EU Plans Shadow Banking Crackdown

Terry Flanagan

The European Commission aims to tighten up financial regulation so that the ‘shadow banking’ sector is brought to account.

Michel Barnier, the European Union’s financial services commissioner, launched a consultation paper on Monday with a view to containing the risks posed by financial institutions on the periphery of traditional banking.

“EU measures already address some aspects of shadow banking, but not all; this consultation should help stem future risk to the financial system,” said Barnier on his Twitter account.

The Financial Stability Board (FSB), a global regulatory body, estimated that the global shadow banking sector was worth some €46 trillion in 2010, up from €21 trillion in 2002, and is made up of a network of non-banks offering credit or banking services. The 2010 figure represents 25%-30% of the total financial system.

The FSB aims to crack down on shadow banking, in particular money market funds, securitization and securities lending. The Commission said that hedge funds will instead be regulated directly through the Alternative Investment Fund Managers Directive, which it says addresses a number of shadow banking issues. The FSB says it will have detailed proposals in place on shadow banking by the end of the year and Barnier will cast a European response much in line with the FSB’s proposals in 2013.

“The European Union has shown global leadership in implementing ambitious reforms in the area of financial regulation, in particular for banks,” said Barnier. “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.”

And Lord Adair Turner, chairman of U.K. regulator the Financial Services Authority, also believes that despite major reforms being put in place in the wake of the global financial crisis for ‘normal’ banks, the shadow banking sector still poses a significant risk to financial stability as well as playing a major role in the 2007-08 crisis.

“In autumn 2008, the developed world’s banking system suffered a severe crisis [following the collapse of Lehman Brothers],” said Turner. “And since then the world’s regulators and central banks have focused on building a more stable banking system for the future: less leverage, more liquid, better supervised and with even the largest banks able to be resolved without taxpayer’s support.

“But it’s striking that the crisis did not initially seem to be one of banks themselves, but rather of an apparently new phenomenon: shadow banking. So we need to ensure that our regulatory response appropriately covers shadow banking as well as banks.”

He added: “We need to understand shadow banking not as something parallel to but separate from the core banking system, but [also] deeply intertwined with it. The way in which shadow banking contributed to financial instability reflected and still reflects fundamental developments in our financial system which are relevant to banks as much as to shadow banks, which remain important today and which could produce new problems in the future.

“We should not take the decline in some specific indicators of shadow activity which has occurred since 2008 as suggesting that the risks have gone away.”

Turner said that some of the risks had been apparent in the earlier 1998 failure of U.S. hedge fund Long Term Capital Management and that some of the reforms now being discussed had been considered, but not taken, in its aftermath. “This time around we need to ensure that we maintain the momentum of reform, and that our response is sufficiently radical,” he said.

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