In a speech made at a banking conference sponsored by the Chicago Federal Reserve Bank , the primary message to come from Federal Reserve Board Chairman Ben Bernanke involve the threat the ”shadow banking system” or Systemically Important Financial Institutions (SIFIs).
Bernanke defines them as “financial firms whose distress or failure has the potential to create broader financial instability sufficient to inflict meaningful damage on the real economy.”
According to Bernanke, the bank funding market may have difficulties dealing with a significant default. He states that the Fed has a major responsibility to monitor the stability of the banking system and must maintain its vigilance over the asset markets and keep an eye on “excessive risk taking.”
Understanding the shadow banking system
Shadow banking refers to financial entities that help with the creation of credit in financial markets around the world. These financial intermediaries include hedge funds, unlisted derivatives and other unlisted financial instruments that have only recently come under regulatory oversight.
However, their activities are not subjected to regulatory rules that guide banks and other financial institutions. Since the entities that make up the shadow banking system do not accept traditional bank deposits, they have largely flown under the radar of regulation. Escaping regulatory supervision allows these institutions to take on tremendous credit and liquidity risks, such as credit swaps.
The shadow banking system does not have mandatory capital reserves to protect institutions and their clients in the event of default or catastrophic economic negative events. The system came under intense investigation and regulation (Dodd-Frank) after the subprime crisis in 2008 threatened the global financial market.
Bernanke states that He points to the worldwide credit meltdown that occurred 2007-09 and the eventual downfall of one of the world’s most respected brokerage houses — Lehman Brothers.
These events shined light on the companies and financial instruments that make up the shadow banking system as well as the high risk and lack of sufficient regulatory oversight.
His warnings have been echo by the Financial Stability Oversight Council—the highest and most powerful assemblage of financial regulators in the United States—which is chaired by Treasury Secretary Jack Lew. Lew expressed his own reservations about the possibility of “runs” on the shadow banking system.
Bernanke said that the wholesale market or repo market needs more work to make certain it can handle any fallout from a default by a broker-dealer or a large borrower. The wholesale market refers to the marketplace that provides services to other banks or large companies funding their day-to-day needs.
Chairman Bernanke also revealed his angst about a potential run on money market funds.