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Wednesday, September 04, 2013

The EU wades into the murky world of shadow banking

The European Commission this morning unveiled its initial proposals to regulate ‘shadow banking’ and money market funds (MMFs) – the press release is here and the FAQs are here and here.

We covered this issue back in May when we exclusively released the initial drafts of the proposals – not too much has changed since then. We’ll refrain from recapping the details since the press releases lay them out but below we outline some of our thoughts.
  • The key point in the regulation is that MMFs will be required to hold a ‘Net Asset Value’ Buffer, equal to 3% of all assets under management; the Commission predicts this will “result in an increase of the management fees of 0.09% to 0.30% annually”. There will also be harmonisation with UCITS and AIFMD to move towards a uniform set of rules for the shadow banking sector.
  • As we noted before, the required buffer has real potential to harm the MMF industry. Given the record low interest rates, and very low returns on liquid short term debt, many funds are struggling to stay afloat (with some already shutting down). Although an outcry against increased costs may be expected from the industry, in this case many of the concerns seem valid given the very small margins involved in these funds.
  • There are also some requirements on MMFs holding very liquid assets which can be sold off quickly, while also limiting the level of assets taken from a single issuer to encourage diversification. These rules seem sensible but add further constraints to the returns and flexibility of these funds. There is always a risk in dictating the investment decisions to the market, although its important that the risks in these funds is made clear. It also seems to be doubling up the effort of the buffer mentioned above  - given that losses of such funds rarely exceed 3% (as the Commission itself notes), pushing beyond this level seems slightly redundant.
  • The question of ‘sponsors’ – the banks or institutions which own and/or backstop an MMF – is also vital for a couple of reasons. First, its clear that some sponsors have a competitive advantage, larger institutions will have the ability to provide greater financial aid to its MMF if it gets into trouble – this gives large banks a significant advantage over smaller asset managers. Secondly, it also provides another clear link between the shadow and traditional banking sector, this could potentially become an avenue for contagion (as was seen in the financial crisis) if MMFs get into trouble and need to be bailed out.
  • Much of the rest of the regulation looks fairly sensible at first glance. It’s clear there needs to be greater transparency within the MMF sector – it can no longer be assumed to be equivalent to bank deposits. There also needs to be significantly less emphasis on external ratings by the credit rating agencies (equally true of the standard banking sector ). Furthermore, investors need to be clearer on the risk taken on when investing in these funds and their approach used to make profit (short term funding of long term assets).
  • The broader shadow banking communication remains fairly vague but it is certainly an area which needs to be regulated. The main aim should be to incorporate international regulatory efforts with the existing multitude of EU regulations (many of which cover parts of the shadow banking sector) and avoid duplication. Tackling the issue of ‘collateral chains’ (using a single piece of collateral many times) is also vital, although the importance of the repo market should not be forgotten (see failure of the FTT).
All that said, there is a long way to go in these regulations yet. There is likely to be significant industry opposition (or at least discussion) and approval from both the European Parliament and member states will be tough to gain. It also seems unlikely that this will be completed before next May’s European elections, adding further delays but also raises the question of whether the next Commission will push in the same direction on this issue.


Rik said...

Has disaster written all over it.
You cannot regulate a sector of which you donot understand a thing.
It will either end up in overkill or leaves holes the size of the Moon. Probably both here but more of the former.

Add the fact that failed legislation is nearly impossible to change and it has everything in it to become a complete mess.

And largely for political reasons. hedgefund apparently are the blame in the misconception-analysis of the crisis so these should be regulated while parties that really f'ed up (next to the banks): regulators and CBs and governments go free. Leaving an ideal platform for a next disaster.

jon livesey said...

Ooh, ooh, I have an idea. Instead of keeping the 3% buffer in unproductive cash, why not make the MMFs invest it in eurozone sovereign debt. That never defaults, right?

Anonymous said...

Another EU disaster in the making which will lead to further job destruction (primarily in the UK) and lower growth and lower pensions throughout Europe:

1. I have just had to move the unitised cash element of my pension fund as it offers me a -0.3% return each year. Yes, that is a minus return! Adding more regulation and hence fees will reduce this even further to nearer -1.0%, meaning that many people like me now have to take on more (unwanted) risk for a decent return. Add this to pointless regulation of hedge funds and UK financial services and it even more unlikely that any of us will be able to retire with an adequate pension.

2. With the latest Basel regulations, more stupid EU regulation (AIFMD, EMIR and Solvency II etc) and the Capital Requirements Directive meaning banks having to hold more cash against 'riskier' business operations, banks themselves are exiting many parts of the market leaving some segments unserved or too expensive to use. Enter the shadow banks who provide competition, lower fees and a more honest service than a bank.

These are just two examples of many that I can think of.

Shutting down the shadow bank market is just going to cause chaos as nobody within the EU understands finance and the law of unintended consequences.

The EU and Eurozone have now managed to create the largest destruction of wealth in the history of this planet and NOW is the time for it to stop.

I want my country back. I firmly believe that the EU and Eurozone are going to cause an economic crash and, ultimately, the very war that they seek to avoid.

UK out.