FED UP WITH THE REPO MAN / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

HEARD ON THE STREET
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Updated May 2, 2012, 2:09 p.m. ET
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Fed Up With the Repo Man
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By DAVID REILLY

For the second time in less than a month, the Federal Reserve has sounded an alarm about an important, if little known, part of financial markets. With that, the time for action is at hand.


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Speaking Wednesday on efforts to strengthen regulation, and before a meeting with the heads of major banks, Fed Governor Daniel Tarullo outlined continuing risks to the financial system from the so-called shadow-banking system. This is made up of activities that typically fall outside traditional, regulated bank business.



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In doing so, Mr. Tarullo focused on money-market funds and a short-term funding area known as the tri-party repo market. Those were also called out by Fed Chairman Ben Bernanke in an early April speech.
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Bloomberg News

Daniel Tarullo

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Mr. Tarullo said that in the tri-party repo market, "a major vulnerability lies in the large amount of intraday credit extended by clearing banks on a daily basis." The two major clearing banks are J.P. Morgan Chase JPM -1.45% and Bank of New York Mellon BK -0.13%.



As part of the clearing function, these banks manage the daily exchange of cash and securities that make up repurchase, or repo, agreements and themselves extend temporary intraday credit as part of this. Mr. Bernanke said this credit averages about $1.4 trillion.



Although this market usually functions smoothly, there is big systemic risk involved because of the interconnectedness of the clearing banks and securities dealers. Problems on either side during a crisis could ricochet, leading to freeze-ups in short-term funding markets and straining firms' finances. The danger is all the more acute given that J.P. Morgan is the biggest bank in the country by assets and ostensibly the most interconnected since it has the largest derivatives portfolio.



An industry initiative to address tri-party repo issues, among them limiting the amount of credit, "fell short," as Mr. Tarullo said. He added that in light of this, "it now falls to the regulatory agencies to take appropriate regulatory and supervisory measures to mitigate these and other risks."



That is tough talk from the Fed's point man on bank supervision. Given banks' inability to address the problem, he needs to follow through. 

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