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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.
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.
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.
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.
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:
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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