david phillips shadow banks
Shadow banks can pose unacceptable risks to financial and economic system

Recent developments in bank regulation have increased capital requirements for banks and so constrained lending, which shows up in small business struggling to secure finance.

The regulations originate from the Basel Committee on Banking Supervision (BCBS) (Basel III – new measures to strengthen regulation, supervision and risk management) and the European Union Capital Requirements Directive (CRD IV – a package of new laws on prudential rules for banks, building societies and investment firms).

The EU CRD IV is intended to implement the Basel III agreement across Europe. Meanwhile, the restricted supply of bank credit has increased the demand for credit from non-bank financial institutions.

The term ‘shadow banking’ is believed to have first been coined by Paul McCulley of the hedge fund Pimco, to refer to financial intermediation activity by institutions other than banks.

Among the many institutions considered to be “shadow banks” are finance companies, other consumer credit providers, various hedge funds, credit investment funds, money market funds, other bond funds, structured investment vehicles (siv); special purpose entity conduits, exchange-traded funds, and (private) equity funds, to name but a few.

Whist they do not take deposits in the normal way, shadow banks engage in largely the same activities as banks. So what sort of activities can they be involved in?

Shadow banks will often secure short-term funds to invest in longer-term assets, an activity which can lead to an acute liquidity squeeze in a crisis such as in 2008. They may also transform cash-like liabilities into harder to sell (or liquidate) assets, such as loans.

While creating a potential systemic liquidity problem by engaging in the above activities, there is also the major challenge of leverage, which is borrowing money to buy fixed assets to increase the hoped-for gains from an investment.

There is also the issue of credit risk transfer, and this is exacerbated by the asymmetry of regulation. While shadow banks do not take deposits in the same way that regulated banks do, they do not have to comply with the same capital adequacy and liquidity rules.

Therefore, profound and deeply damaging systemic risks can arise. Regulatory arbitrage can lead to a systemically significant, unregulated build-up of credit. In some instances the end borrower may not be visible at all and the same ultimate obligation may circulate round the shadow banking system several times with minor adjustments. This practice is known as re-hypothecation and is an area which needs to be resolved as a matter of urgency.

There have been attempts at regulatory responses to shadow banking. The Financial Stability Board (FSB), the Bank for International Settlements (BIS), the European Commission, the European Banking Authority, the IMF, and the Bank of England (recent speech by Mark Carney [Monetary Authority of Singapore Lecture 2014]) have made statements on the need, and in some cases proposals, for regulatory action.

What are these proposals?

There would be enhanced requirements for
• the quality and quantity of capital,
• a basis for new liquidity and leverage requirements,
• new rules for counterparty risk, and
• new macroprudential standards, including a countercyclical capital buffer and capital buffers for systemically important institutions (part of CRD IV)

The estimated size of the shadow banking market is $75 trillion (FSB Monitoring Report 31 October 2014), and its growth rate is believed to be around 7% per annum.

What activities do shadow banks engage in?

• Management of collective investment vehicles providing short term funding
• Finance / leasing company activities
• Credit broking
• Credit protection provision (guarantees, insurance)
• Securitisation based credit intermediation
Shadow banks appear to provide a valuable alternative to bank credit to support economic activity. But they can pose unacceptable risks to the financial and economic system and customers can be treated unfairly.

What are some of these risks?

One significant risk is the mismatching of loan maturities, where there is gross over-reliance on short-term funding, with the consequent vulnerability to runs.

There is also the problem where “conventional” banks may be reliant on shadow banks for funding and vice versa, along with other rather opaque interconnections between conventional banks and shadow banks.

The current regulatory position is that IOSCO (International Organization of Securities Commissions) has proposed common standards for the regulation of Money Market Funds: e.g. liquidity fees, redemption gates (a charge, and restriction, when trying to exit funds).

Meanwhile, the FSB has made policy recommendations for managing shadow banking risks in securities lending and repos, standards for valuing cash collateral, reinvestment and re-hypothecation.

It has also published a Policy Framework for oversight and regulation of shadow banking and monitors changes in national balance sheets. The BCBS has also made proposals for monitoring large exposures and investments in equity funds.

2008: Failure of Execution not Regulatory Framework

The regulatory response to the financial system difficulties in 2007 /2008 assumed there was a failure of design rather than a failure of execution, and in doing so constrained the ability of banks to lend and as such facilitated the growth of shadow banking.

In the case of the UK, the design of the system was sound. The banking returns (BSD3, LR) launched around the turn of the century were designed for effective macro and micro prudential analysis. They would have showed the trends that resulted in the 2007 UK financial system problems. But we can infer they were not acted on properly.

The balance sheet regulatory return (BSD3) would have shown that RBS and HBOS needed to shore up their capital in the early 2000s. Also the liquidity return (LR) would have shown that Northern Rock and others were heavily reliant on wholesale funding but had sufficient capital. Although Northern Rock was not provided liquidity by the bank of England, the others must have been. Perhaps Northern Rock should have been provided it too?

The original decision to create the Financial Services Authority was the right one. Separating prudential from conduct of business regulation, however, as the present government has done, can create competing regulatory requirements. The arguments for integrated regulation in the City of London, the world’s pre-eminent financial centre, are strong.

Returning prudential regulation to the Bank of England may prove to be unwise. It may be worth recalling that the Bank of England was in charge of supervision when Barings Bank, BCCI, Johnson Matthey Bankers and earlier the fringe banks, collapsed. These took place during relatively benign financial conditions compared with 2007. Care needs to be exercised to avoid a repetition of these previous problems.

David Phillips is the Editor of Labour Finance and Industry Group

Shadow Banking, the Elephant in the Room
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