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Monday, May 06, 2013

Exclusive: Internal docs give first look at EU plans to regulate 'shadow banking'

The Times reports today on another round of exclusive documents leaked by Open Europe, this time regarding European Commission plans to regulate the ‘shadow banking sector’. See here and here for the docs.

A rather niche story you might think but it could have important implications for the way money is lent throughout the economy. Below we provide some background and our thoughts on the proposals.

What is the shadow banking sector?
“The FSB defined the shadow banking system as "the system of credit intermediation that involves entities and activities outside the regular banking system". This definition implies the shadow banking system is based on two intertwined pillars.

First, entities operating outside the regular banking system engaged in one of the following activities:
  • accepting funding with deposit-like characteristics;
  • performing maturity and/or liquidity transformation;
  • undergoing credit risk transfer; and,
  • using direct or indirect financial leverage.
Second, activities that could act as important sources of funding of non-bank entities. These activities include securitisation, securities lending and repurchase transactions ("repo").”
Essentially, it is made up of institutions outside the banking sector but which provide paths for borrowing and lending as well as significant financial investments. According to the Financial Stability Board (FSB) in 2011 it totalled €51 trillion worldwide.

Why are there concerns regarding it and are they valid?
  • Shadow banking came to light in the aftermath of the financial crisis where it is thought to have played an important role in allowing the financial sector to hide the true level of risk in the system.
  • There are some valid concerns over shadow banking. It operates outside but closely related to and interlinked with the regular banking system. This means it falls outside of scope of regular supervision and regulation.
  • Often pursue highly leveraged activities, search for high yields and transform maturities from short to long (can cause a mismatch in funding if a crisis hits). There is significant use of opaque securitisation, hard to judge real value.
  • Often have very low levels of capital, funded in the short term by lending and investments which needs to be regularly rolled over. This is used to fund long term assets. Helps boost profits but also magnifies losses. Due to this set up, the system very exposed to liquidity crises which can hit hard and fast.
  • IMF recommended recently that key aims should be to reduce spill over from shadow banking to regular banking system (reduce prospects for rapid contagion in a crisis) and to reduce the procyclicatlity of the shadow system.
  • All that said, it does provide a valuable service in many cases, particularly as an alternative method for distributing credit to the real economy when the banking sector is failing to do so sufficiently.
Thoughts on the EU proposals so far
  • The proposals are still at an early stage and subject to change. A key issue is how any shadow banking regulation will fit with the raft of other financial regulation in the pipeline or already in force – AIFMD, CRD IV, EMIR, UCITS, and Solvency II to name but a few.
  • Importantly, many of these other regulations already cover many of the institutions involved in the shadow banking sector. Avoiding double regulation and inefficiency is vital, therefore judging and implementing the current regulations is important before a shadow bank regulation is brought in.
  • Shadow banking is not part of regular market and those involved do not have deposits so there is no question of a government backstop or bailout scenario. Can and should go bust. The main point is that any shadow banking crisis should not transform into a ‘systemic crisis’. The approach should therefore be ‘macroprudential’, taking an overview of the market and ensuring it is not overly risky and/or that it is not too heavily intertwined with regular banking sector.
  • This may be more effectively done by setting out guidelines for supervision and cross border data collection that a strict regulation.
  • The EU must also be wary of regulating against specific financial instruments, which could have perverse effects. For example, ‘securitisation’ has become a hot topic. This tool was misused during the financial crisis but is not an inherently bad thing. As ECB President Mario Draghi pointed out recently, effective securitisation of SME loans could help boost lending to SMEs and increase level of quality assets in Europe.
  • Money Market Funds are different to many other parts of this sector. They are essentially pools of deposits or excess funds from finanical firms which are invested in the short term to gain small gains above what standard deposits would reap. They invest heavily in short term government, corporate and finanical debt and play a key role in providing liquidity to the market. The Commission looks to be regulating these separately, which is the right way to go. However, any small increase in costs could hamper the whole industry since their margins are so low - in fact some have already been closed due to the record low interest rates. 
As we said the proposals are just getting going so all this is still open. Regulation of the shadow banking sector is necessary but its also vital to note that it plays an important role in providing credit to the real economy (despite its rather ominous sounding name). At this point in time its not clear that a regulation is needed immediately and it may be more effective to improve and work with what is currently on the table. Furthermore, in an ideal world, any attempt to tackle it would be done on a global level in the form of a set of guidelines and plans for data sharing and increased transparency.


Jesper said...

