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.