What was new prior to the crisis was the extent to which maturity transformation and financial intermediation had migrated outside of commercial banks. The growth of what we call the shadow banking system occurred largely without the types of safeguards—robust prudential regulation, deposit insurance, lender of last resort—that have safeguarded the commercial banking system from the types of widespread panics and runs that are capable of destabilizing the financial system. The systemic risk created by this gap in coverage was not well recognized by regulators or the private sector prior to the global financial crisis. Market participants had little incentive to internalize the negative externality of the run-risk created by their collective choice of finance, and they made erroneous assumptions about the liquidity of asset markets and the capacity and willingness of banks to distribute central bank liquidity to the wider financial system during periods of stress. 

Let me summarize. The creation of private money--that is, safe claims that are useful for transactions purposes--is obviously central to what banks do. But safe claims can be manufactured from risky collateral in different ways, and banks are not the only type of intermediary that engages in this activity. What makes banks unique is that they use a particular combination of financial and institutional arrangements--including capital, deposit insurance, and access to a lender of last resort--as well as substantial investments in bricks and mortar, to create liabilities that are not only safe and money-like, but also relatively stable and thus unlikely to run at the first sign of trouble. This is in contrast to shadow banks, who create money-like claims more cheaply, by relying on an early exit option, and who are therefore more vulnerable to runs and the accompanying fire-sale risk. I have argued that there is a synergy between banks' stable funding model and their investing in assets that have modest fundamental risk but whose prices can fall significantly below fundamental values in a bad state of the world. This synergy helps explain both why deposit-taking banks might have a comparative advantage at making information-intensive loans and, at the same time, why they tend to hold the specific types of securities that they do.

This experience of the run on the shadow banking system that occurred in 2007 and 2008 reminds us that similar disorderly flights of uninsured deposits from banks lay at the heart of the financial panics that afflicted the nation in the late nineteenth and early twentieth centuries. The most dramatic of these episodes were the bank runs of the early 1930s that culminated in the bank holiday in 1933. Just as it was necessary, though not sufficient, to alter the environment that led to those successive deposit runs by introducing deposit insurance in order to create a stable financial system in the early-twentieth century, today it is necessary, though not sufficient, to alter the environment that can lead to short-term wholesale funding runs in order to create a stable financial system for the early twenty-first century.

Many of the key problems related to shadow banking and their potential solutions are still being debated domestically and internationally, but some of the necessary steps are already clear.

First, we need to increase the transparency of shadow banking markets so that authorities can monitor for signs of excessive leverage and unstable maturity transformation outside regulated banks. Since the financial crisis, the ability of the Federal Reserve and other regulators to track the types of transactions that are core to shadow banking activities has improved markedly. But there remain several areas, notably involving transactions organized around an exchange of cash and securities, where gaps still exist. For example, many repurchase agreements and securities lending transactions can still only be monitored indirectly. Improved reporting in these areas would better enable regulators to detect emerging risks in the financial system.

Second, we need to reduce further the risk of runs on money market mutual funds. Late last year, the Council issued a proposed recommendation on this subject that offered three reform options. Last month, the SEC issued a proposal that includes a form of the floating net asset value (NAV) option recommended by the Council.

Third, we need to be sure that initiatives to enhance the resilience of the triparty repo market are successfully completed. These marketwide efforts have been underway for some time and have already reduced discretionary intraday credit extended by the clearing banks by approximately 25 percent. Market participants, with the active encouragement of the Federal Reserve and other supervisors, are on track to achieve the practical elimination of all such intraday credit in the triparty settlement process by the end of 2014.

Completing these three reforms would represent a strong start to the job of reducing systemic risk in the short-term wholesale funding markets that are key to the functioning of securities markets.

Today, although some of the most fragile investment vehicles and instruments that were involved in the pre-crisis shadow banking system have disappeared, non-deposit short-term funding remains significant. In some instances it involves prudentially regulated firms, directly or indirectly. In others it does not. The key condition of the so-called "shadow banking system" that makes it of systemic concern is its susceptibility to destabilizing funding runs, something that is more likely when the recipients of the short-term funding are highly leveraged, engage in substantial maturity transformation, or both…

First, the regulatory and public transparency of shadow banking markets, especially securities financing transactions, should be increased. Second, additional measures should be taken to reduce the risk of runs on money market mutual funds. The Council recently proposed a set of serious reform options to address the structural vulnerabilities in money market mutual funds.

Third, we should continue to push the private sector to reduce the risks in the settlement process for tri-party repurchase agreements. Although an industry-led task force made some progress on these issues, the Federal Reserve concluded that important problems were not likely to be successfully addressed in this process and has been using supervisory authority over the past year to press for further and faster action by the clearing banks and the dealer affiliates of bank holding companies.