MEPs approve rules shining a light on ‘shadow banking’

Lord Jonathan Hill [European Commission]

Financial transactions using shares, or other assets, to secure credit, will come under greater scrutiny after the European Parliament approved a new law on Thursday (29 October) on the ‘shadow banking’ sector.

Shadow banking refers to the creation of billions of euros in credit outside mainstream banking by allowing asset managers, pension funds and others to access secured funding by temporarily lending assets like shares.

Borrowers of securities can include hedge funds, who have sold shares short and need to cover their positions.

The law introduces mandatory reporting of securities financing transactions to help regulators spot the build up of overly risky positions.

“Today’s rules will increase transparency in securities financing markets,” said Jonathan Hill, financial services chief at the European Commission, which proposed the law in 2014.

“They will allow market participants to use them for financing the economy, while making it easier to monitor and assess the risks involved,” Hill argued.

>>Read: EU steps up regulatory pressure on ‘shadow banks’

Under the new law, investment funds will have to disclose to investors the returns they make on the transactions.

Member states are due to formally rubber stamp the legislation soon, and it will start taking effect in 2016.

Shadow banking was seen as a problem during the 2007-09 financial crisis, but the sector has since been viewed in a different light.

As banks rein in lending to focus on rebuilding their core capital levels, policymakers like Hill have been promoting markets as a source of funding for the economy.

The European Central Bank stated that shadow lenders, such as investment funds, have driven growth in eurozone financial assets.

“The shadow banking sector is an increasingly important provider of funding to the euro area economy,” the ECB said.

On 29 January 2014, the European Commission adopted a proposal for a regulation to stop the biggest banks from engaging in proprietary trading and to give supervisors the power to require those banks to separate other risky trading activities from their deposit-taking business.

To prevent banks from attempting to circumvent these rules by shifting parts of their activities to the less-regulated shadow banking sector, the Commission adopted a proposal for a regulation aimed at increasing transparency of certain transactions outside the regulated banking sector.

This proposal provides a set of measures aiming to enhance regulators’ and investors’ understanding of securities financing transactions (STFs). These transactions have been a source of contagion, leverage and procyclicality during the financial crisis and they have been identified in the Commission’s Communication on Shadow Banking as needing better monitoring.

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.

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