FSB Tackles Shadow Banking Regulations

by Ulrika Lomas, LawAndTax-News.com, Brussels

02 November 2011

The Financial Stability Board (FSB) has published a report providing its recommendations on strengthening oversight and regulation of the shadow banking system, as was requested by the G20 Leaders at their November 2010 Summit in Seoul.

The shadow banking system refers to activities by credit intermediaries not subject previously to regulation, primarily because they do not accept traditional bank deposits. As a result, many such institutions and the instruments they issue are able to incorporate higher market, credit and liquidity risks, and may not have capital requirements commensurate with those risks.

Their ranks include finance companies, asset-backed commercial paper conduits, structured investment vehicles, credit hedge funds, money market mutual funds and securities lenders, intermediating credit through a wide range of securitization and secured funding techniques, such as credit default swaps, asset-backed securities and collateralized debt obligations.

It has been estimated that the global shadow banking system grew rapidly from an estimated USD27 trillion in 2002 to USD60 trillion in 2007, and remained at around the same level in 2010.

It has been said that intermediating credit through non-bank channels can have advantages, for example by providing an alternative source of funding and liquidity. However, as the recent financial crisis has shown, the shadow banking system can also be a source of systemic risk both directly and through its interconnectedness with the regular banking system.

In addition, it may also create opportunities for arbitrage that might undermine stricter bank regulation and lead to a build-up of additional leverage and risks in the overall financial system. Enhancing supervision and regulation of the shadow banking system in areas where systemic risk and regulatory arbitrage concerns are inadequately addressed is therefore seen to be important.

The FSB’s report’s recommendations for effective monitoring set out high-level principles for the relevant authorities and a monitoring process. It calls on authorities to first assess the broad scale and trends of non-bank credit intermediation in the financial system, drawing on information sources such as flow of funds and sector balance sheet data, and complemented with other information such as supervisory data.

Based on this assessment, authorities should then narrow down their focus to those types of non-bank credit intermediation that have the potential to pose systemic risks, by focusing in particular on those involving the four key risk factors - maturity transformation, liquidity transformation, imperfect credit risk transfer, and/or leverage.

Authorities should then assess in detail the potential impact that the severe distress or failure of certain shadow banking entities/activities would pose to the overall financial system through looking at other factors, such as the inter-connectedness between the shadow banking system and the regular banking system.

Drawing on this enhanced monitoring framework, the FSB will also continue to conduct annual monitoring exercises to assess global trends and risks. It is expected that such assessments will improve over time as more data become available through initiatives by the FSB and its member authorities.

The report also describes work plans for five work-streams that will assess in more detail the case for further regulatory action. For example, the Basel Committee on Banking Supervision (BCBS) will examine enhanced consolidation for prudential regulatory purposes, concentration limits/large exposure rules, risk weights for banks’ exposures to shadow banking entities, and treatment of implicit support by July 2012.

The International Organization of Securities Commissions (IOSCO) will examine regulatory action related to money market funds (MMFs) by July 2012; the FSB’s own task force will examine shadow banking entities other than MMFs by September 2012; IOSCO, in coordination with the BCBS, will examine retention requirements and transparency by July 2012; and the FSB’s task force will examine securities lending and repurchase agreements, including possible measures on margins and haircuts, by the end of 2012.

All five work-streams will report their proposed policy recommendations to the FSB, which will continue to review them so as to provide consistency to the overall project.

Adair Turner, the Chairman of the FSB Standing Committee on Supervisory and Regulatory Cooperation, said:“With regulation on banks tightened, it is important to address systemic risks – such as maturity transformation and leverage – arising from the shadow banking sector and its interaction with the regular banking system. The detailed recommendations that will be produced by the five work-streams during 2012 are thus fundamental to the stability of the global financial system.”

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