Shadow Banking in the G20 Agenda: Shining a Light on Regulatory Reform

By Dr Megan Bowman, UNSW.

SYDNEY: 31 October 2014 – Key reform pathways for the G20 under the Australian Presidency coalesce around two core priorities: stimulation of economic growth and strengthening economic resilience. To this end, items on the G20 agenda include regulatory reform of over-the-counter (OTC) derivatives and shadow banking. There is also a growing unease around market pricing and asset bubbles. This piece comprises the second of three articles to explore some contemporary concerns and international efforts in those respective areas. The focus of this piece is regulatory reform of shadow banking in the context of the G20’s twinned priorities as highlighted by the September 2014 G20 Policy Note on Building Financial Resilience.

Shadow Banking: Definition, Players, Benefits and Risks

In most market economies, banks have a tight regulatory envelope within which they must function. They are highly regulated entities because their way of doing business makes them susceptible to failure: they function on a small asset reserve, hold a large proportion of illiquid assets, and work within an inter-bank market that comprises a network of large, unsecured debtor and creditor relationships such that failure of one bank can lead to the collapse of others. Accordingly, banking regulation and supervision tends to emphasise prudence and appropriate risk-taking. Strict rules exist to regulate and monitor day-to-day banking activities such as bank-customer relationships, credit lending, mortgages and other securities transactions, and also financial crime.

In contrast, the term ‘shadow banking’ has been adopted by economists and regulators in the wake of the 2008/09 financial crisis to describe the system of “credit intermediation that involves entities and activities (fully or partially) outside the regular banking system” (per FSB, emphasis added). In short, shadow banking is non-bank credit intermediation. It includes financing by non-regulated entities as well as the non-regulated financing activities of regulated banking institutions. The term covers a range of non-bank financial intermediaries, such as money market funds, hedge funds, and structured investment vehicles, which provide credit and other services similar to traditional commercial banks.

Nonetheless, regulated banks can and do operate within the shadow banking system. For example, shadow banks can facilitate credit in financial markets by becoming part of a chain that involves regulated banks; and investment banks may conduct  business in the shadow banking system, including the use of hedge funds and special purpose entities to enhance client returns on investment. Moreover, shadow banking activity may involve off balance sheet (OBS) financing by regulated financial institutions, which use their subsidiaries to engage in behaviours outside of regulated areas in securitization of loans, repo markets, and OTC derivatives markets.

Indeed, it is the entwined nature of this ‘shadow’ system with prudentially-regulated banks that makes regulation of it particularly challenging.

In addition, shadow banking is not inevitably ‘bad’. In Building Financial Resilience, the G20 acknowledges that shadow banking provides access to credit which in turn supports economic activity, that is, the twin priority to stability in the G20 agenda. Similarly, the FSB states that shadow banking is “a valuable alternative to bank funding that supports real economic activity”. Specifically, in its special report on shadow banking in May 2014, The Economist revealed that it is sometimes cheaper and easier to access credit through a shadow bank for the very reason that it avoids stringent regulation around capital requirements. Ironically, shadow banking can facilitate economic resilience and stability by “disseminating risk beyond the banks… increase[ing] the pool of possible lenders and reduc[ing] the likelihood that defaults will cascade through the financial system, leading to a crisis of confidence”.

Nonetheless, certain types of shadow banking activity can create systemic instability as demonstrated by the financial crisis. Particularly, the FSB has identified shadow banking risk in two key areas: first, risk that stems from large-scale operations “that create bank-like risks to financial stability”; and second, risk created by a complex chain of transactions that generate “multiple forms of feedback into the regular banking system” due to the different stages of leverage and maturity transformation. There is also a risk to investors or depositors that engage in the shadow banking system while expecting the same levels of prudence in risk-taking as regulated banking entities. Such depositors have no recourse against shadow banks under banking legislation and rules.

Regulatory Reform: Objectives and Challenges

Acknowledging the above benefits and risks of shadow banking, the G20 regulatory reform agenda focuses on mitigating shadow banking impacts on financial stability. This is an appropriate focus given the high volume of shadow banking activity. As Cally Jordan reveals: “in the United States, the volume of privately placed securities (which escape most of the regulatory apparatus) exceeded that of publicly offered securities for the first time several years ago”.

