International watchdogs publish "long anticipated" proposals for the regulation of 'shadow' banks

Out-Law News | 02 Sep 2013 | 2:18 pm | 3 min. read

Brokers and fund managers that engage in bank-like activities could face tougher regulatory oversight under plans put forward by the Financial Stability Board (FSB).

The international watchdog, chaired by Bank of England Governor Mark Carney, has published a final set of recommendations that will be delivered to the G20 group of leading global economies for action. The FSB is made up of G20 representatives, and although its recommendations are not binding they are usually carried out.

"The UK's Banking Reform Bill proposes to restrict transactions between UK ring-fenced banks and certain shadow banking entities, but the G20 proposes to extend this still further," said banking law expert Tony Anderson of Pinsent Masons, the law firm behind Out-Law.com. "Regardless, the creation of an effective regulatory framework for shadow banks has long been anticipated."

"As the FSB concludes, this review is in its early stages and, given the diversity of the shadow banking sector, we can expect to see a more diverse regulatory approach than that that will be extended to banks," 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, known as 'repos', and investments in exchange-traded and private equity funds and money market funds (MMFs). Activity in the sector has tripled over the past decade and covered assets worth $67 trillion by the end of 2011 according to FSB estimates.

Shadow banking activities are typically subject to less stringent, if any, 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 of 2007-09. MMFs are open-ended mutual funds that invest in short-term debt securities, and are attractive due to their relative safety and high yields.

As part of its programme to reform the regulation of traditional banking at an international level, the interaction between banks and the shadow banking system will be caught by the work of Basel Committee on Banking Supervision. As well as ensuring that such interactions are appropriately captured in prudential supervisory regimes, banks’ large exposures to single counterparties whether traditional or ‘shadow’ would be limited by the reforms. Banks would also be required to hold sufficient capital to cover the risk of these exposures.

The FSB has identified the need for new laws in five specific areas. These are minimising the “spill-over effect” between shadow banking and the regular banking system; tackling inappropriate incentives associated with the securities market; reducing the potential for securities financing transactions, such as repos and securities lending to exacerbate funding strains in times of market stress; reducing the susceptibility of money market funds (MMFs) to ‘runs’; and assessing and mitigating the systemic risks posed by other shadow banking entities and activities.

Its proposals are contained in two separate reports. One sets out a high-level policy framework for assessing and addressing risks posed by shadow banking entities other than MMFs (39-page / 361KB PDF), which are covered by the work of the International Organisation of Securities Commissions (IOSCO). The other deals with potential risks arising from the securities lending and repo market (59-page / 584KB PDF). It includes new data collection standards and processes, among other recommendations to improve transparency; securities financing regulation, including a requirement that these instruments are cleared through central counterparties to mitigate risk; and improvements to market structure.

Most of the FSB’s recommendations are final, following a consultation exercise that took place last year. However, it is planning further impact assessments and is seeking views on the minimum ‘haircuts’, or margins that limit the amount of finance that can be provided against a given security, that should apply to non-centrally cleared transactions. It intends to complete its work on these recommendations by spring 2014. The FSB will monitor the implementation of the final policy recommendations in coordination with standard-setting bodies such as IOSCO, and will report on overall progress to the G20 in November 2014.

“The policy recommendations issued by the FSB address important sources of maturity transformation and leverage in shadow banking,” said FSB chairman Mark Carney.

“Implementation of these recommendations will be an essential first step towards achieving our aim of transforming shadow banking into market-based financing conducted on a sound basis. 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,” he said.