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Fed's Tarullo wants more tools to counter shadow bank risks

By Douwe Miedema

WASHINGTON (Reuters) - Global financial watchdogs should have more policy tools and powers over firms such as hedge funds to counter the risk of a devastating run on investment banks, the U.S. Federal Reserve's top regulator said on Friday.

Fed Governor Daniel Tarullo unveiled new details of the central bank's plans to require banks to hold more capital if they rely heavily on raising short-term cash from other banks, and he pushed regulators writing global rules to do more.

But oversight should not be limited to banks, he said, because risks that could bring them down can often hide in the so-called shadow banking system, a loosely defined set of lending activities outside banks.

"There is a need to supplement prudential bank regulation with a third set of policy options in the form of regulatory tools that can be applied on a market-wide basis," Tarullo said at a conference with other regulators.

Shadow banking remains largely unregulated even though it was a key factor in the collapse of Lehman Brothers at the height of the financial crisis in 2008, which led to a raft of new regulations for bank capital and derivatives trading.

Tarullo detailed the Fed's planned rule -- announced earlier this year -- to make it less attractive for banks to raise cash in short-term wholesale funding markets, which have proven to be fickle if a panic hits the market.

Banks that rely on short-term funding from peers should be required to hold more capital on top of what is already mandated by the international Basel III pact, he said.

The extra buffer would be calculated by looking at total liabilities minus regulatory capital, deposits and obligations with a maturity longer than a certain minimum, Tarullo said, and could take account of the level of risk of the funding source.

International regulators should also consider a surcharge on banks' exposure to a prominent part of shadow banking, the repurchasing -- or repo -- markets, even if books were fully matched, or the maturities of assets and liabilities evenly distributed.

Banks would be inclined to support the books even if a counterparty went under so as not to hurt their reputation, Tarullo said. That means the actual risk in those matched books is higher than it would appear, due to accounting standards.

Tarullo said supervisors at the global Financial Stability Board could still include plans for repo books in the so-called net stable funding ratio, designed to encourage banks to move away from short-term funding.

Regulators should address risk in such transactions regardless of whether they were executed by banks or by other market participants, such as hedge funds, and focus on overseeing a certain type of transaction rather than a specific set of institutions.

"There have already been reports of some hedge funds exploring the possibility of disintermediating deals by lending cash against securities collateral to other market participants," Tarullo said.

Minimum safety buffers in repo markets - so-called haircuts - should be extended to include all market participants, regulated or not, he said.

Tarullo said that JP Morgan Chase's $6 billion "London Whale" trading loss -- named for the huge positions the bank took -- had been a reality check for regulators writing the so-called Volcker rule, which bans banks from betting on financial markets with their own money.

The rule, which regulators are hoping to finalize this year, had been proposed at the time the loss happened, but regulators were then still redrafting it and taking into account a ream of comment letters from the industry.

"One of the key mandates to the staff from all the five agencies working on the final rule has been to ensure that London Whale in substantive and procedural terms couldn't happen again," Tarullo said.

(Editing by Dan Grebler, Krista Hughes and Leslie Adler)

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