Arising from initial G20 recommendations to strengthen oversight and regulation of the shadow banking system in October 2011, the FSB has a Workstream on Securities Lending and Repos (WS5) to “assess financial stability risks and develop policy recommendations, where necessary, to strengthen regulation of securities lending and repos”. On 29 August 2013, the FSB published the report Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos comprising policy recommendations for addressing financial stability risks arising from securities lending and repos (“securities financing transactions”). Those recommendations included:

  • standards and processes for data collection and aggregation at the global level to enhance transparency of securities financing markets;
  • minimum standards on cash collateral reinvestment;
  • requirements on re-hypothecation;
  • minimum regulatory standards for collateral valuation and management; and
  • policy recommendations related to structural aspects of the securities financing markets such as central clearing and bankruptcy law.

In October 2014, the FSB reported that most of the 2013 policy recommendations have been finalised and set out its regulatory framework for haircuts on non-centrally cleared securities financing transactions. In revealing the regulatory framework, the FSB is clearly cognisant of cross-border differences in implementation: it has specified that application of the framework “may vary in details across jurisdictions, depending on existing regulatory frameworks and approaches adopted by national/regional authorities for implementing the numerical haircut floors”.

Europe provides a good example here. Similar to the G20, the European Commission (EC) approach to shadow banking reform consists of “delivering transparent and resilient market-based financing while tackling major financial risks”. The EC has been promulgating a number of reform measures in this space over the past year. Following consultation on a Green Paper on Shadow Banking in March 2012, the EC adopted a Communication on 4 September 2013 that set out its roadmap to limit the emergence of risks in shadow banking with specific focus on systemic risks arising through interconnectedness and contagion with the regulated banking system. Concomitantly, the EC proposed new rules on money market funds as one of the actions recommended by the Communication on shadow banking. In January 2014, the EC 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. The EC then needed to adopt a proposal for a regulation aimed at increasing transparency of certain transactions outside the regulated banking sector in order to prevent banks from attempting to circumvent the initial rules by shifting parts of their activities to the shadow banking sector. That proposal provides a set of measures aimed at enhancing the understanding of securities financing transactions by regulators and investors.

The European experience illustrates that regulatory reform of the shadow banking system involves two key areas of tension or challenge. The first is ensuring dynamism in the economy by creating space for financial innovation for economic growth, while protecting against systemic risks that could undermine the financial stability. According to Phoebus Athanassiou, contemporary financial regulation differs from the traditional, more established branches of law, such as criminal law, because “financial law rules are man-made and artificial” in the sense that they are not based on “natural laws, collective moral value judgements or recourse to everyday human experience”. Athanassiou believes that “there is something of an experiment involved when it comes to drawing up rules” in the field of financial regulation and writes that “where one draws the line and where one puts the threshold in the field of financial law is more a question of choice than it is a matter of strict necessity or an act of science”.

The second challenge is to promulgate better regulation as opposed to more or even stronger regulation. This is relevant to shadow banking reform given that the G20 is seeking to deliver measurable progress on addressing shadow banking risks "by improving transparency and, where appropriate, increasing regulation" (emphasis added). As Elisabetta Bellini notes “the exceptional circumstances of a financial crisis tend to influence the technical aspects of rulemaking, so that the strong political demand for reform influences the mode of regulation and the legal framework chosen by the legislator”. Moreover, Priya Nandita Pooran writes that the effectiveness of “new institutional measures to address systemic risk requires a necessary appreciation of risk, a forward-looking approach, and a balance between enabling continued innovation with regulatory control and oversight”. She writes that it is not enough to have regard to the regulated entities that presently exist. Indeed, in order to meaningfully address systemic risk, such as the risk posed by unregulated shadow banking, “the wider dynamic of the interplay between the composite financial sector and the broader financial system from an economic perspective” must be considered.

Looking forward

To be effective, regulation of the shadow banking sector will need to pay attention to cost/benefit analysis and a careful balancing of multiple interests. Moreover, there will need to be an element of regulatory experimentation in shadow banking reform as the innovation/stability dichotomy is a challenging balance for regulators to strike. On these points, the FSB mandate is heartening. It reports that its objective is to subject shadow banking to:

appropriate oversight and regulation to address bank-like risks to financial stability emerging outside the regular banking system while not inhibiting sustainable non-bank financing models that do not pose such risks. The approach is designed to be proportionate to financial stability risks, focusing on those activities that are material to the system.

Progress on this objective and its concomitant challenges will become apparent during the G20 Leaders Summit in Brisbane from 15-16 November 2014.

The author wishes to thank Jacqui Vorreiter, CLMR intern, for additional research assistance.

 

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