The global financial crisis revealed a host of deficiencies in the existing regulatory regime. Regulators have spent the last three years working their way through a myriad of perceived issues, from increased capital requirements to regulation of trading of over-the-counter derivatives. Regulators are now turning to "shadow banking."
The concept of shadow banking has been discussed since the first responses to the financial crisis. However, it was not until a report published by the Financial Stability Board (FSB) in October 2011 that a comprehensive definition of shadow banking was articulated.The report broadly defines shadow banking as "The system of credit intermediation that involves entities and activities outside the regular banking system."
This is an intentionally broad definition as the FSB wants regulatory authorities to cast their net wide when conducting market surveillance to ensure that all areas where shadow banking-related risks to the financial system might potentially arise are captured. This broad definition reveals that the size of the shadow banking sector grew from $27 trillion in 2002 to $60 trillion in 2007 (these figures cover Australia, Canada, Japan, Korea, UK, United States, and the euro area) to make up approximately 25-30 percent of the total global financial system.
What are the Benefits of Shadow Banking?
The size of the shadow banking sector suggests that it plays a useful role in the financial system. In particular, shadow banking activities can perform the following functions:
- Provide alternatives for investors to bank deposits.
- Channel resources towards specific needs more efficiently due to increased specialization.
- Constitute alternative funding for the real economy, which is particularly useful when traditional banking or market channels become temporarily impaired.
- Constitute a possible source of risk diversification away from the banking system.
To reflect these functions, some in the industry prefer the term "alternative" banking, rather than shadow banking.
Why Does Shadow Banking Raise Concerns?
Shocks in the financial sector have led to discussions from commentators and regulators about regulated and unregulated activities.
The FSB's definition of shadow banking is very broad and encompasses a large range of activities, each with its issues. However, in a recent speech, Lord Turner (chairman of the Financial Services Authority and the co-chair of the FSB Task Force on Shadow Banking) explained that the regulators' key concerns with shadow banking are essentially the same as those in the regulated banking sector:
- Maturity transformation is inherently risky activity -- if all depositors want their money back simultaneously, they cannot have it.
- The volume of credit extended and money created can be subject to strong pro-cyclical self-reinforcing cycles -- more credit lent drives up asset prices, higher asset prices mean lower losses on credit extended, meaning banks have more capital to support further borrowing. This works until a shock in confidence causes all these factors to work in the opposite direction.
Implementation of prudential regulations, lender of last resort liquidity insurance from central banks, and deposit insurance schemes have mitigated these issues in the regulated sector. However, there are no equivalent policies for the shadow banking sector.
To deal with its concerns, the FSB has made eleven recommendations on which to base further work and has divided these recommendations into five workstreams -- regulation of banks' interaction with shadow banking entities, regulatory reform of money market funds, regulation of other shadow banking entities, regulation of securitizations, and regulation of securities lending and repos. Work has now begun on these five workstreams and a number of discussion papers have been published. It is expected that the recommendations under each of the workstreams will be complete by the end of 2012, at which point the FSB will publish a final report to the G20.
Eight of the recommendations have been captured in these five workstreams. The remaining three recommendations are included in a sixth catch-all workstream and reflect recommendations on which implementation of existing initiatives will be monitored. This sixth workstream includes transparency and reporting, rigorous underwriting and reducing the role of credit rating agencies in facilitating shadow banking activities.
In parallel to the FSB's work, the European Commission of the European Union (EU) has published a green paper (EU Green Paper) on the regulation of shadow banking in 2012, which deals broadly with the same areas. While no similar formal reports or white papers on broad regulatory changes to shadow banks have been published on the subject by United States regulators, some members of the Board of Governors of the Federal Reserve System have been very vocal on the subject of shadow banking, stressing the importance of implementing a regulatory response and suggesting certain near- and medium-term reforms.
This article summarizes the recommendations of the FSB together with any subsequent policy developments. We have structured the article to track the five workstreams identified by the FSB.
