EU, G20 to coordinate drive to regulate ‘shadow banks’

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The European Commission may apply the EU’s mandatory capital rules for banks to a wider set of institutions to cover risks in "dark corners" of the financial system, says a draft EU law to be presented next Wednesday (4 September). The regulatory drive is coordinated with the G20, which is set to endorse a new global set of rules at a summit next week.

The draft law, seen by the Reuters news agency, outlines possible reforms to regulate "shadow banking", or lightly supervised intermediaries outside mainstream banks that generate trillions of euros to finance the economy through securities lending, repurchase markets and securitisation.

Extending the scope of capital rules to shadow banks would respond to EU lawmaker concerns that similar activities should be regulated in the same way, according to the draft.

"It is not possible to discuss shadow banking without considering the scope of application of the EU banking prudential rules," the EU document said.

The European Banking Authority, an EU watchdog, will be asked to assess the size of financial entities that fall outside the scope of current bank capital rules, the document added.

Globally the shadow banking sector is estimated at around $60 trillion (€45 trillion), with $31 trillion (€23 trillion) in the EU.

The European Commission’s started looking into shadow banking in March last year when it launched a public consultation aimed at establishing a clear definition of the sector.

“What we do not want is for financial activities and entities to circumvent existing and foreseen rules, allowing new sources of risk to accumulate in the financial sector,” Internal Market Commissioner Michel Barnier said at the time. 

The draft law, which may be revised prior to publication, says the Commission will look at risks from "certain investment techniques and strategies".

Officials explained that shadow banking could act as a useful alternative source of funding for the economy, but also gave rise to “financial stability concerns”, particularly fears of panic runs on banks or financial markets.

"In particular, the review will examine how investment funds use securities financing transactions. Funds will have to ensure that use of this type of transaction does not impair their liquidity," the document said.

The Commission may propose a securities law to regulate how securities are re-lent throughout the financial system, making it difficult to know who actually owns them.

The collapse of Lehman Brothers bank in 2008 highlighted this problem, showing how a default of a large institution may destabilise securities markets, the document said.

The European Commission will also publish its first draft law on Wednesday 4 September to toughen up supervision of another part of the shadow banking sector – money market funds.

G20 to endorse global rules

The drive to regulate shadow banking is not limted to the EU. Leaders of the group of 20 economies (G20) will meet in Russia next week to endorse a new set of global rules setting out requirements for the sector and how it must be supervised.

The sector has been given until 2015 to comply fully with the rules, written by the Financial Stability Board (FSB), an international regulatory task force. Checks on compliance will start in two years' time.

The rules are designed to curb excessive risk-taking by a sector that does not have access to central bank support or safeguards such as deposit insurance and debt guarantees. However, the FSB has sought to balance its proposals with the need to avoid harming an industry that is vital to financing the economy.

Governments have already forced mainstream banks to hold more capital and FSB Chairman Mark Carney said the latest reform is an essential first step in transforming shadow banking into sound market-based financing.

"This in turn will help diversify the sources of financing of our economies in a sustainable way and contribute to the G20's ultimate objective of strong, sustainable and balanced growth," added Carney, who is also Governor of the Bank of England.

Daniel Tarullo, an FSB member and a governor at the U.S. Federal Reserve, said the rules were necessary because the tighter leash on banks may encourage risky operations to move to sectors with less stringent regulation.

Haircuts ahead

The FSB said the focus is mainly on identifying shadow banking activities rather than individual businesses – a change of tack from the approach taken with big banks and insurers.

The G20 summit is set to endorse tougher rules for nine named insurers, as it has done for nearly 30 big banks, but a comparable hit-list of shadow banks has not been outlined.

Shadow banking activities that have been targeted include credit investment funds, exchange-traded funds, credit hedge funds, private equity funds, securities broker dealers, credit insurance providers, securitisation and finance companies.

Despite the FSB's softly-softly approach, the reforms are certain to raise the hackles of some within the industry.

The FSB has decided to press ahead with plans to set the world's first minimum discounts, known as "haircuts", on the value of collateral to back repurchase, or repo, transactions and securities lending to ensure a big enough cushion if market valuations plunge.

The repo market involves borrowers selling the lender a security as collateral and agreeing to buy it back later at a set time and price.

Industry players including BlackRock and the International Securities Lending Association have said that minimum haircuts – which could be set at anything between 0.5% and 7.5% – could disrupt markets at a time when funding is needed to put sluggish economic recovery into a higher gear.

The warning has been heeded by the FSB. To soothe concerns the rule has has been put out to consultation and it won't be finalised until next year.

Actual implementation won't start until market conditions are right and authorities and industry have enough time to adjust their systems, the FSB said.

Regulators are also finalising new curbs on links between mainstream banks and shadow banking participants, though the FSB has not set a date for their introduction.

Hedge funds and private equity are often cited as examples of shadow banking, but the term can also take in investment funds and even cash-rich firms that lend government bonds to banks, and which in turn use them as security when taking credit from the European Central Bank.

The sector, which operates on the fringes of mainstream banking, has more than doubled to €46 trillion since 2002, when it accounted for €21 trillion of the global economy.

Political leaders have been alerted to the difficulties presented by shadow banking. In response to invitations by the G20 in Seoul in 2010 and in Cannes in 2011, the Financial Stability Board (FSB) – a G20 task force – is in the process of developing recommendations on the oversight and regulation of these entities and activities. The Commission’s green paper is designed as a parallel action to complement and track the ongoing FSB work.

  • 4 Sept.: European Commission presents legislative proposal on shadow banking
  • 5-6 Sept.: G20 summit in Saint Petersburg, Russia
  • By 2015: New global supervisory framework to be operational

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