AS FED SHINES LIGHT ON SHADOW BANKING, ITS REGULATORY LIMITS GET LAID BARE / THE WALL STREET JOURNAL

The Outlook

As Fed Shines Light on Shadow Banking, Its Regulatory Limits Get Laid Bare

Central Bank Faces Hurdles as Officials Look to Stamp Out Potential Problems in Financial System

By Pedro Nicolaci da Costa and Ryan Tracy

Dec. 21, 2014 3:28 p.m. ET

As Federal Reserve officials ramp up their efforts to monitor and curb risky activities by financial firms outside the banking system, a key question is emerging: What can they do about any problems they find?

The so-called shadow-banking system is growing again in the U.S. after declining from 2008 through 2011 in the wake of the financial crisis. The value of U.S. financial assets held by money-market funds, hedge funds, trust companies and financial firms other than banks reached $25.2 trillion in 2013, for the first time exceeding the precrisis peak of $24.9 trillion, according to a November report by the Financial Stability Board, an international body of regulators.

U.S. shadow-banking assets accounted for about one-third of the global total of $75.2 trillion in 2013, which was up from $70.5 trillion the year before. And in the U.S., shadow banking is bigger than the more tightly regulated traditional banking system, which according to the FSB had $20.2 trillion in assets as of 2013.

The burgeoning numbers are giving financial regulators around the world an urgency to get a handle on shadow banking before history repeats itself with another crisis.

Fed officials recall that many roots of the financial crisis lay in the shadow-banking world, for example with nonbank lenders making subprime mortgage loans to risky borrowers, financial firms then bundling the debt into securities, and insurers pledging to cover the risk of default on the securities. In a July speech recounting lessons from the crisis, Fed Chairwoman Janet Yellen said “key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, weak underwriting of loans, deficiencies in risk measurement and risk management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.”

The Fed board’s new three-member committee on financial stability, led by Vice Chairman Stanley Fischer , is focusing on shadow-banking issues. One of the panel’s chief challenges is that the Fed was created as a banking regulator and has limited powers to monitor or influence other types of firms. And while other federal regulatory agencies have authority over many nonbank financial activities, blind spots remain.

“No U.S. agency yet has access to complete data regarding bank and nonbank financial activities,” Fed governor Lael Brainard, a member of the committee, said in a speech earlier this month.

Ms. Brainard, outlining how the Fed is trying to overcome these hurdles, said the central bank has increased its surveillance efforts by assessing “financial vulnerabilities”—such as high valuations and high levels of borrowing by households and businesses—in a variety of asset classes. The central bank also is working with other U.S. and foreign agencies to share data.

A next step is for Mr. Fischer’s committee to figure out what the Fed can do about any risks it identifies outside the banking system.

Aside from the gray area about its authority to oversee nonbank financial firms, the Fed lacks some “macroprudential” regulatory and supervisory tools used by other central banks in recent years. Such macroprudential measures aim to maintain the stability of the whole financial system, in contrast with “microprudential” efforts to ensure the soundness of individual institutions.

The Fed, for example, can’t impose limits on loan-to-value ratios for home or business loans, as some other central banks have done. In his former post as governor of the Bank of Israel, Mr. Fischer used regulatory policies to try to slow credit growth in the housing market—including raising minimum down payments for mortgages—with what he has said was mixed success.

Fed policy makers could raise interest rates to rein in excessive borrowing, but they view that as a blunt instrument that could damp growth across the economy rather than address specific problems. Ms. Yellen and other officials have said they view rate increases specifically aimed at asset bubbles and other risky behavior as a second line of defense of financial stability, to be used only after more targeted measures fail.

But the Fed’s macroprudential tool kit isn’t empty. It could adopt capital requirements that rise when bubbles start to form, leaning against risk-taking when regulators believe it has become excessive. It could also raise required levels of equity needed to fund investments in particular sectors, like corporate debt or real estate. Fed officials have cited the bank stress-test process as a way to not only check the health of banks but remedy any shortcomings they encounter.

Another approach could be regulation of so-called securities-financing transactions that help fund a lot of shadow-banking activity. Ms. Brainard cited the Fed’s authority to require participants to hold a minimum amount of extra collateral at the margin, regardless of whether a bank or other party is executing the transactions.

In the end, it’s unclear how effective such measures will be, and Ms. Brainard and other Fed officials have said that at times they might need to turn to interest-rate increases to do the job.