Regulation of Banks' Interactions
The first four of the FSB's recommendations make proposals for adjustments to bank regulatory capital rules so that the rules properly reflect the risks arising from a bank's interaction with shadow banking entities. The sixth recommendation proposes that the shadow banking entities themselves be subject to regulatory capital and liquidity requirements. Both the FSB and the European Commission are giving further consideration to the issues covered by these recommendations. Some of these recommendations are inherent in the Dodd-Frank Wall Street Reform and Consumer Protection Act enacted in the United States in 2010. Primarily through the law's ability to designate certain systemically important nonbank financial institutions for supervision by the Federal Reserve, including the imposition of capital and liquidity requirements.
Consolidation. Bank regulatory capital rules apply both on a stand-alone basis and on a consolidated basis. The FSB first recommends, in order to ensure that the rules work effectively on a consolidated basis, that the consolidation includes all shadow banking entities which are sponsored by the bank. This will prevent banks from moving risky assets into shadow banking entities for the purpose of avoiding the application of the regulatory capital rules to those assets.
Exposure Limitations. In its second recommendation, in order to limit interconnectedness to the shadow banking system, the FSB proposes placing limits on the size and nature of exposure banks will be permitted to have to shadow banking entities. If introduced, these limits would form part of the existing large exposure limits.
Adequate Risk-Weighting of Shadow Banking Exposures. The FSB's third recommendation addresses the need for banks to assign risk weights to shadow banking exposures that reflect the true level of risk. The FSB is particularly concerned about banks being able to treat their investments in funds as equity exposures without regard to the assets or liabilities held within the funds. The FSB wishes to introduce a "rigorous look-through treatment." A further area of concern is the treatment of undrawn short term liquidity facilities made available to shadow banking entities. Under Basel II, banks can apply a 20 percent credit conversion factor to these facilities, which the FSB considers may be too lenient given the risks of non-payment if the facilities are drawn down.
Restrict Bank Support of Shadow Banking Entities. In its fourth recommendation, the FSB focuses on scenarios in which a bank may give "implicit support" to shadow banking entities -- that is, where it might be expected to support an entity even in the absence of a formal, legally enforceable commitment to do so, for example, for reputational reasons. The FSB notes that this issue has already been the subject of reform in 2009, but suggests that more detailed standards may be needed.
Regulatory Reform of Money Market Funds
The FSB's fifth recommendation relates to regulatory reform of money market funds (MMFs). Although there is no globally accepted definition, MMFs are defined broadly as funds which invest in money market instruments (such as bonds) to preserve capital and provide daily liquidity. In order to achieve this, MMFs typically invest in a diversified portfolio of high-quality, low-duration fixed-income instruments. As such, MMFs have an important role to play both as an investment option for those looking for an efficient way to achieve diversified cash management and also as a buyer of short-term debt issued by a large number of businesses and governments.
During the financial crisis, a number of events in relation to MMFs highlighted their potential role in spreading or even amplifying a crisis. In particular, the International Organization of Securities Commissions (IOSCO) has noted:
- MMFs are susceptible to runs as there is an incentive for shareholders to redeem their shares before others do where there is a perception that the fund may suffer a loss. This is particularly an issue for MMFs that give a constant, rounded Net Asset Value (NAV), where the effect of rounding the NAV concentrates losses in remaining shareholders.
- When MMFs face redemption pressures, they may need to unwind their positions. Since MMFs are such an important supply of short-term funding, this can fuel a liquidity crisis.
- MMFs have relied historically on discretionary sponsor capital support to preserve the stability of NAV. As the size of MMFs have grown, this has created substantial risks for sponsors.
- MMFs are important participants in the repo market. Problems with MMFs can therefore transfer into the repo markets, which are an important source of funding for banks.
Since the financial crisis, both the EU and the United States have introduced additional regulation for MMFs. In the EU, this took the form of guidelines issued by CESR/ESMA, which cover issues such as portfolio quality, portfolio maturity and the use of constant NAV. In the United States, amendments were made to the main regulation governing MMFs (Rule 2a-7 under the Investment Companies Act of 1940) to tighten up the requirements in relation to portfolio quality, portfolio maturity, portfolio liquidity, stress testing, and public disclosures.
