Capital and liquidity requirements for money market funds proposed as part of EU shadow banking reform

It has published a draft regulation on MMFs (46-page / 197KB PDF), designed to make these products more stable in the event of stressed market conditions. It has also produced a communication setting out future plans including transparency requirements, measures to govern the interaction between shadow banking institutions and the traditional banking sector, and potential regulation of the securities market.

"We have regulated banks and markets comprehensively – we now need to address the risks posed by the shadow banking system," said Internal Market Commissioner Michel Barnier. "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."

The Commission's proposals are in line with the final recommendations on how shadow banking activities should be regulated published the Financial Stability Board (FSB) last week. The FSB's recommendations are due to be endorsed by the leaders of the G20 major global economies this week.

Banking law expert Tony Anderson of Pinsent Masons, the law firm behind Out-Law.com, said that the introduction of more stringent regulation for the sector, including liquidity and capital rules, had "long been mooted" following the financial crisis and the collapse of the Reserve Primary Fund in the US.

"As more non-banks begin to participate in loan markets, payment systems and other spaces traditionally occupied by banks, this makes sense," he said.

"The concern, however, is the diversity in the biosphere which constitutes 'shadow banking' and how well equipped its participants will be to comply with stringent financial regulation. Unlike banks, these entities historically haven't required significant legal or compliance teams until now," he said.

The term 'shadow banking' generally refers to the provision of credit either fully or partially outside of the regular banking system. It can include securities lending agreements, repurchasing agreements or 'repos', and investments in exchange-traded and private equity funds. Activity in the sector covered assets worth €51 trillion, or roughly 25-30% of the total financial system, in 2011 according to FSB estimates. Of this, €16.8 trillion was held within the Eurozone and around €6.8 trillion in the UK.

Shadow banking activities are typically subject to less stringent, if any, regulatory oversight than traditional banking activities. However, these activities and the entities that carry them out can also run into financial difficulties, as was the case with MMFs during the economic crisis. MMFs are open-ended mutual funds that invest in short-term debt securities such as commercial paper and government debt, and are attractive due to their relative safety and high yields. In Europe, MMFs hold around 22% of short-term debt securities issued by companies and governments, and 38% of short-term debt issued by the banking sector.

Under the terms of the draft regulation, MMFs would be required to hold at least 10% of their portfolio in assets that mature within a day and another 20% that mature within a week. This would allow the MMF to repay investors who wish to withdraw funds at short notice. Standard MMFs would also not be allowed to invest more than 10% of their portfolios with a single issuer, while short-term MMFs would be limited to 5% with a single issuer.

The regulation would also prevent MMF sponsors, which are primarily banks, from providing additional support to those MMFs that offer a guaranteed share price to investors when asset values fall. Instead these MMFs, which make up almost half of those operating in the EU, would be required to build up a capital buffer of 3% of the value of the assets under management. These rules are tougher than those proposed by the Securities Exchange Commission (SEC) in the US. The SEC's proposals (698-page / 2.9KB PDF) were published in June, and contained liquidity requirements but not a capital buffer.

Future proposals, as set out in the Commission's communication on the shadow banking sector as a whole, could include new data collection and exchange initiatives, extending the scope of the prudential rules that already apply to banks, improving supervision at a European and national level, and the development of central registries for securities trades. A proposal to reduce the risks associated with securities financing transactions will be published "in the coming months", the Commission said.