Europe To Shine A Light On Shadow Banking

Terry Flanagan

Leading European regulators are calling for more transparency and greater levels of control over the growing shadow banking sector to prevent a repeat of the 2008 financial crisis.

The opaque sector was worth some €46 trillion in 2010, up from €21 trillion in 2002, according to the Financial Stability Board (FSB), a global regulatory body, 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.

“We must be in a position to identify who owns what along the financing chains linked to these practices,” Michel Barnier, the European Union’s financial services commissioner, told the Shadow Banking Conference in Brussels last week. “And we must improve the transparency, supervision and security of these practices for all players on the market, wherever they may be situated along the securities lending chain. Lastly, we must ensure that the supervisory authorities are properly equipped to control the total leverage exerted by these practices.

“We must, of course, ensure consistent regulation across the various financial sectors. In particular, I believe that the minimum capital to be tied up for a single operation must be comparable across all sectors to avoid encouraging any form of supervisory arbitrage.”

Barnier added that it was critical regulators obtain a “complete overview” of the “complex” sector to prevent “excessive risk-taking, sheep-like behavior and excessive volatility in liquidity provision”. He added: “These practices, left unchecked, played a decisive role in the difficulties faced by AIG, Bear Stearns and Lehman Brothers.”

The EU commissioner is also worried that inaction may push certain banking activities towards the non-regulated sector.

He said: “What lessons have we drawn from the crisis if we allow risky activities to prosper alongside better regulated and more solid ones? We are simply moving the risks off the radar of the supervisors. For all that, this is not about penalizing players in the shadow banking system who play an important role in financing the real economy.”

While Paul Tucker, the Bank of England’s deputy governor, told the same Brussels conference that any such rules should not necessarily stifle innovation but called for prompt regulatory action.

“This should not be about eliminating shadow banking,” he said. “We need to be able to monitor the system and respond flexibly.

“It would be foolhardy to imagine that we can frame policies today that will stand the test of time. The financial system will evolve, and we need to permit innovation. A policy framework on shadow banking therefore needs to be adaptive. And it mustn’t try to shut everything down—non-bank finance is not intrinsically a bad thing.

“We will need effective surveillance of what is going on and what concentrations of risk are emerging and we will have to make discerning policy judgments that are explained and consulted upon. That is exactly what the EU, alongside the FSB, is now embarked upon.”

The FSB has had shadow banking, in particular money market funds, securitization and securities lending, on its radar for a couple of years and plans to complete work on policy recommendations for the G20 group of nations in November. Barnier is set to cast a European response, much in line with the FSB’s proposals, some time next year.

The European Commission has also previously said that hedge funds will instead be regulated directly through the upcoming Alternative Investment Fund Managers Directive, which it says addresses a number of shadow banking issues.

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