TWN Info Service on Finance and Development (Nov12/05)
30 November 2012
Third World Network

FSB sets out recommendations on shadow banking
Published in SUNS #7487 dated 26 November 2012

Geneva, 23 Nov (Kanaga Raja) -- The Financial Stability Board (FSB) has this week published three consultative documents containing policy recommendations aimed at strengthening the oversight and regulation of the shadow banking system.

In a press release, the FSB said that the three documents are open for public consultation, with comments on the recommendations contained in these documents to be submitted by 14 January 2013.

According to the press release, the three documents are:

-- a report titled "An Integrated Overview of Policy Recommendations" setting out the FSB's overall approach to shadow banking issues, as well as an overview of its recommendations;

-- a report titled "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 money market funds (MMFs); and

-- a report titled "Policy Recommendations to Address Shadow Banking Risks in Securities Lending and Repos", which outlines 13 recommendations to enhance transparency, strengthen regulation of securities financing transactions, and improve market structure.

According to the FSB, it has focused on five specific areas in which it believes policies are needed to mitigate the potential systemic risks associated with shadow banking: (i) to mitigate the spill-over effect between the regular banking system and the shadow banking system; (ii) to reduce the susceptibility of money market funds (MMFs) to "runs"; (iii) to assess and mitigate systemic risks posed by other shadow banking entities; (iv) to assess and align the incentives associated with securitisation; and (v) to dampen 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 FSB said that the Basel Committee on Banking Supervision (BCBS) will develop policy recommendations for area (i) by mid-2013, while for areas (ii) and (iv), the International Organisation of Securities Commissions (IOSCO) has set out final policy recommendations in its reports "Policy Recommendations for Money Market Funds" and "Global Developments in Securitisation Markets."

In the first document, "An Integrated Overview of Policy Recommendations", the FSB said that the "shadow banking system" can broadly be described as "credit intermediation involving entities and activities (fully or partially) outside the regular banking system".

While such intermediation, appropriately conducted, provides a valuable alternative to bank funding that supports real economic activity, the FSB said that "experience from the crisis demonstrates 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 (longer-term credit extension based on short-term funding and leverage)."

Such risk creation may take place at an entity level but it can also form part of a complex chain of transactions, in which leverage and maturity transformation occur in stages, and in ways that create multiple forms of feedback into the regulated banking system, it added.

Like banks, a leveraged and maturity-transforming shadow banking system can be vulnerable to "runs" and generate contagion risk, thereby amplifying systemic risk. Such activity, if unattended, can also heighten pro-cyclicality by accelerating credit supply and asset price increases during surges in confidence, while making precipitate falls in asset prices and credit more likely by creating credit channels vulnerable to sudden losses of confidence.

According to the FSB, these effects were powerfully revealed in 2007-09 in the dislocation of asset-backed commercial paper (ABCP) markets, the failure of an originate-to-distribute model employing structured investment vehicles (SIVs) and conduits, "runs" on money market funds (MMFs) and a sudden reappraisal of the terms on which securities lending and repos were conducted.

"But whereas banks are subject to a well-developed system of prudential regulation and other safeguards, the shadow banking system is typically subject to less stringent, or no, oversight arrangements," it noted.

The FSB said it 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. It also provides a process for monitoring the shadow banking system so that any rapidly growing new activities that pose bank-like risks can be identified early and, where needed, those risks addressed.

At the same time, given the interconnectedness of markets and the strong adaptive capacity of the shadow banking system, it is apparent that any proposals in this area necessarily have to be comprehensive, the FSB underlined, adding that a "piecemeal or incomplete approach would be quickly arbitraged."

FSB members believe that the recommendations developed across these areas represent a major step forward and present the G20 with concrete proposals. If taken forward, these will provide a significant measure of additional protection against "runs" in the shadow banking sector of a type that exacerbated pro-cyclicality and added to systemic risk in the years leading to 2007/8.

"So looking ahead, authorities must be mindful that, by strengthening the capital and liquidity requirements applying to banks (an essential pillar of the G20's financial reform programme), the Basel III framework may increase the incentives for some bank-like activities to migrate to the non-bank financial space. Other forms of regulatory reform may have similar effects."