However, the FSB has recommended that regulatory reform of MMFs be further enhanced and has instructed the IOSCO to consider possible policy options. Following a consultation process, IOSCO published its final report on October 9, 2012. The report sets out 15 recommendations intended to form the basis for common standards for the regulation and management of MMFs across jurisdictions. The general approach of IOSCO is that while MMFs are currently regulated as funds, their role in the market and their potential risks are more akin to banks. As such, regulation of MMFs should reflect banking rules, rather than investment fund rules. The key recommendations include:
- A requirement that stable NAV funds move to variable NAV where such a move is workable. Because variable NAV values assets on a marked-to-market basis, this provides price transparency and removes the first mover advantage by forcing redeeming shareholders to redeem at a NAV that reflects current losses, lessoning the transfer of losses to remaining shareholders. This should therefore reduce the risk of MMFs suffering runs.
- Where a move to variable NAV is not workable, stable NAV funds should be subject to additional requirements. This could include imposing NAV buffers (i.e., a fund-level capital reserve which would act as a backstop against losses) or a liquidation fee charged on investors seeking to withdraw.
- Restrictions on the type of assets MMFs may hold and the imposition of limits on the average weighted term to maturity and the weighted average life of the portfolio.
- MMFs should undertake appropriate efforts to identify patterns in investors' cash needs, their sophistication, their risk aversion, as well as to assess the concentration of the investor base. This will allow MMFs to predict likely redemption profiles. However, IOSCO does not propose specific concentration limits for MMFs.
- Each jurisdiction should define a minimum level of liquid assets that MMFs should hold.
- MMFs should have in place tools to manage a run on the fund, such as temporary suspensions, gates, and/or redemptions-in-kind.
- Disclosure requirements, including a requirement for MMF documentation to explicitly state the possibility of principal loss and information regarding valuation and procedures in time of stress.
- Regulators should develop guidelines governing the use of the repo market by MMFs. Such guidelines should include areas such as settlement, counterparty risks, and collateral management, including the nature of the collateral received.
It is too soon to judge the market's reaction to the final report. However, it is fair to say that when a number of the recommendations were raised as options in IOSCO's prior consultation paper they were not widely welcomed by the industry. The overarching view in the market is that MMFs actually performed relatively well during the crisis and additional regulation (beyond that already brought in by the EU and the United States since the crisis) is unnecessary. In particular, a mandatory move to variable NAV funds was criticized by both MMF managers and investors who still see important uses for stable NAV funds (stable NAV funds are treated differently on investors' balance sheets than variable NAV funds). It is not clear whether the opt-out where a conversion to variable NAV is not workable is sufficient to deal with these concerns. In addition, any move towards bank-like regulation for MMFs, either directly or through options such as capital buffers was criticized as making MMFs less attractive to investors and therefore running the risk of driving business into less regulated vehicles. However a number of the final recommendations do impose such bank-like requirement.
Regulation of Other Shadow Banking Entities
Recommendation 6 of the FSB's report is to assess what other types of shadow banking entities should be captured by the regulatory regime and subject to appropriate regulatory capital and liquidity requirements to the extent the entity is a source of systemic risk. The need to regulate other types of shadow banking entities is also reflected in the EU Green Paper. Via the Dodd-Frank Act, the United States has extended its oversight of other shadow banking entities, but generally only if the entity is viewed as systemically important.
The FSB and the EU identify other shadow banking entities that might need to be caught by regulation as entities such as finance companies, conduits/structured investment vehicles, mortgage insurance companies, and credit hedge funds. This is on the basis that these entities could pose systemic risk and may provide opportunities for regulatory arbitrage.
The FSB is working to identify and categorize other shadow banking entities. The FSB has set up an Expert Group to coordinate creation of a global Legal Entity Identifier (LEI) and to prepare recommendations for an appropriate global LEI governance framework.
