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Home > Blogs > Anthony Harrington > Shadow banking system to get the regulatory make-over

Shadow banking system to get the regulatory make-over

Shadow banking system to get the regulatory make-over Anthony Harrington

The European Financial Stability Board (FSB) has issued a consultation draft setting out the ways it is proposing to extend regulation from the deposit taking banking system to the shadow banking system. In so many ways this was always the inevitable next step for the regulatory machine. The regulators have been gamed again and again by the banking community via the shadow banking system (SBS), through the use of exotic special purpose vehicles and numerous other ploys. So not turning the regulatory spotlight on this area of financial activity would have constituted a gross dereliction of duty.

Of course, the first order of business, if you want to regulate something, is to define what it is that you propose to regulate. With the SBS, this is no simple matter. The FSB approaches the task from the standpoint that there clearly is what it terms “an increasing area of non-bank credit activity, or shadow banking, which has not been the prime focus of prudential regulation and supervision.” It will not escape the reader’s attention that this is a pretty broad brush stab at a definition. The FSB knows this and is calling for all interested parties to come up with useful suggestions here.

The FSB is not quarrelling with the idea that the SBS performs a useful function. It concedes that the SBS “creates additional sources of funding and offers investors alternatives to bank deposits.” But, and this is the huge caveat, the SBS “can also pose potential threats to long-term financial stability.” How? In a number of ways. First, as the FSB notes, “the disorderly failure of shadow banking entities can carry systemic risk, both directly and through their interconnectedness with the regular banking system.”

What the FSB is getting to here is leverage. Shadow banking entities love leverage and they quite often get their debt from banks. That should, of course, be covered by the Capital Requirements Directive (CRD) which requires banks to set aside more capital for more risky ventures. So what is the FSB fussing about? What is alarming it is that banking and shadow banking interconnectedness is not just about A lending to B, but quite often, about A lending to itself because it has rather sneakily set part of itself up as a “B”.

The use of SPVs (special purpose vehicles) by investment banks through the run up to the crash, coupled with the use of “innovative financial engineering” in the form of Collateralised Debt Obligations (CDOs) spread toxicity from the US sub-prime mortgage debacle through much of the global banking system. The FSB doesn’t expect banks to go down that specific road again in a hurry, particularly since it now has consolidation rules that pull SPVs back onto bank consolidated accounts. But it is really worried that bankers will look at the stringent CRD regime they are labouring under and then look at the relative freedom of the SBS. “Reinforced banking regulation could drive a substantial part of banking activities beyond the boundaries of traditional banking and towards shadow banking,” the FSB notes.

In other words, if you regulate the banks, you have to regulate the SBS or banks will simply cross the road to the brighter side of the street.

The problem the FSB has, however, in getting this next phase of its regulatory mission off the ground is that the SBS is a catchall phrase that covers a wide assortment of very different activities. Securities lending gets swept up into the SBS, as do the numerous new funds being set up to lend directly to non-investment grade corporates. These two activities have just about nothing in common with each other, so best of luck defining a single set of rules that covers both in a sensible fashion. One could go on and on.

The FSB points out that it is not alone in setting out on this courageous quest. Half a dozen regulatory organisations are at its elbow, locking shields with it and constituting a formidable phalanx advancing on the SBS. There is the International Organisation of Securities Commissions (IOSCO), which is taking aim at Money Market Funds. The Basel Committee on Banking Supervision (BCBS) is right in there. And there is the regulatory machinery of the US, China and Japan, all lining up with the FSB, supposedly, though conflicting national priorities could create a few bumps in the road here.

This green paper is the first shot the FSB is firing in what will doubtless be a long campaign. It will be interesting to watch the responses from the various constituent parts of the SBS…

Further reading on Basel III and Solvency II:

Tags: banking , banking system , banks , Basel III , central banks , investment banks , investments , liquidity , shadow banking system , Solvency II , systemic risk
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