Thursday, April 28, 2011

FSB Task Force Frames the Regulation of Shadow Banking


Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

The “shadow” banking system played a major role in the financial crisis, but was not a central focus of many countries’ reform legislation and potentially remains largely unregulated. At the November 2010 Seoul Summit, the G20 Leaders heralded the development of new bank capital and liquidity requirements under Basel III. But concerned by the growing importance of the “shadow banking system,” which grew out of the securitization of assets and the integration of banking with capital market developments, the G20 Leaders called on the Financial Stability Board (FSB), in collaboration with other international standard setting bodies, to develop recommendations to strengthen the oversight and regulation of the “shadow banking system” by mid-2011.

Strengthening regulation and supervision of shadow banking: With the completion of the new standards for banks, there is a potential that regulatory gaps may emerge in the shadow banking system. Therefore, we called on the FSB to work in collaboration with other international standard setting bodies to develop recommendations to strengthen the regulation and oversight of the shadow banking system by mid-2011.

In response, the FSB formed a task force (Task Force) whose primary goal is to develop initial recommendations for discussion that would:
  • clarify what is meant by the “shadow banking system”; 
  • set out potential approaches for monitoring the shadow banking system; and 
  • explore possible regulatory measures to address the systemic risk and regulatory arbitrage concerns posed by the shadow banking system. 

On April 12, 2011 the Task Force issued its initial report, “Shadow Banking: Scoping the Issues,” laying out “the current thinking of the task force especially on the first of the above three items so as to invite views from the public in taking the work forward.” Though preliminary in nature, this “background note” may provide some valuable clues about the nature, scope, and extent of upcoming proposals to regulate shadow banking.

Notably, the Task Force defines “shadow banking” very broadly and may signal an intention to bring under the ambit of regulation the widest range of credit intermediation involving entities and activities outside the regular banking system under the ambit of regulation. At the same time, the broad definition is nevertheless limited in scope to “entities and activities involved in extending credit (either directly or as part of a chain of credit intermediation) or involved in facilitating its intermediation.”


While the term is used widely in the news media and in policy discussions, there is as yet no clear commonly-agreed definition. This stems not only from its recent origins but also from how the banking sector is structured and regulated in each jurisdiction. Moreover, financial transactions outside the banking sector can be complex and may evolve over time depending on factors such as financial innovation and regulatory changes. A flexible forward-looking perspective is crucial to capture mutations in credit intermediation that can pose risks to the financial system.


The Task Force sees two major dangers posed by shadow banking:
  • systemic risk concerns: . . . these predominately arise from activities that generate maturity and/or liquidity transformation, that involve flawed credit risk transfer, and that create or facilitate leverage; and 
  • regulatory arbitrage concerns: shadow banking activity can be used to circumvent and undermine banking regulations.


They therefore recommend that authorities focus first on intermediation activities that give rise to either or both of these dangers. Sensibly, the Task Force makes it clear that, given the broad definition of “shadow banking” activities and entities swept up in its definition, a single regulatory approach is not feasible, and multiple regulatory responses may be more effective.

Rather, differentiation may be required to account for differences in business model, risk characteristics and contribution to systemic risk. Accordingly, the regulatory response to shadow banking should be carefully balanced and targeted to the risks the system creates, taking into account the expected costs and benefits of potential policy interventions in a comprehensive way and using appropriate criteria on which to judge their efficacy.

Further, because shadow banking practices are ever evolving, flexibility in regulatory responses and monitoring are also key to their effectiveness.

In addition, regulatory responses need to be forward-looking and flexible, so they should not focus solely on the recent crisis but also address issues and problems that may arise as financial markets adapt and evolve for example as institutions adjust in response to the changes in incentives provided by the Basel III framework.


Given the fluid, evolving nature of the shadow banking system, the Task Force proposes that monitoring and responses be guided by a two-stage risk aware approach focused on intermediation.
 
Authorities should cast the net wide, looking at all non-bank credit intermediation to ensure that data gathering and surveillance cover all the activities within which shadow banking-related risks might arise.  Authorities should then narrow the focus, concentrating on the subset of non-bank credit intermediation where maturity/liquidity transformation and/or flawed credit risk transfer and/or leverage create important risks.


While many academics, regulators, and market participants feel that shadow banking may be held in check simply by imposing more stringent financial regulation and by measures to prevent excessive leverage and maturity mismatch, given the fluid, evolving nature of the shadow banking system, the Task Force does not recommend any single regulatory approach. They do, however, group potential regulatory responses into four categories. In future reports, the Task Force will examine the merits of each of the categories of regulatory approaches.

  • Banks’ interactions with shadow banking entities (indirect regulation): By regulating banks’ interactions with shadow banking entities, the spill-over of risks into the regular banking system will be reduced. Actions can also be taken to close opportunities for regulatory arbitrage by which banks seek to reduce capital or liquidity requirements by organising transactions wholly or in part through shadow banking entities. 
  • Shadow banking entities (direct regulation): Shadow banking entities can themselves be regulated to reduce the risks they pose to the system. 
  • Shadow banking activities: Instead of regulating shadow banking entities, authorities may intervene to address risks affecting particular instruments, markets or activities so as to facilitate sound credit intermediation through the shadow banking system.
  • Macro-prudential measures: Rather than focusing on certain entities or activities, policy measures can address systemic risk in the shadow banking system more broadly (eg regulatory measures for mitigating procyclicality or policies to strengthen market infrastructure to lower contagion risks).


Though not championing any of these approaches in particular, it is clear from the way the Task Force has framed the issues and defined “shadow banking” that only a combination of regulatory approaches will address both systematic risk and regulatory arbitrage concerns. The reality of the market is that shadow banking’s securitization, Repo, and the intermediation that goes with them are in essence new and necessary forms of banking. As such, it is clear, that ad hoc regulatory efforts or efforts that treat only parts of the system are doomed to fail, and a more integrated approach will be necessary to regulate traditional and shadow banking activities. Although this report merely defines the terms of the discussion rather than recommending action steps, it and future Task Force reports will no doubt be read closely, and taken very seriously by the regulatory authorities of the G20 countries and others.
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