Both the FSB and the EU recommend a detailed assessment of current regulation. Such an assessment should identify potential gaps, develop possible policy recommendations, and propose additional prudential measures where necessary. The FSB also recommends that it assess the scale and risk of these entities and their role during the economic crisis. Both the FSB and the EU recognize that national supervisors may lack the powers necessary for collection of this data and will consider what steps, whether legislative or otherwise, are required to ensure it is possible. The FSB is to publish its report setting out policy recommendations in September 2012.
In the United States, the Dodd-Frank Act's newly created Financial Stability Oversight Council (FSOC) has the authority to monitor potential threats to the financial system and to provide for more stringent regulation of nonbank financial companies that the FSOC determines pose a risk to the financial system (i.e., systemically important financial institutions or "SIFIs"). Specifically, identified SIFIs would be subject to regulation by the Federal Reserve and to stricter operating standards, including higher capital requirements, leverage limits, liquidity requirements, concentration limits, resolution plans, credit exposure requirements, short-term debt limits, enhanced public disclosure requirements, and overall risk management requirements. The FSOC also may make recommendations to apply more strict standards to a financial activity or practice that it determines poses a risk to the financial system.
Regulation of Securitization
The FSB's Recommendation 7 addresses the incentives associated with securitizations -- specifically, risk retention and transparency and standardization of securitization products. In June 2012, IOSCO published a consultation paper titled "Global Developments in Securitization Regulation" in response to the FSB's recommendation. IOSCO's observations and findings point to policy recommendations about the following primary issues for consultation with interested parties:
- Risk Retention: IOSCO proposes that it monitor industry experience and views on the impact of the differences it has identified in regulatory approach between jurisdictions (e.g., the U.S. and the EU). IOSCO foreshadows that should industry feedback and experience point to the envisaged impacts emerging it will consider developing appropriate regulatory responses and mechanisms to address those differences.
- Disclosure (Stress Testing/Scenario Analysis): IOSCO proposes that it consult with investors about their appetite for stress testing information and, if appropriate, provide guidance on the disclosure issuers should be expected to make about stress testing and scenario analysis of pooled assets. Increased transparency could also contribute to the broader objective of reducing investor's reliance on credit rating agencies.
- Standardization of Disclosure: IOSCO proposes that it encourage industry to develop best practice disclosure templates and to encourage industry bodies to work with their counterparts in other jurisdictions to ensure consistent and harmonized approaches. IOSCO should consider developing principles to support harmonization in these approaches.
Separately, the European Commission in its EU Green Paper recognizes the need to examine whether existing regulatory provisions applying to securitizations concerning transparency, standardization, retention, and accounting requirements effectively address shadow banking concerns. The European Commission and the U.S. Securities and Exchange Commission are working jointly on comparing securitization rules in the EU and the United States with this aim in mind.
In its response to the EU Green Paper, the Association for Financial Markets in Europe (AFME) stresses the need for clarification over what is and what is not a securitization that partakes shadow banking:
- AFME's view is that not all forms of securitization by definition generate shadow banking concerns. AFME has stressed that the Commission focus its actions on shadow banking on "activities" that generate risk rather than entities of asset classes. In addition, a number of regulatory changes in respect of securitization have already been introduced (or are in the process of being introduced) in Capital Requirements Directive IV, CRA I, and CRA III. These developments should be taken into account by regulators when considering any additional regulatory needs in the securitization field in relation to shadow banking.
- Many traditional securitizations include "pass-throughs," where the investor's right to repayment is dependent on the securitized assets producing cash and the timing of that event. As such, they involve no maturity transformation and do not involve any leverage issues.
- AFME also draws attention to existing regulatory measures being undertaken in Europe, such as the Prime Collateralized Securities (PCS) initiative, which is aimed at ensuring that securitizations with the "PCS" label demonstrate a high level of quality, simplicity, and transparency.
- In the case of Asset-Backed Commercial Paper Conduits (ABCP), maturity transformation can clearly be undertaken. There may be a maturity mismatch between conduit assets and liabilities. However, this mismatch is absorbed through the existence of liquidity lines provided by banks in almost all cases. Therefore, maturity transformation risks that appear within ABCP conduits are not shadow banking risks, as such, they are being extensively covered by changes in banking regulations such as CRD IV and Basel III.
