20 Mar, 2012

Learning the Lessons of Economic Crisis, EU Bids to Regulate “Shadow Banking”

EUROPA PRESS RELEASE

Brussels, 19 March 2012 – So that the EU learns all the lessons from the crisis, it is implementing ambitious regulatory reforms in the financial sector in general and in the banking sector in particular. This will contribute to creating a stronger and sounder financial sector at the service of the real economy.

As part of these reforms, it is now time to deal with the growing area of non-bank credit activity, or so-called “shadow banking”, which has so far not been a prime focus of prudential regulation and supervision. To a certain extent, shadow banking performs important functions in the financial system. For example it creates additional sources of funding and offers investors alternatives to bank deposits. But it can also pose potential threats to long-term financial stability because unknown sources of risk accumulate in the financial sector and there are potential spill-over effects from the shadow banking sector to the regular banking sector.

In response to invitations by the G20 in Seoul in 2010 and in Cannes in 2011, the Financial Stability Board (FSB) is in the process of developing recommendations on the oversight and regulation of these entities and activities. With today’s consultation in the form of a Green Paper, the Commission is participating actively in the ongoing FSB work.

Internal Market and Services Commissioner Michel Barnier said: “The European Union has shown global leadership in implementing ambitious reforms in the area of financial regulation, in particular for banks. What we do not want is for financial activities and entities to circumvent existing and foreseen rules, allowing new sources of risk to accumulate in the financial sector. That is why we need to better understand what shadow banking actually is and does, and what regulation and supervision may be appropriate, and at what level. We must shed light on all parts of the financial sector.”

Background

According to the Financial Stability Board, the shadow banking system is “the system of credit intermediation that involves entities and activities outside the regular banking system”. Possible shadow banking entities and activities include:

• Money Market Funds (MMFs) and other types of investment funds or products with deposit-like characteristics
• Investment funds that provide credit or are leveraged, including Exchange Traded Funds (ETFs) and hedge funds
• Finance companies and securities entities providing credit or credit guarantees or performing liquidity and/or maturity transformation without being regulated like a bank
• Insurance and reinsurance undertakings which issue or guarantee credit products, and
• Securitisation and securities lending and repurchase agreement (repo) transactions.

Today’s Green Paper sets out how existing and proposed EU measures already address shadow banking activities. For example, off-balance sheet vehicles, such as Special Purpose Vehicles, are regulated indirectly through banking regulation. Hedge fund managers are regulated directly through the Alternative Investment Fund Managers Directive, which addresses a number of shadow banking issues. Some Member States also have additional national rules for the oversight of financial entities and activities that are not regulated at EU level.

Although these measures go some way towards addressing shadow banking entities and activities, there is still further progress to be made given the continually evolving nature of shadow banking and our understanding of it. In coordination with the FSB, the standard-setting bodies and the relevant EU supervisory and regulatory authorities, the aim of the Commission’s current work is to examine existing measures carefully and to propose an appropriate approach to ensure comprehensive supervision of the shadow banking system, coupled with an adequate regulatory framework.

In this context, there are five key areas relating to banking, asset management, securities lending and repurchase agreements, securitisation, and other shadow banking entities where the Commission is further investigating options and next steps.

Next steps

Stakeholders are invited to respond to the consultation before 1 June 2012. A conference on shadow banking will take place in Brussels on 27 April. All this work will inform the Commission’s position in the international arena and its decision on the appropriate follow-up to be given.

See also MEMO/12/191

More information: http://ec.europa.eu/internal_market/bank/shadow_banking/index_en.htm

Green Paper on Shadow Banking – Frequently asked questions

1. What is shadow banking?

Shadow banking is the system of credit intermediation that involves entities and activities that are outside the regular banking system, and thus are not regulated like banks.

“Shadow banking” entities operate outside the regular banking system, and yet engage in the following bank-like activities:

• accepting funding with deposit-like characteristics;
• performing maturity and/or liquidity transformation;
• undergoing credit risk transfer; and
• using direct or indirect financial leverage.

Shadow banking activities are those that could act as important sources of funding for non-bank entities. These activities include securitisation, securities lending and repurchase transactions (“repo”).

