Monday, November 19, 2012

FSB Renews its Focus on Shadow Banking

Appropriate monitoring and regulatory frameworks for the shadow banking system needs to be in place to mitigate the build-up of risks.

On November 18, 2012, the Financial Stability Board (FSB) published for public consultation an initial integrated set of policy recommendations intended to strengthen oversight and regulation of shadow banking. Given the FSB's finding that the shadow banking system grew to a new high of $67 trillion globally last year, it is understandable that regulators and policy-makers, including those among the FSB's membership, fear that shadow banking activities harbor serious and sometimes hidden risks to the global financial system.  The FSB's November 18 release calls for greater controls on this area of the financial world that has thus far escaped explicit regulation.  The consultation paper is timely given the European Commission is poised to propose EU-wide shadow banking rules in 2013, and the US Treasury Department has recently proposed structural changes to money market funds, considered a key part of the shadow banking system, to combat the perceived systematic risks posed by them.

For purposes of its consultation paper and review, the FSB has defined "shadow banking" widely as non-bank credit intermediation or "credit intermediation involving entities and activities (fully or partially) outside the regular banking system.” This definition sweeps in many kinds of entities, activities, and transactions, from money market funds, to repo, securities lending, and securitization. Despite this broad remit, the FSB's workstreams and this most recent release have focused on five specific areas they feel must be addressed to mitigate the potential systemic risks associated with shadow banking:

  1. Mitigating the spill-over effect between the regular banking system and the shadow banking system; 
  2.  Reducing the susceptibility of money market funds (MMFs) to “runs”; 
  3. Assessing and mitigate systemic risks posed by other shadow banking entities; 
  4. Assessing and align the incentives associated with securitization; and 
  5. Dampening risks and pro-cyclical incentives associated with secured financing contracts such as repos, and securities lending that may exacerbate funding strains in times of “runs."

The November 18 consultation paper, a result of more than a year of study, is made up of three parts:

  1. An Integrated Overview of Policy Recommendations, 
  2. A report entitled Policy Framework for Strengthening Oversight and Regulation of Shadow Banking Entities which sets out a high-level policy framework to assess and mitigate bank-like systemic risks posed by shadow banking entities other than MMFs ; and
  3. A report entitled Policy Recommendations to Address Shadow Banking Risks in Securities Lending and Repos that sets out 13 recommendations to enhance transparency, strengthen regulation of securities financing transactions, and improve market structure.
The Integrated Overview report summarizes the FSB’s overall approach to shadow banking issues and provides an overview of the recommendations of the workstreams across the five specific areas.  These recommendations are supported by the findings and data in the other two supporting reports.  In sum, the FSB recommends not sweeping reforms, but rather, precision.

The FSB is of the view that the authorities’ approach to shadow banking has to be a targeted one. The objective is to ensure that shadow banking is subject to appropriate oversight and regulation to address bank-like risks to financial stability emerging outside the regular banking system while not inhibiting sustainable non-bank financing models that do not pose such risks. Indeed, a resilient system of non-bank credit intermediation would be welcomed. The approach is designed to be proportionate to financial stability risks, focusing on those activities that are material to the system, using as a starting point those that were a source of problems during the crisis.
Notable among the FSB's more specific recommendations are their approaches to money market funds ("MMFs"), as well as repo and securities lending. The FSB's recommendations regarding MMFs went beyond regulatory proposals being floated in the US and elsewhere. These include clear limitations on the kinds of instruments MMFs may invest in, holding a statutory minimum level of liquid assets at all times, marking portfolio assets to market (i.e., a floating net asset value as opposed to a stable one), forbidding them from offering investors capital guarantees, and restricting MMF's use of repos.  

The FSB also looked closely at repo and securities lending practices, worried about the extent to which they may increase leverage and risk across the financial system.  The FSB recommends increasing transparency both in the market and to regulators by moving repos and securities lending transactions to trade repositories and clearing these trades through central counterparties. It also suggested limits on the amount of money that can be borrowed against certain forms of collateral, and proposes that fund managers be required to disclose more about their use of repos. Further, the FSB also proposed that intermediaries who lend out securities owned by their clients not be able to use the collateral they recieve to fund their own activities.

Based on the feedback from this set of consultation papers, as well as any additional findings from the individual workstreams, FSB will prepare final proposals, including the detailed recommendations from each workstream in September 2013. It will then turn its attention to ensuring policy recommendations are implemented appropriately.

In subsequent posts, CSFME will examine in more detail the implications of some of the FSB's November 18 proposals and some of the supporting data, particularly those associated with securities lending, repo, central counterparties and trade repositories, and money funds.