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FSB Publishes Shadow Banking Regulation Recommendations

by Ulrika Lomas,, Brussels

21 November 2012

The Financial Stability Board (FSB) has published, for public consultation, a set of policy recommendations to strengthen oversight and regulation of the global shadow banking system, as was initially requested by the G20 Leaders at their November 2010 Summit in Seoul.

In November 2011, the G20 Leaders had endorsed the initial recommendations of the FSB, and its work plan to further develop policy recommendations during 2012. In June 2012, the G20 Leaders reiterated their support for the shadow banking work and asked the FSB to submit its recommendations for review in November 2012.

The FSB describes the ‘shadow banking system’ as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”. They have previously not been 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 funds (MMFs) 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 and reached some USD67 trillion in 2011.

While intermediating credit through non-bank channels is regarded as having certain advantages, for example by providing an alternative source of funding and liquidity, it is said that the recent financial crisis has shown that 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 has focused on five specific areas in which it believes policies are needed to mitigate the potential systemic risks associated with shadow banking.

It is intent on mitigating the spill-over effect between the regular banking system and the shadow banking system; reducing the susceptibility of MMFs to ‘runs’; assessing and mitigating systemic risks posed by other shadow banking entities; assessing and aligning the incentives associated with securitization; and dampening risks and pro-cyclical incentives associated with secured financing contracts, such as repos and securities lending, that may exacerbate funding strains in times of ‘runs’.

The FSB is of the view that the regulatory authorities’ approach to shadow banking has to be a targeted one. The objective is to ensure that shadow banking is subject 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.

It emphasizes the importance of taking a practical two-step process in approaching the shadow banking system - for monitoring purposes, authorities should cast the net wide, looking at all non-bank credit intermediation to ensure that data gathering and surveillance cover all areas where shadow banking-related risks might potentially arise; and, for policy purposes, authorities should narrow the focus to the subset of non-bank credit intermediation involving maturity/liquidity transformation, imperfect credit risk transfer, leverage, and/or regulatory arbitrage concerns.

The FSB has therefore developed policy recommendations for regulatory measures that are guided by the principles that they should be carefully designed to target the risks the shadow banking system creates; should be proportionate to the risks shadow banking poses to the financial system; and should be forward-looking and adaptable to emerging risks.

The measures should also be should be designed and implemented so as to balance the need for international consistency to address common risks and to avoid creating cross-border arbitrage opportunities, against the need to take due account of differences between financial structures and systems across jurisdictions; and should be regularly reviewed to assess their effectiveness after implementation and make adjustments to improve them as necessary in the light of experience.

The FSB is welcoming comments on its recommendations, which should be submitted by January 14, 2013.

TAGS: investment | law | banking | financial services | capital markets | investment funds | hedge funds | G20 | standards | regulation | alternative investment | services

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