2. What is the size of the shadow banking sector?

The Financial Stability Board (FSB) has roughly estimated the size of the global shadow banking system at around €46 trillion in 2010, up from €21 trillion in 2002. This represents 25-30% of the total financial system, and half the size of bank assets. In Europe, the proportion of these other financial intermediaries’ assets is lower than the global average (13% in UK, and 5% in Germany, for example, compared to an estimated 35-40% in the United States). However, according to FSB estimates, the share of these assets in Europe has sharply increased in recent years, while it is falling elsewhere, including in the US. Shadow banking is therefore a growing concern for Europe’s financial system.

3. Who are the shadow banking entities and what are the shadow banking activities addressed in the consultation?

Shadow banking entities include:

• Special purpose entities which perform liquidity and/or maturity transformation, for example, securitisation vehicles such as ABCP (Asset-Backed Commercial Paper) conduits, Special Investment Vehicles (SIV) and other Special Purpose Vehicles (SPV);
• Money Market Funds (MMFs) and other types of investment funds or products with deposit-like characteristics, which make them vulnerable to massive redemptions (“runs”);
• Investment funds that provide credit or are leveraged, including Exchange Traded Funds (ETFs);
• Finance companies and securities entities providing credit or credit guarantees, or performing liquidity and/or maturity transformation without being regulated like a bank; and
• Insurance and reinsurance undertakings which issue or guarantee credit products.

Shadow banking activities include:

• securitisation (creating securities by pooling bank loans and selling these to investors),
• securities lending (transactions in which an institution or its counterparty transfers securities against appropriate collateral, subject to a commitment that the borrower will return equivalent securities at some future date); and
• repurchase agreements (“repo” – the practice of selling assets while the seller simultaneously obtains the right and obligation to repurchase it at a specific price on a future date or on demand).

For the moment, at the consultation stage, the Commission is focusing on these possible shadow banking entities and activities. However, this list should not be viewed as exhaustive, as shadow banking entities and activities can evolve very rapidly.

4. Are shadow banking activities dangerous?

Shadow banking activities are a useful part of the financial system:

• they provide alternatives to bank deposits for investors;
• they channel resources towards specific needs more efficiently due to increased specialisation;
• they constitute alternative funding for the real economy – which is particularly useful when traditional banking or market channels become temporarily impaired; and
• they constitute a possible source of risk diversification away from the banking system.

At the same time, shadow banking entities and activities may also create a number of risks:

• Deposit-like funding structures may lead to funding “runs”. Shadow banking activities are exposed to similar financial risks as banks, without being subject to all the same constraints imposed by banking regulation and supervision. For example, certain shadow banking activities are financed by short-term funding, which is prone to risks of sudden and massive withdrawals of deposits by clients.
• High, hidden leverage can build up. High leverage can increase the fragility of the financial sector and be a source of systemic risk. Shadow banking activities can be highly leveraged with collateral funding being churned several times, without being subject to the limits imposed by regulation and supervision.
• Rules and regulatory arbitrage can be circumvented. Shadow banking operations can be used to avoid regulation or supervision applied to regular banks by breaking the traditional credit intermediation process in legally independent structures dealing with each other. This “regulatory fragmentation” creates the risk of a regulatory “race to the bottom” for the financial system as a whole, as banks and other financial intermediaries try to mimic shadow banking entities or push certain operations into entities outside the scope of their consolidation. For example, operations circumventing capital and accounting rules and transferring risks outside the scope of banking supervision played an important role in the build-up to the 2007/2008 crisis.
• Disorderly failures could take place and affect the banking system. Shadow banking activities are often closely linked to the regular banking sector. Any failures can lead to important contagion and spill-over effects. Under distress or severe uncertainty conditions, risks taken by shadow banks can easily be transmitted to the banking sector through several channels: direct borrowing from the banking system and banking contingent liabilities (credit enhancements and liquidity lines), or massive sales of assets with repercussions on prices of financial and real assets.

Some of these risks can be systemic in nature, in particular due to the complexity of shadow banking entities and activities, their cross-jurisdictional reach and the inherent mobility of securities and fund markets, and the links between shadow banking entities and activities with the regular banking system. It is the Commission’s objective to ensure that those risks are dealt with appropriately, while maintaining the useful functions performed by shadow banks.

