European Union regulators are targeting shadow banking as the next part of the financial-services industry to come under scrutiny, determined that tighter rules imposed on traditional banking should not simply push problems elsewhere.
Shadow banking – made up of financial entities that create credit outside the regular banking sector – has grown rapidly over the past few years, to the extent that it is now estimated to be worth about €50 trillion worldwide, representing nearly one-third of the global financial system.
Michel Barnier, the European commissioner for the internal market and services, is to launch a consultation on Monday (19 March) as to whether and how to regulate shadow banking. So far the sector has gone largely unregulated, and many observers believe that it poses a greater systemic risk to global financial stability than almost anything else.
One of the first things that regulators will have to do – and this is central to the questions in the European Commission’s consultation document, a draft of which has been seen by European Voice – is to decide exactly what should be classed as shadow banking. The name does not help. As one top banker, Douglas Flint, the chairman of HSBC, said last week (8 March), the term ‘shadow banking’ makes people think of “a dodgy guy around the corner with a suitcase”. He called for it to be “eliminated from the lexicon of finance”.
But the name has taken root and, as regulators shine their spotlight into the shadows over the next few months, a battle will intensify over what should and what should not be illuminated. From special-purpose vehicles to money-market funds and repurchase transactions (‘repos’), all mentioned in the Commission’s document (see panel), pinning down exactly what should be regulated will not be an easy task.
A different approach
Regulators have a careful balance to strike. Shadow banking has become increasingly important in keeping the wheels of finance well oiled over the past few years, particularly as traditional banks, restrained by tighter rules, a loss of confidence and unhealthy balance-sheets, have struggled to gain access to funding in the ways that they once did.
Analysts warn against regulation going too far and stifling healthy shadow-banking activities. Much shadow-banking behaviour is considered a useful alternative to the regular financial system – particularly useful when ordinary banks’ liquidity dries up. Many in the industry also claim that shadow banking provides a useful diversification of risk away from the traditional system.
What might shadow banking include?
Private equity funds
The companies run by investment specialists that channel capital, often raised from financial institutions, into commercial projects.
Short-term investment vehicles that tend to invest in very low-risk securities such as companies’ commercial paper or government securities. They pay very low rates of interest and dividends.
Investment funds that aim to achieve a return on an asset irrespective of the current state of the market. They have huge minimum investment levels. Investors are often pension funds and large financial institutions.
Entities created for a specific purpose, normally for a limited amount of time, into which companies transfer debt. This is designed to protect the company from financial risk associated with that debt. They are often used to help companies fund a large specific project without putting the rest of the company at risk.
Process of pooling assets and converting them into securities that can then be traded to increase liquidity.
Exchange Traded Funds
A portfolio of assets such as bonds, currencies or stocks that are traded on an exchange.
Repurchase transactions (‘repos’)
Transactions in which one party sells securities to another and agrees to buy them back at a set price later.
But shadow banking has become a victim of its own success. It has been able to produce credit in ever more innovative ways; but as the sector has become bigger, the prospect that it might trigger the next financial crisis has begun to worry regulators.
“We must be careful,” said Barnier in a speech on systemic risk at a City of London event on 23 January. He said that there was a danger that new rules imposed on traditional banks “drive banking and other financial activities into shadow banks, or unregulated entities which lend funds like banks”.
The inter-dependent nature of the financial system is what is causing the fear. As with traditional banks, ‘runs’ on shadow banks can cause havoc, and that could infect ordinary banks. If depositors make sudden huge withdrawals of money, the effects can be even worse in the shadow-banking sector since they lack the type of protection offered in the traditional banking sector.
The EU’s financial legislation has already regulated a certain amount of shadow-banking activity, either directly or indirectly. Banking and insurance regulation, notably the international Basel rules and the EU’s capital requirements directives, which obliged banks to carry more capital if they engaged in shadow-banking activity, has attempted to limit the involvement of traditional banks in unregulated behaviour. The directive on alternative investment fund managers, adopted in 2010, which clamped down on hedge funds, took a more direct approach to one part of the shadow-banking sector.
The Commission’s work will run in tandem with that carried out by the Financial Stability Board (FSB), the organisation established after a summit of the G20 group of advanced and emerging economies in London in 2009. The FSB is made up of finance ministers, regulators and bankers. Mark Carney, the FSB’s chairman, said when he was appointed in November that regulating the shadow-banking industry was one of his top priorities. The FSB’s recommendations for G20 member states are expected to be concluded by the end of 2012.
There is a long way to go. If part of the growth of the shadow-banking sector can be directly attributed to the increase in regulation on traditional banks then regulators must guard against merely pushing problems elsewhere again. Companies involved in shadow banking fear that what they see as vagueness of the term could lead to sweeping regulation being introduced, with unintended consequences. However, most observers are agreed: shadow banking is a sector whose time for regulation has come. The hard part will be working out exactly what that means.
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