Shadow banking, the huge but unregulated frontier of the financial world, will soon be subject to bank-like supervision as global policymakers start to hammer out rules that reduce the chances of future crises yet still allow new creative financing models to emerge.
The Financial Stability Board (FSB), which monitors and coordinates global financial regulation, has proposed an ambitious policy framework and recommendations that it believes are needed to “mitigate the potential systemic risks associated with shadow banking,” and expects to issue final proposals in September 2013 following industry comment.
The term shadow banking describes the murky world of hedge funds, money market funds and investment vehicles that are often used by major banks to carry out sophisticated financial transactions.
As these shadow legal entities do not take customer deposits, they don’t need banking licenses and are not subject to supervision.
The 2008 global financial crises exposed the threat from shadow banking to financial stability, not just because of its vast size but because it was completely interwoven with the supervised banking system; a regulated banking system relied on unregulated entities with a razor-thin capital base.
Global political leaders, meeting as the Group of 20, decided that the risks from shadow banking – about half the size of the normal banking system - posed too great a threat and asked the FSB to come up with policy recommendations.
But while the risks are now obvious, it is also clear to regulators that shadow banking provides benefits. Shadow entities, for example, help channel funds from pension funds that have money to invest to those in need of funds, such as a private company.
The challenge for the FSB, along with the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO), has been to devise rules that limit the risks yet retain the benefits and don’t stymie future financial innovation.
“The objective of the FSB’s work 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,” the FSB said.
The FSB’s policy recommendations come at a time when shadow banking is set to expand even more as tougher Basel III banking rules are being phased in, providing added incentive for banks to shift activities into non-regulated space.
While off-balance sheet financial entities and various forms of securitization have been around for centuries, the current form of shadow banking first took off in the last decades as banks exploited regulatory gaps and used regulatory arbitrage to minimize cost.
For every new rule imposed by banking supervisors, mathematical wiz-kids at investment banks quickly figured out how to circumvent the rules, a challenge the FSB was well aware of.
“The FSB therefore believes that oversight and regulation for shadow banking must incorporate a system of “embedded vigilance” through on-going review and be capable of evolving in response to market changes,” it said.
In addition to its policy recommendations, the FSB has created a process for monitoring the shadow banking system “so that any rapidly growing new activities that pose bank-like risks can be identified early and, where needed, those risks addressed.”
By focusing on function and activity, rather than form or names, supervisors will in the future be able to include new legal structures or innovations that create “shadow banking risks.”
Trying to understand the true size and reach of the shadow banking system, the FSB expanded its mapping system from the previous 2011 exercise to include 25 jurisdictions, including the entire euro area, compared with 11 jurisdictions, bringing the coverage to 86 percent of global Gross Domestic Product and 90 percent of global financial system assets.
At a time when the traditional banking system has been shrinking, the shadow banking system has expanded by a further $5-6 trillion to $67 trillion by the end of 2011 from the previous study, the equivalent of 111 percent of the aggregate GDP of covered jurisdictions.
The initial surge in the size of the shadow banking system took place from 2002 to 2007 when it exploded from $26 trillion to $62 trillion, when the global financial crises temporarily halted its growth.
The mapping system showed that the United States has the largest shadow system with assets of $23 trillion, followed by the euro area’s $22 trillion and the UK’s $9 trillion. While the U.S. share of the global system eased to 35 percent from 44 percent in 2005, the share of the UK and euro area has risen.
Jurisdictions where shadow banking are the largest relative to GDP are Hong Kong (520 percent), Singapore (260 percent) and Switzerland (210 percent) – major international financial centres that host foreign-owned institutions.
Among the policy tools that supervisors should be given to limit the potential damage of shadow entities, FSB recommends limits on assets concentration and leverage, capital cushions to cover potential losses, segregation of client monies from other assets, and redemption fees that would make it costly for investors to bail out during financial unrest.
Money market funds, which provide short-term deposit funds to the banking system, suffered runs during the global financial crises that only stopped after intervention by the U.S. Treasury. Endorsing IOSCO’s findings, the FSB recommended a series of recommendations, including that money market funds should hold enough liquid assets to avoid fire sales.
Click to read the FSB’s policy framework and recommendations.