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International watchdogs call for stronger oversight of 'shadow banking'

International watchdogs have called for stronger oversight of non-bank lending in a recently-published set of draft policy recommendations.21 Nov 2012

The Financial Stability Board (FSB), a Basel-based group made up of representatives from the G20 countries, is consulting on an "initial integrated set of recommendations" to tackle the growing 'shadow banking' sector. It has identified five areas in which new laws are needed, including minimum levels of assets that must be held.

The recommendations (19-page / 151KB PDF), produced following a request from the G20 last year, form part of a new report (45-page / 1.2MB PDF) on shadow banking. The report analyses the relationship between banks and non-bank institutions across 25 jurisdictions, made up of all 24 FSB member jurisdictions plus Chile.

The term 'shadow banking' generally refers to the provision of credit either fully or partially outside of the regular banking system. Activity in the sector has tripled in the sector over the past decade and covered assets worth $67 trillion by the end of 2011 according to FSB estimates. Of the jurisdictions covered by the FSB's report, 17 saw an increase in non-bank financial intermediaries since the crisis with half of these based in emerging markets.

The FSB said that these activities where "appropriately conducted" provide a "valuable alternative to bank funding that supports real economic activity". However, it believes that regulation is needed due to the capacity for some non-bank entities and transactions to "operate on a large scale" in ways that create "bank-like risks to financial stability", particularly where complex "chains" of transactions are involved.

In its report, the FSB suggested that money market funds (MMFs) in particular could be just as likely as mainstream banks to experience 'runs' during times of financial stress, as was demonstrated during the crisis of 2007-09. However, unlike banks, they are typically subject to "less stringent, or no, oversight". MMFs are open-ended mutual funds that invest in short-term debt securities, and are attractive due to their relative safety and high yields.

Among its recommendations, the FSB proposes a limit to the type of assets that MMFs can invest in and a ban on them offering investors capital guarantees. It also suggests that they be required to hold statutory minimum levels of liquid assets.

It has also made recommendations for security lending and repurchasing, or 'repo', which many banks and funds use as a method of short-term funding. According to the FSB, an increase in repo-ing of securities could exacerbate funding strains in times of 'runs' on more traditional funding models.

It has recommended that these deals be logged with central trade repositories in order to improve regulatory oversight of the market, and has suggested that these trades should be directed through central counterparties (CCPs) as a means of mitigating risk. The role of CCPs, which sit in the middle of a trade between two parties to ensure financial performance if one party does not meet its commitments, is an important part of forthcoming regulation of the over-the-counter (OTC) derivatives market.

The Economic and Monetary Affairs Committee (ECON) of the European Parliament also reported on shadow banking this week, with MEPs adopting a non-legislative resolution calling for better prudential oversight of the sector. ECON warned that the collapse of the shadow banking sector would have a "domino effect" across other financial institutions and borders due to the nature of the links between the sector and mainstream banking. Better monitoring and supervision of shadow banking would reduce the systemic risks these institutions could pose to financial stability without affecting its "beneficial effects on the real economy" as a source of alternative funding and liquidity, it said.

"The Bank Reform Bill currently envisages prohibitions being imposed on UK ring-fenced banks from entering into transactions with certain shadow banking entities due to the risks already associated with the sector," said banking expert Tony Anderson of Pinsent Masons, the law firm behind "The introduction of effective regulation into shadow banking will hopefully reduce the amount of prohibitions likely to be imposed."