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UPDATE 3-Fed's Tarullo warns on passing the buck on money-fund reforms

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* SEC action is 'first-best' option; FSOC is 'second-best'

* Fed official still hopes SEC will adopt money market rules

* Tarullo also floats 'upper bound' on bank size

(Adds comments on limits to bank size)

By Jonathan Spicer

PHILADELPHIA, Oct 10 (Reuters) - It would be best if theSecurities and Exchange Commission finally moved forward withmoney market reforms instead of leaving the job to the new U.S.financial risk council, a top Federal Reserve official said onW edn esday.

Fed Governor Daniel Tarullo said it was unfortunate that theSEC, the primary regulator of the $2.6 trillion industry, has sofar failed to advance new rules for the market, which since thefinancial crisis has been viewed as posing a systemic risk.

In a wide-ranging lecture that touched on the limits anddifficulties of crafting new rules in the wake of the 2007-2009financial crisis, Tarullo, the U.S. central bank's point personon regulation, also floated the idea that the size of banksshould be capped.

The Fed official's comments on money market funds, however,shed some light on how regulators intend to deal with theindustry after SEC Chairman Mary Schapiro said on Aug. 22 thather agency would not formally put forward its reform proposals,since three of five commissioners opposed them.

That left the next move to the Financial Stability OversightCouncil, or FSOC.

"Each of the options open to the FSOC and the rest of itsconstituent agencies is decidedly a second-best alternative ascompared to a change in SEC rules to remove the fixed net assetvalue exception, to require a capital buffer that would staunchor buffer runs, or measures of similar effect," Tarullo said atthe University of Pennsylvania Law School.

Any FSOC reforms would be worse for the funds themselves, heargued, because the tools available to the council "do not fitthe problem precisely and thus will not regulate at the leastcost to the funds while still mitigating financial risk."

The industry says money market funds are a safe investmentwith attractive returns, while critics worry that they arevulnerable to runs and create a false sense of security forinvestors who do not realize they are not backed by federalinsurance.

Schapiro has argued that a series of reforms the SEC adoptedin 2010 do not go far enough to prevent runs on funds like theone experienced in 2008 when the Reserve Primary Fund "broke thebuck," meaning its net asset value fell below $1 a share.

On Sept. 27, U.S. Treasury Secretary Timothy Geithner calledon the FSOC to formally ask the SEC to move forward with newrules. He also said the council should consider exercising otherpowers to regulate the money market fund industry more tightly.

The next day, Daniel Gallagher, a Republican SECcommissioner who had previously helped block the fund reforms,told Reuters he hopes the agency will consider a fresh packageof reforms.

In a nod to those comments, Tarullo said: "My hope, ofcourse, is that recent indications that other SEC commissionersare now willing to move forward with reforms will lead to theSEC adopting first-best measures in the near term."

While Tarullo sits in on FSOC meetings, Fed Chairman BenBernanke is the central bank's official representative on thecouncil.

The FSOC's options include imposing restrictions on banks'and other firms' "ability to sponsor, borrow from, invest in, orprovide credit to" money market funds that do not havestructural protections, Tarullo said.

The council could also designate money funds as"systemically important" and thus subject to capital andliquidity rules included in the Dodd-Frank financial reform law,he said.

For non-banks in general, the FSOC is "actively considering"possible systemically important designees, Tarullo added.

Turning to bank acquisitions - which under Dodd-Frank arereviewed by the Fed for threats to financial stability - Tarullosaid the fact that lawmakers did not set an "upper bound point"makes things difficult for regulators.

"To the extent that a growing systemic footprint increasesperceptions of at least some residual too-big-to-fail quality insuch a firm, notwithstanding the panoply of measures inDodd-Frank and our regulations, there may be funding advantagesfor the firm, which reinforces the impulse to grow," he said.

"There is, then, a case to be made for specifying an upperbound," Tarullo said, adding, "It would be most appropriate forCongress to legislate on the subject."

(Reporting by Jonathan Spicer; Editing by Eric Walsh; Editingby Diane Craft and Dan Grebler)

((jonathan.spicer@thomsonreuters.com)(+1 646 223 6253)(ReutersMessaging: jonathan.spicer.reuters.com@reuters.net))

Keywords: USA FED/TARULLO