- Other types of structured vehicles, such as SIVs, are not strictly speaking securitizations since SIV liabilities were not directly backed by SIV assets. Their nature is more that of leveraged funds. While SIVs did engage in highly leveraged forms of maturity transformation (for example Collateralized Debt Obligations) AFME states that this is not the case for traditional real economy asset securitizations and as above, stresses that the focus for shadow banking regulation should be on "activities" that generate risk rather than entities or asset classes.
In the United States, the Dodd-Frank Act made substantial changes to the way in which asset-backed securities are created, rated, and sold. The Dodd-Frank Act generally requires securitizers to retain 5 percent of the credit risk of their offerings, imposes conflict of interest prohibitions, and expands disclosures of asset-backed securities in registered public offerings. However, proposed rules to implement this provision remain pending.
Regulation of Securities Lending and Repos
Recommendation 8 provides that the regulation of securities lending and repos should be assessed carefully and further enhanced from a prudential perspective. Securities lending and repurchase agreements (repos) are in the focus of the regulators because these activities can be used rapidly to increase leverage and are a key source of funds used by some shadow banking entities. Regulators also fear that there are regulatory gaps in existing regulations as well as inconsistencies between various jurisdictions.
The EU Green Paper indicates that special attention should be given to global leverage resulting from securities lending, collateral management, and repos transactions in order to ensure that supervisors have accurate information to assess this leverage, the tools to control it and to avoid its excessive procyclical effects. Moreover, bankruptcy laws and their impact on collateral should also be reviewed with regard to increasing international consistency along with the accounting practices of such transactions.
The FSB in its report has initially identified three main areas that should be considered in addressing the risks in the secured funding market:
- Regulating securities lending-related cash collateral reinvestment programs: Regulatory measures should be introduced to place limits on the maturity of investments into which cash collateral is invested or on the types of instruments that are used for these investments. Limits on the use of customer's collateral to finance banks and securities dealers (re-hypothecation) should also be reviewed.
- Macro-prudential measures related to repos and securities lending: Introduction of macro-prudential requirements such as minimum margin or haircuts to mitigate procyclicality should be considered further in addressing systemic risks, drawing on the Committee on the Global Financial System report "The role of margin requirements and haircuts in procyclicality of March 2010."
- Improving market infrastructure for secured funding markets: Strengthening market infrastructure for secured funding markets such as repo clearing, settlement and trade reporting arrangements should be considered.
In its subsequent Interim Report, published in April 2012, the FSB identified the following issues that should be especially considered from a financial stability perspective:
- Lack of transparency: Due to the usual bilateral nature of securities financing transactions market transparency may be lacking for its participants as wll as policymakers.
- Procyclicality of system leverage/interconnectedness: Because leverage may be obtained in a way that is sensitive to the value of the collateral as well as to the financial institutions own perceived creditworthiness, the leverage and the level of risk-taking may potentially destabilize the entire financial system.
- Fire-sale of collateral assets: Collateral fire-sales may lead to market turmoil especially when the defaulting party's asset pool is large and rather illiquid in comparison to the market.
- Cash collateral reinvestment: By reinvesting cash collateral received from securities lending transactions, any entity with portfolio holdings can effectively perform "bank-like" activities, such as credit and maturity transformations, thereby subjecting its portfolio to credit and liquidity risks.
In the United States, the Federal Reserve Bank of New York in late 2009 created the Task Force on Tri-Party Repo Infrastructure (Task Force) to address the systemic risk that had become evident during the financial crisis in the tri-party repo market. The Federal Reserve asked the Task Force, made up of market participants and relevant industry associations, to review and make recommendations regarding opportunities for improvement to the tri-party repo infrastructure. The Task Force's recommendations, published in February 2012, included reducing demand and supply on intra-day credit, shortening the window for the daily unwind, increasing transparency, and speeding settlement finality.