WASHINGTON — Prudential rules dealing with liquidity and other market-related items may be a better regulatory response to the expansion of the asset management industry than higher capital buffers, Federal Reserve Board Gov. Daniel Tarullo said on Monday.

Tarullo said in a speech in Paris that while the growth of asset managers such as hedge and mutual funds is a cause for concern, they do not pose leverage risk comparable to that of banks. The risk of asset managers causing a run could be better managed with market rules than capital rules, he said.

"While some commentators have suggested that liquidity challenges and consequent fire sale type behavior might develop if the structure of the fund places a premium on exiting first, these kinds of risks would support an argument less for capital buffers than for some form of prudential market regulation, such as rules on liquidity or redemptions," Tarullo said at a conference hosted by the Banque de France. "Likewise, to the degree that certain idiosyncratic risks might exist with respect to the decisions and operations of certain asset managers, their liability structure again suggests that some form of prudential market regulation would be better suited to address these risks."

Last week, the Securities and Exchange Commission proposed liquidity rules for exchange-traded funds and mutual funds that would require them to disclose their liquidity levels and redemption practices and to manage those risks to reduce the possibility of runs.

Such nonbank firms that operate in the so-called "shadow banking" sector have attracted more focus after the financial crisis. Following the meltdown, Basel III and the Dodd-Frank Act required most of the world's largest banks to vastly increase their capital buffers. But various nonbanks that perform many of the same functions have faced either no similar capital requirements or less stringent ones.

The Financial Stability Oversight Council — an interagency panel tasked with identifying and addressing systemic risks — last year began examining whether any additional rules may be necessary to shore up the asset management sector.

But the SEC's recent proposal on mutual funds and ETFs — the first of what is expected to be several new regulations on the shadow banking sector — indicates the agency continues to oppose the FSOC's intervention.

Meanwhile, Tarullo said international regulators looking to address systemic risk generally outside of the traditional banking industry should include a focus on the liabilities of systemically risky firms in any future rules.

He noted that regulators have taken such steps in dealing with liquidity risks at banks. While the Basel accords have traditionally focused on capital, global regulators have sought to strengthen liquidity standards and set limits on "runnable liabilities" with both the Liquidity Coverage Ratio and the Net Stable Funding Ratio. The former deals with an institution's ability to weather a short-term liquidity crisis, while the latter focuses more on a company's longer-term liquidity strength.

He added that the Fed has taken initiative to address the link between liquidity and systemic problems by requiring "global systemically important banks" that rely on short-term wholesale funding to a pay higher capital surcharge — an approach that he said should be adopted as the standard in future Basel accords.

"I hope that when it comes time for a review of the Basel methodology for identifying and grouping GSIBs, funding practices and vulnerabilities will receive more attention," Tarullo said. "Exploring ideas along these lines seems to me far preferable to raising minimum liquidity requirements for all banks, even those with capital levels well above the regulatory minimum."

Tarullo said emphasizing a company's liabilities might also particularly help guide any approach to addressing systemic risks at systemically significant insurance firms.

The traditional life or property insurance business itself does not pose inherent risk to the financial system, he said, but as those firms diversify their offerings and the liabilities on their balance sheet, the need for additional prudential controls becomes apparent.

"The move of some insurance firms into securities lending, [repurchase agreements], over-the-counter derivatives, and other capital market activities can work significant changes in the balance sheets of those firms, creating tighter connections to the rest of the financial system," Tarullo said. "As with other financial intermediaries, insurers then become subject to demands for posting additional collateral or closing out positions as unfavorable market conditions take hold."

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