Central Clearinghouses May Need Stronger Protections: Tarullo

WASHINGTON — Federal Reserve Board Gov. Daniel Tarullo warned again Friday that more focus is needed on certain areas of systemic risk, particularly central counterparty clearinghouses and shadow banking.

Speaking at a joint conference of the Office of Financial Research and the Financial Stability Oversight Council, Tarullo said the risks posed by the largest banks are well understood and efforts to deal with them are "various stages of implementation."

But other systemic risks are not as easily assessed, including the risks posed by a failure of one or both of the major U.S. central counterparty clearinghouses. The Dodd-Frank Act required many derivatives and other financial transactions to be centrally cleared — meaning the credit risk of those transactions is assumed by the CCP rather than the counterparties of the transaction.

Such clearing makes the swaps markets more transparent and standardizes margin requirements for many transactions, Tarullo said. But the international standard for clearinghouse capitalization has been for them to hold enough capital to withstand the failure of their two largest members -- so-called "cover 2." Tarullo said that may not be sufficient.

"Perhaps this is the right standard when contemplating the well-being of a CCP in isolation," Tarullo said. "But it seems worth considering whether this standard is adequate when hypothesizing stress throughout the financial system, since the default of two large counterparties would almost surely be accompanied by significant market disruption. At the least, it is important to ensure a consistent, robust implementation of the cover 2 standard that has already been agreed."

Tarullo added that because clearinghouses will turn to their members for liquidity if their own capital is exhausted, the risk posed by them could reduce liquidity among members who might also be enduring a liquidity crunch. In the U.S., eight CCPs were designated as systemically important financial institutions by FSOC in 2012 as Financial Market Utilities.

"There is little question that more attention must be paid to strengthening stress testing, recovery strategies, and resolution plans for significant CCPs," Tarullo said. "In at least some cases, uncertainty is increased by the difficulty of estimating with any precision the extent of potential liability of members to the CCP, thereby complicating both their recovery planning and efforts by the official sector to assess system-wide capital and liquidity availability in adverse scenarios."

In response to a question about whether CCPs are so systemically important that they should be made public, Tarullo said that it is important for regulators to have backup plans if initial regulatory efforts fail to meet their goals. But to date taking over CCPs has not been a serious consideration either in the U.S. or elsewhere around the world.

"The implicit preference of the various international and domestic [regulators] is for strengthening private entities," Tarullo said. "To get there it is going to take a significant building out of a regulatory regime, and so I think that's where attention is going to be directed."

Tarullo said another area also poses possible systemic risk — namely the potential for risk to "migrate outside the regulatory perimeter." The central bank is working to address some of those concerns by developing its own version of a rule requiring minimum margins for securities financing transactions that include the extension of credit to unregulated financial institutions.

That margin is "intended to serve the macroprudential aim of moderating the build-up of leverage" in those unregulated areas and "mitigate the risk of procyclical margin calls by preventing their decline to unsustainable levels during credit booms."

The risks posed by the so-called "shadow banking" sector have been a strong focus of U.S. regulators in recent months. FSOC voted in December to seek public comment on how and whether to regulate the asset management industry as a SIFI activity. Securities and Exchange Commission Chair Mary Jo White likewise laid out a series of initiatives at the agency meant to make regulation of asset managers more effective and reflective of the systemic risk posed by the industry.

But Tarullo said the Fed will also move on its own in developing a securities financing transaction margin rule, using its authority under the Securities and Exchange Act "to supplement our prudential regulatory authorities."