• Industry: Financial Services
  • Type: Regulatory update
  • Date: 10/25/2013

Shadow Banking 

The recent European Commission proposals do not really shed any new light on shadow banking and the recommended regulatory approaches, but are interesting when we compare them with the three Shadow Banking papers released by the FSB. Some common weaknesses and divergence of thinking emerge.

As you would expect, the FSB tends to frame high-level principles and not focus on the detail of how these would be implemented in practice across countries and markets, also recommending retrospective tools to identify divergence, such as reporting and peer review. However, at the EU level, there is a need to be far more prescriptive in order to bring about harmonisation – which may have a number of unintended consequences – and significant implications for firms.

The EU proposals – at a glance

The proposal starts by defining shadow banking, drawing on previous FSB commentary and mirroring previous discussions at both national and EU level around monitoring financial activities and entities outside the regulated banking sector, tackling the associated systemic risk and avoiding regulatory arbitrage.

Steps already made to address funding

The proposals summarise work already being undertaken indirectly via firms and other regulations to improve transparency around interaction with the shadow banking sector. These include:

  • In banking – Action already being taken indirectly via banks to bring visibility to their transactions with the shadow banking sector and, where relevant, consolidate their non-regulated entities. This, along with Funds Transfer Pricing (FTP), is intended to reduce the incentive for banks to transact with the shadow banking sector and reduce the attractiveness of Money Market Fund (MMF) short-term funding. The Commission also proposes reporting to supervisors on main exposures to unregulated entities and awaits the European Banking Authority (EBA) proposal on limiting exposures to unregulated entities. This raises some important questions on funding. Money market funds and other vehicles for investing in short term debt instruments have become a critical source of funding and liquidity to the wider financial sector. If corporate depositors have to actively manage placements, risk aversion could quickly create distortions in the market.
  • For insurers – Action being taken indirectly via insurers – with some discussion around how Solvency II is intended to bring visibility to the risks.
  • For investment managers – Steps taken under AIFMD that subjects managers and administrators to capital, risk and liquidity requirements and the need to monitor leverage and intervene if systemic. Strengthening the UCITS Directive to focus on investment techniques and strategies including securities financing in order to avoid impaired liquidity.
  • Transparency – Comments on the transparency that EMIR will bring through central data repositories, noting that CCP coverage will be review to avoid exemptions (note: reference is also made to MiFID bringing high-frequency trading reporting within scope). Going forward, it is recommended that Europe assigns Legal Entity Identifiers (LEIs) to European companies that are globally cohesive; and strike a balance between public and private sector monitoring of the data.
  • Repo and securities markets – The ECB initiative around reporting securities financing (repo and securities lending) is also endorsed to tackle inter-connectedness, excessive leverage and pro-cyclicality.
  • Short selling – The proposals refer to short selling restrictions and offering Credit Default Swaps (CDSs) on sovereign bonds.
  • Amending securities law – A proposal is made to amend securities law to prohibit the re-hypothecation of collateral.

Reference is also made to securitisation reforms; other reforms to tackle rating agencies and the possible introduction – albeit probably delayed now – of a Financial Transaction Tax (FTT) in 11 member states.

For more information, please contact Giles Williams.

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