It is being said that EU institutions are filled with highly qualified people but when I read their output it seems like it has been written by undergraduates without work-experience...

A (capital?) buffer of 3% to cover fluctuations? Is that the same as saying that a leverage of 33 is ok?

Sorry, but this bit is plain wrong:
"All that said, it does provide a valuable service in many cases, particularly as an alternative method for distributing credit to the real economy when the banking sector is failing to do so sufficiently."
The shadow banking sector does not distribute credit to the real economy. That is what banks do, so either they are banks or they are not.

The shadow banking is problematic and the problem is highlighted by the incomplete description of the shadow banking sector. The report includes what the shadow banking sector finances but not who finances it.

Using a MMF can keep huge amounts guaranteed: A MMF dedicated to one customer can in theory and in practice spread out deposits across all euro-zone banks - suppose there is 600 banks in the euro-zone and multiply that number by the guaranteed amount of 100,000 EUR. That will give a protected amount of 60,000,000 EUR (60 million EUR, would be quite a large monthly payroll...). Good thing is that liquidity will spread, bad thing is that as there is a guarantee it means that the pressure to do due diligence is reduced. Regulators aren't enforcing much in some jurisdictions, if the market doesn't impose much discipline either then banks won't have to do much better than they have been doing in the last couple of years...

Record low interest rates have made it less attractive to use the shadow banking sector, however, the Cypriotic haircut has made it more attractive to use the shadow-banking sector. On balance it might possibly be a wash.

Want to actually deal with the shadow banking sector? Treat them as banks and force them to have at least the same size capital buffer as banks are legally required to have.

jon livesey said...

I think it must be Spot the begged Question Week once more.

It doesn't really matter what you think of shadow banking or what "concerns" you have. Is the body that has made such a hash of the European economy and the euro really the right one to regulate a whelk stall?

Rik said...

They are indeed highly skilled and qualified people, well at least their uncles Mikos, Juan and Paolo told me so.

Like with tax, after legislation is in place people more clever than the ones who drafted it (often assisted by the ones who drafted it) and all with the benefit of hindsight, will look where the gaps are and exploit them.
If you want these control systems to work you need therefor to do a lot of things different.

In a nutshell being able (legally allowed, with sufficient powers to be effective and even better skilled than the highly qualified people from the EU) to react when a problem could occur.

We are talking about a sector that is essential for the whole economy and where the idea for leverage is the equivalent of thinking that a 50 miles sign means you have to go 50 miles an hour and not max 50 miles an hour.

Jesper said...


the speed limit analogy is a good one, I might extend it a bit:

The people who run banks would not see a speed limit of 50mph as a maximum nor as an order to drive 50mph. What they'd do is to drive at 60mph. They'd do that by first tampering with the speedometer of their car so that it showed a lower speed than what they were actually driving at. If ever stopped, they'd ague that the police measuring equipment isn't statistically proven to be sufficiently correct and drag out for as long as possible. In addition they'd hire any police who'd be brave enough to stop them. If their speeding where to be a factor in an accident they'd accept no blame, they'd put it on everybody else.

Banks and shadow banks are to be treated as dangerous and therefore heavily regulated. The 'I didn't know/understand' excuse is not to be applicable in dangerous industries. Leverage to the minimum, control to the maximum and if a bank or a shadow bank fails then make the board of directors accountable.

Jesper said...

A story about shadow banks in Ireland:

And an online search for the below search terms might be enlightening: Whistleblower Ireland Uncredit

Anonymous said...

As the EU increasingly and disproportionately regulates the UK's banks and their functions, banks will just not lend, leading to zero growth.

Under EMIR (European Market Infrastructure Regulation - read the EU's Dodd-Frank Act for OTC derivatives), OTC derivative volumes will dive off of a cliff because the EU do not want anyone using them. Investors will be taking on basis risk and will also not be able to hedge out bonafide risks.

My point is that entities and investors with risk capital are entering the shadow banking world where banks have stepped out (due to punitive regulation and cost). It is only shadow banks that will lend in certain areas and we risk, much like the FTT, doing more harm than good - AGAIN.

I would sooner trust a monkey with a pin than the EU.

In fact, the monkey would get a mandate from the UK's people and the EU wouldn't. Says it all.

Referendum and OUT. UKIP.


Anonymous said...

Unelected political failures interfering and getting it wrong yet again. The eussr can never be effective because the constitution and the myriad of unelected bodies gets in the way of progress. Time to dismantle the whole corrupt democratically deficient body.