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Shadow Banking: Emerging into the light?

Key points

  • There is a strong push by governments towards regulation of the shadow banking sector. The question is only how extensive the regulation will be. The G20 economies have committed to implementing the final recommendations of the Financial Stability Board.
  • The Financial Stability Board's November 2012 proposals focus on activities which threaten the stability of the financial system. In particular the consultation documents highlight the dangers of excessively leveraged lenders and lenders that borrow short to lend long. They put forward a series of policy tools including controls on leverage, asset maturity, asset concentration and others; though make clear that implementation needs to be proportionate to the risks.
  • There is no threshold being proposed, so lenders engaging in the regulated activities would fall within the scope of the regulations however small they may be. Trade bodies have suggested that there should be a threshold to exempt entities too small to have an impact on the stability of the financial sector, which many specialist lenders would be.
  • Ironically, for those shadow banks which are soundly funded and managed, there is no proposal for regulatory endorsement of their quality. The likely outcome is that riskier entities will obtain a regulatory stamp of approval while sounder entities lack an equivalent quality mark.
  • Final recommendations taking the results of consultation into account are expected in Autumn 2013.

Current position

The Financial Stability Board (FSB) has been mandated by G20 governments to investigate the oversight and regulation of shadow banking as part of their wider efforts to ensure the stability of the financial sector. They have issued a suite of consultative documents which set out a range of policy recommendations.

It is anticipated that the FSB will issue its final recommendations in September 2013.

What is the Financial Stability Board?

The FSB, based in Basel, Switzerland, coordinates the work of national financial authorities and international standard setting bodies. It develops and promotes the implementation of effective regulatory, supervisory and other financial sector policies internationally. It brings together national authorities responsible for financial stability in major financial centres, large institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts. It is chaired by Mark Carney, the current Governor of the Bank of Canada, who becomes Governor of the Bank of England on 1 July 2013.

What is shadow banking and why are moves afoot to regulate it?

Shadow banking means lending by entities that are partly or fully outside the regulated banking system, or (if you prefer jargon) non-bank credit intermediation. So lending by funds, specialist lenders and high net worth individuals all fall into this category, as do corporate bonds and securitisation. The FSB estimates that the shadow banking sector amounts to $67 trillion wolrdwide, or a quarter of all banking activity.

The FSB has been investigating ways to control risks to financial stability that can arise from bank-like activities. As the regulation of banks tightens, there are clear incentives for institutions to transfer riskier business to the shadow banking sector and the FSB wants to ensure that evasion of tough new banking standards is no longer possible by these means.

The principal concerns relate to entities that borrow excessively in order to fund their lending and entities that borrow short term funds, such as customer deposits, in order to lend for longer maturities. These risks were put into focus when the debt capital markets closed down in 2007-9. Unregulated entities, in many cases linked to or created by the regulated financial sector, amplified the risks in the system by accelerating lending at the top of the market, leading to precipitous falls in asset prices and credit availability in the downturn.

Principled approach

The FSB's recommendations reflect a series of clear principles. At the highest level, their approach has been based on two key principles. First, casting the net wide when gathering data about shadow banking so as to ensure that regulators have full information about all areas where risks may arise. Secondly, focussing more narrowly for policy purposes on those shadow bank activities which either (i) increase risks of mismatches of maturity, imperfect credit transfer and/or excessive leverage, and/or (ii) indicate a level of regulatory arbitrage which is undermining the benefits of financial regulation.

When setting policy, the FSB has put forward a set of overarching principles, which focus on defining the types of entity to be regulated by reference to their economic function rather than their legal form; and on the collection of information from and disclosure by market participants to enable the authorities to assess where the risks lie and when problems may arise.

Concerns have been expressed that this approach might lead to excessive regulation. The FSB hopes to guard against this by a number of further principles, the most relevant of which is the requirement for proportionality, in other words policies should be proportionate to the risks posed by shadow banking. It is to be hoped that this principle is properly emphasised in the FSB's final recommendations.

Implications for the real estate debt market

In setting the tone of the recommendations, the FSB has been careful to state that shadow banking can bring benefits to the financial system and the real economy, particularly the provision of alternative financing to the banks and, by creating competition, the possibility of increased innovation, efficient credit allocation and cost reduction. This will be welcome news for investment firms and high net worth investors active in the property debt market, where new funds have been plugging some of the gap left by the retreat of the mainstream banks.

The FSB is seeking to regulate vehicles which perform specified economic functions of which two are particularly relevant to the real estate debt market. The first function, described as "management of cash pools with features that make them susceptible to runs", would potentially include funds and joint ventures, depending on investors' exit terms. The second function, described as "loan provision that is dependent on short-term funding", would potentially include vehicles that had raised finance by taking deposits, issuing short-term notes or borrowing from bridging facilities. It follows from this that vehicles which have committed funding from investors beyond maturity of the loans they make should fall outside the net.

Vehicles which find themselves within the regulatory net will find themselves subject to various requirements based on "policy toolkits" suggested by the FSB. These include restrictions on maturity of portfolio assets, limits on leverage, limits on illiquid assets and liquidity buffers. The consultation document also proposes limits on asset concentration, which would potentially be a danger to the existence of specialist sector lenders, but any specialist vehicle which is neither borrowing short to lend long nor excessively leveraged would, on the face of it, fall outside the regulatory perimeter and thus not be subject to these requirements.

One point to note is that the proposed regulations apply to all entities performing the regulated functions, regardless of size. This could potentially lead to an excessive burden on small firms which could not plausibly be said to pose a threat to financial stability. Representations have been made to the FSB requesting a threshold on the basis that it would be proportionate to the risks to exempt smaller firms.

January 2013

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