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Tougher rules on securities financing collateral will reduce global shadow banking risk, says FSB

Hedge funds, private equity firms and other non-bank lenders will have to provide a minimum level of collateral when borrowing money from banks, under plans put forward by the Financial Stability Board (FSB).

The FSB, which coordinates international financial services regulation, published the plans as part of its drive to reduce risks in the 'shadow' banking sector. Its rules would require banks to impose 'haircuts' on securities financing transactions, which are short-term loans secured by stocks or bonds. This means that in exchange for a loan, these firms would have to set aside stocks or bonds worth a certain percentage more than their borrowing.

Bank of England governor Mark Carney, who chairs the FSB, said that the new rules marked "a big step forward in the FSB's overall work programme to transform shadow banking into resilient market-based financing conducted on a sound basis".

The new rules must now be adopted by members of the FSB, including the G20 group of leading global economies, before coming into force before the end of 2017.

The FSB is also consulting on whether to extend the rules to cover transactions involving non-banks only, as well as those between banks and non-banks. Doing so would "ensure shadow banking activities are fully covered, to reduce the risk of regulatory arbitrage and to maintain a level playing field", it said. This consultation will close on 15 December 2014, with final rules due for publication by summer 2015, it said.

The term 'shadow banking' refers to the provision of credit either fully or partially outside of the regulated banking sector. It includes transactions such as securities lending agreements; repurchasing agreements, known as 'repos'; and investments in exchange-traded and private equity funds and money market funds. Although these activities have typically been subject to less stringent, if any, oversight than traditional banking activities, they can also run into financial difficulties as was the case with Lehman Brothers during the 2008 economic crisis.

The FSB originally proposed the introduction of 'haircuts' to limit the amount of finance that could be provided against a given security in non-centrally cleared transactions when it published its wider recommendations for shadow banking reform last August. The minimum haircut for corporate bonds with a maturity of between one and five years has increased from that in the original recommendations from 1% to 1.5%, while that for equities has increased from 4% to 6%. However, transactions that use government bonds as collateral would not be caught by the new requirements.

"Securities financing transactions such as repos are important funding tools for a wide range of market participants, including non-bank financial firms," said Daniel Tarullo, who chairs the FSB's standing committee on supervisory and regulatory cooperation.

"The implementation of the numerical haircut floors on securities financing transactions will reduce the build-up of excessive leverage and liquidity risk by non-banks during peaks in the credit and economic cycle. It will be important for the FSB to monitor the impact of the framework following the implementation to help ensure that it achieves these objectives."

"The proposals currently target short-term loans between non-banks and banks," said banking law expert Tony Anderson of Pinsent Masons, the law firm behind Out-Law.com. "There might be concerns on certain levels were similar restrictions to be introduced for term lending by non-banks: such entities are becoming more prevalent in debt syndicates, particularly as banks face pressure to resist lending their balance sheets from various quarters including the implementation of Basel III in 2019."

"The worry is the uncertainty of where the regulation will come out on this, as well as other measures being introduced. Already the FSB's minimum requirements have moved upwards from those proposed in August," he said.

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