Shadow banking—fallout from the financial crisis?

A widespread and highly profitable banking system is operating outside of the regulation of traditional banking. Tony Anderson, partner at Pinsent Masons, who consulted during the financial crisis, discusses the nature of shadow banking and whether regulation is not only desirable, but necessary.

Original news

The Financial Stability Board (FSB) is proposing to apply numerical haircut floors to non-bank-to-non-bank transactions in order to ensure shadow banking activities are fully covered, reduce the risk of regulatory arbitrage, and to maintain a level-playing field. The proposal has been set out for consultation in the Annex 4 of the Regulatory Framework for Haircuts on Non-centrally Cleared Securities Financing Transactions. Comments on the proposal should be submitted by 15 December 2014.

What exactly is meant by ‘shadow banking’? What type of activities does it cover?

Shadow banking encompasses a range of services undertaken by non-bank financial institutions and intermediaries similar to those which have been provided traditionally by commercial banks. Because they are performed by entities which are outside the regulatory framework governing banks and other deposit-taking institutions, they have caught the attention of regulators as being an area of potential risk. They include intermediaries as diverse as money market funds, hedge funds, private equity funds, securities broker dealers and credit insurance providers.

What are the key concerns of regulators around the issue of shadow banking, ie lending by non-bank institutions?

A key concern is that because they are not deposit-taking institutions, shadow banks are subject to far less regulation than traditional banks. They are able to enhance the returns they achieve by leveraging their balance sheets far more than traditional bank counterparts by circumventing the capital and liquidity requirements imposed on regulated banks. Shadow banks can also contribute to systemic risk indirectly due to their ‘interconnectedness’ with the traditional banking systems. Similarly, systemic issues within shadow banking can then spread to traditional banking via credit intermediaries.

What constraints or checks are currently being proposed and by which bodies? How likely are these to be enforced?

The size of the global shadow banking industry has been estimated at $70trn. The UK’s exposure to shadow banking as a share of its GDP is twice that of any other country’s economy. There have been numerous initiatives commenced in various jurisdictions, including the enactment of provisions under the Dodd-Frank Wall Street Reform and Consumer Protection Act, providing for the Federal Reserve System to have the power to regulate all institutions of systemic importance. Separately, the FSB has proposed a reform programme of three elements:

  • the implementation of fresh standards to limit large exposures of traditional banks to shadow banks—including the installation of a firebreak between the sectors
  • reforms to make those institutions and markets at the heart of the shadow banking sector more resilient—for example, the establishment of minimum liquid asset requirements contributing towards the decreased susceptibility of money market funds to runs
  • the establishment of a mature regulatory framework to monitor and address financial stability risks arising from shadow banking—this is of course an on-going process dependent on system-wide oversight and global monitoring, and constant innovation in these markets as well as arbitrage will challenge any such regulation to remain relevant

Could there be any unintended consequences of trying to regulate shadow banking? Is regulation desirable?

There will always be the risk of unintended consequences where regulation is required to govern an area as diverse as shadow banking—containing vastly different participants, operating in a range of jurisdictions across numerous markets. Already we have seen very distinct and different approaches to banking reform being implemented in the UK, Europe and the US—the ramifications of which are still being worked through and understood. This is understandable given the unprecedented impact of the financial crisis across markets globally, and it is difficult to see regulation of shadow banking being any less so. Regardless of these difficulties however, appropriate regulation of shadow banking is both desirable and necessary given what we have seen occur in the finance sector in the past five or six years.

Interviewed by Jo Edwards.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

First published on LexisPSL Banking & Finance. Click here for a free trial.

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