The ‘shadow’ banking industry is worth €24 trillion globally, holding more than a fifth (22%) of short-term government and corporate debt, and accounting for 38% of short-term debt issued by the banking sector.
The sector is made of money market funds, some hedge funds, and firms involved in securities lending and repurchase markets. Such funds allow companies and governments to spread their risk outside the traditional banking sector.
But they have also remained largely unregulated, posing a potential systemic risk to the economy, according to the European Commission, which has announced a package of measures designed to increase the security of the sector. This is because traditional banks often sponsor the funds and rely on them to finance themselves, making the banking sector vulnerable to systemic risk, according to the EU executive.
"We have regulated banks and markets comprehensively," said Michel Barnier, the EU's internal market commissioner, who presented the proposals yesterday (4 September).
"We now need to address the risks posed by the shadow banking system. It plays an important role in financing the real economy and we need to ensure that it is transparent and that the benefits achieved by strengthening certain financial entities and markets are not diminished by the risks moving to less highly regulated sectors."
Buffers proposed to withstand panic withdrawals
Most controversially the proposals would see constant net asset value (CNAV) funds – which maintain a fixed value of €1 per share to keep their holdings stable – forced to hold a cash buffer equivalent to 3% of their assets, with a three-year phase in.
The EU executive hopes such buffers would guard against the danger of panic withdrawals leading to a run on such funds.
The measure is also designed to encourage funds with share prices that fluctuate in line with performance, which are seen by regulators as more transparent.
The draft law also outlaws credit ratings on money market funds, to prevent ratings downgrades creating panic and also includes a "roadmap" on regulating the wider sector, with a proposal that all institutions involved in shadow banking set aside capital buffers to cover risks.
France, Germany wanted more
The proposals will now be subject to negotiation among EU member states and the parliament.
France and Germany originally called for a ban on shadow banking activities, and sources in the Germany's Finance Ministry said on Wednesday that the Commission proposals were not far reaching enough.
Barnier, said he was not "waging a war" on CNAV funds and that the 3% buffer represented a compromise after calls from the European Systemic Risk Board, a body linked to the European Central Bank, Germany and France for an outright ban.
The EU executive's proposals are designed to run in parallel with the work of a G20 task force - the Financial Stability Board - which will consider shadow banking at the summit in St Petersburg beginning today (5 September).
The United States is also considering proposals to regulate money market funds in the shadow banking sector, but is not expected to opt for an EU-style 3% buffer.