5. What is the international context of the Commission’s consultation?

At its November 2010 Seoul Summit, the G20 leaders identified the financial sector regulation issues still to be addressed. Regulation and supervision of shadow banking was one of these issues. The G20 requested that the Financial Stability Board (FSB), in collaboration with other international standard-setting bodies, develop recommendations to strengthen the oversight and regulation of the shadow banking system.

In response, the FSB released a report on 27 October 2011 highlighting that the disorderly failure of shadow bank entities can carry systemic risk, both directly and through their links with the regular banking system. The FSB also suggested that as long as such activities and entities remain subject to a lower level of regulation and supervision than the rest of the financial sector, reinforced banking regulation could drive a substantial part of banking activities beyond the boundaries of traditional banking and towards shadow banking.

Building on this report and on the invitation of the November 2011 G20 Cannes Summit to develop its work further, the FSB has also initiated five workstreams to analyse the issue in more detail and develop effective policy recommendations. These workstreams bring together the EU and other major jurisdictions including the US, China and Japan, which are each considering appropriate regulatory measures.

6. What are the challenges for supervisory and regulatory authorities?

Given the potential risks posed by shadow banking, it is essential that supervisory and regulatory authorities consider how best to address shadow banking entities and activities. However, this task presents various challenges.

First, the authorities concerned have to identify and monitor the relevant entities and their activities.

Secondly, the authorities have to determine the approach to supervising shadow banking entities.

Thirdly, as shadow banking issues may require extending the scope and nature of prudential regulation, appropriate regulatory responses are needed.

7. What regulatory measures apply to shadow banking in the EU?

In the EU, a number of legislative proposals with implications for shadow banking entities and activities are already in place or currently being negotiated by the European Parliament and the Council:

• Indirect regulation of shadow banking activities through banking and insurance regulation: The EU has taken important steps to regulate the exposures of financial institutions to shadow banking entities. For example, recent reviews of the Capital Requirements Directive (CRD II and CRD III) and amendment to the International Financial Reporting Standards endorsed in November 2011 (related to IFRS 7) address shadow banking issues raised by securitisation structures to deter banks from circumventing existing capital requirements and other legislation.
• Enlarging the scope of current prudential regulation to shadow banking activities: The EU has proposed to enlarge the scope of existing regulations to new entities and activities so as to have a broader coverage, address systemic risk concerns and make future regulatory arbitrage more difficult. For example, the review of the Markets in Financial Instruments Directive (MiFID)¹ proposed by the Commission on 20 October 2011 broadens the scope of the framework, increases the transparency of non-equity instruments – which will enhance the ability to identify risks from shadow banking – and entrusts competent national authorities and the European Securities and Markets Authority (ESMA) with enhanced and proactive intervention power.
• Direct regulation of some shadow banking activities: The EU has adopted measures to regulate shadow banking entities and activities directly. For example, as far as investment funds are concerned, the Alternative Investment Fund Managers Directive (AIFMD)² already addresses a number of shadow banking issues. Asset managers are now required to monitor liquidity risks and employ a liquidity management system. Given new methods for calculating the leverage and reporting requirements, activities such as repurchase agreements or securities lending will be easier for the competent authorities to monitor.

Some Member States also have additional national rules for the oversight of financial entities and activities that are not regulated at EU level.

8. What are the issues which the Commission is examining?

There are five key areas where the Commission is further investigating options and next steps:

• Banking Regulation
• Asset Management Regulation
• Securities lending and repurchase agreements
• Securitisation
• Other shadow banking entities.

9. What are the next steps envisaged by the EU?

On the basis of the outcome of this consultation and taking into account any relevant work carried out by the European Systemic Risk Board (ESRB), the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA), the Commission will decide on the appropriate follow-up regarding the shadow banking issues outlined in this Green Paper, including legislative measures, as appropriate. The Commission will continue to engage in ongoing international work, including ensuring any level playing field concerns are addressed. Any regulatory follow-up will be accompanied by a careful assessment of its potential impacts and will also take into account the results of the work of the high-level expert group on structural banking reforms recently appointed by the Commission. After the publication of the group’s report, the Commission will assess the need for additional, targeted consultations on selected issues, as necessary.

¹: Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments, OJ L 145, 30.4.2004, p. 1–44.

²: Directive 2011/61/EC of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010, OJ L 174, 1.7.2011, p.1.