the extent it is in fact uniform—also diminish incentives to use more complicated and less transparent transactional forms to increase leverage or reduce its cost. Some proponents suggest that such systems of uniform haircut and margin requirements could also dampen the observed procyclical character of many collateralized borrowings that results from changes in margins and haircuts following general economic or credit trends.”

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