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Fed Governor Tarullo Concerned about Liquidity and Redemption Risks in Asset Management

In a recent speech, Federal Reserve Governor Dan Tarullo identified liquidity and redemption risks in the asset management industry as important areas of focus in regulating “shadow banking.”  He expressed concern that holding less liquid assets combined with allowing investors to redeem on short notice could exhaust market liquidity.  In addition, he discussed the risk that once an asset manager begins selling assets, a contagion may spread to similar assets and other asset management vehicles holding the assets.  Further, in his view, the use of leverage by investment funds “could create interconnectedness risks between funds and key market intermediaries and amplify the risk of such firesales.”

Governor Tarullo called for prudential market regulation, “a policy framework that builds on the traditional investor protection and market functioning aims of securities regulation by incorporating a system-wide perspective.”  He praised SEC Chair White’s December speech as an important step in this approach to regulation of the asset management industry.

Governor Tarullo recognized that the demand for safe, short-term assets complicates the goal of developing prudential regulations with respect to short-term fund markets and some areas of asset management.  In pursuing regulation, he acknowledged that regulating one area of the industry may encourage investors to turn elsewhere for their investments.  According to Tarullo, “the ultimate effectiveness of what I have termed prudential market regulation will depend on policymakers taking into account in their regulatory approaches the sources of, and motivation for, demand for short-term, liquid, and relatively safe assets beyond the debt of very creditworthy sovereigns.”