Bernanke to the Fed: Watch Out for Shadow Banking!

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“We are now more than four years beyond the most intense phase of the financial crisis, but its legacy remains,” began Federal Reserve Chairman Ben Bernanke’s speech at the 49th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago. That legacy is the lingering and stubbornly high unemployment rate and a financial system that — despite experiencing a significant recovery over the past four years — continues to struggle with the economic and legal ramifications of the crisis.

In his wide-ranging speech, aimed primarily at the Federal Reserve’s role in monitoring the financial system for any signs of vulnerabilities that could prompt another crisis, Bernanke said the central bank was examining asset markets for signs of excessive risk taking. “While the shadow banking sector is smaller today than before the crisis … regulators and the private sector need to address remaining vulnerabilities,” he explained.

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The financial crisis, which precipitated a recession from December 2007 to June 2009, drew the attention of regulators to a group of firms and funding vehicles, known as the shadow banks, which were poorly regulated but concealed huge risk. Because of that reality, the crisis engendered a major shift in financial regulatory policy and practice. Not since the Great Depression have such extensive regulatory changes taken place, including the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States and the Basel III Accord, internationally. Particular attention was given to those companies designated as systemically important institutions and the shadow banking system.

After all, “systemic risks can only be defused if they are first identified,” as Bernanke noted.

Leading the Federal Reserve’s increased monitoring is its Office of Financial Stability Policy and Research, which informs the policy decisions of both the central bank and the Federal Open Market Committee. Just last month, the Financial Stability Oversight Council, which is chaired by U.S. Treasury Secretary Jack Lew, warned of the possibility of runs on the shadow banking system, the term used to describe the collection of non-bank financial intermediaries that compete with banks to provide credit.

In his speech, Bernanke said that additional regulation was needed to ensure that repossession market — the wholesale market that financial institutions, including shadow banks, use for their daily funding requirements — could deal with the potential consequences of a default by a broker-dealer or a large borrower. He further acknowledge that a run on money market funds was possible as well. These funds often provide the short-term funding for shadow banking.

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In the run-up to the financial crisis, investors, who invested in certain asset-backed securities provided by such institutions, “did not fully understand the quality of the assets they were financing,” stated Bernanke. “Investors were lulled by triple-A credit ratings and by expected support from sponsoring institutions — support that was, in fact, discretionary and not always provided.” When investors lost confidence in the assets or the institutions, they ran, creating serious funding pressure throughout the financial system, threatening the solvency of main firms, and inflicting serious damage on the broader economy.

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