The FSB therefore believes that oversight and regulation for shadow banking must incorporate a system of "embedded vigilance" through on-going review and be capable of evolving in response to market changes.

Since the crisis, the FSB pointed out, BCBS members have implemented or are in the process of implementing a number of measures (through Basel II. 5 and Basel III) that should strengthen the resilience of the banking sector against some risks posed by shadow banks.

In particular, the BCBS has: increased the capital requirements applied to banks' re-securitisation exposures and for liquidity facilities (under one year) provided to securitisation vehicles; increased the capital requirements under the internal ratings-based approach (IRB) for exposures to regulated financial institutions whose total assets are greater than or equal to US$100 billion, and to unregulated financial institutions, regardless of size; enhanced the banks' internal capital adequacy assessment process under Pillar 2 for securitisation risk, reputational risk and implicit support; and enhanced the Pillar 3 disclosure requirements related to securitisation.

Meanwhile, the FSB also released this week its second annual "Global Shadow Banking Monitoring Report", whose coverage this year has been broadened to include 25 jurisdictions and the euro area as a whole, as opposed to 11 jurisdictions and the euro area as a whole last year.

The FSB said that the addition of new jurisdictions brings the coverage of the monitoring exercise to 86% of global GDP and 90% of global financial system assets.

According to FSB, among the main findings from the report are:

-- The global shadow banking system grew rapidly before the crisis, rising from $26 trillion in 2002 to $62 trillion in 2007. The size of the total system declined slightly in 2008 but increased subsequently to reach $67 trillion in 2011
(equivalent to 111% of the aggregated GDP of all jurisdictions).

Compared to last year's estimate, expanding the coverage of the monitoring exercise has increased the global estimate for the size of the shadow banking system by some $5 to $6 trillion. The newly included jurisdictions contributing most to this increase were Switzerland ($1.3 trillion), Hong Kong ($1.3 trillion), Brazil ($1.0 trillion) and China ($0.4 trillion).

-- The shadow banking system's share of total financial intermediation has decreased since the onset of the crisis and has remained at around 25% in 2009-2011, after having peaked at 27% in 2007. In broad terms, the aggregate size of the shadow banking system is around half the size of banking system assets.

The US has the largest shadow banking system, with assets of $23 trillion in 2011, followed by the euro area ($22 trillion) and the UK ($9 trillion). However, the US' share of the global shadow banking system has declined from 44% in 2005 to 35% in 2011. This decline has been mirrored mostly by an increase in the shares of the UK and the euro area.

-- There is a considerable divergence among jurisdictions in terms of: (i) the share of non-bank financial intermediaries (NBFIs) in the overall financial system; (ii) relative size of the shadow banking system to GDP; (iii) the activities undertaken by the NBFIs; and (iv) recent growth trends.

The Netherlands (45%) and the US (35%) are the two jurisdictions where NBFIs are the largest sector relative to other financial institutions in their systems. The share of NBFIs is also relatively large in Hong Kong (around 35%), the euro area (30%), Switzerland, the UK, Singapore, and Korea (all around 25%).

Jurisdictions where NBFIs are the largest relative to GDP are Hong Kong (520%), the Netherlands (490%), the UK (370%), Singapore (260%) and Switzerland (210%). Part of this concentration can be explained by the fact that these jurisdictions are significant international financial centres that host activities of foreign-owned institutions.

-- After the crisis (2008-2011), the shadow banking system continued to grow although at a slower pace in seventeen jurisdictions (half of them being emerging markets and developing economies undergoing financial deepening) and contracted in the remaining eight jurisdictions.

-- Among the jurisdictions where data is available, interconnectedness risk tends to be higher for shadow banking entities than for banks. Although further analysis may be needed with more cross-border and prudential information, shadow banking entities seem to be more dependent on bank funding and are more heavily invested in bank assets, than vice versa.

The FSB also said that data granularity is improving, with the share of unidentified non-bank financial intermediaries within overall non-bank intermediation falling from 36% in 2010 to 18% in 2011.

However, it added, further improvements are needed in jurisdictions that still lack granular data to adequately capture the magnitude and nature of risks in the shadow banking system. +