In 2008 the world experienced another financial crisis ; the bankruptcy of Lehman Brothers and the subprime crisis, after these two crisis the Shadow Banking (SB) became an hot topic for the financial regulator and of course a large press coverage started to talk about this “new way of financing “.
What is the “Shadow Banking”…?
The Financial Safety Board (FSB) defines as “a system of credit intermediation that involves entities and activities outside the regular banking system”.
Two major intertwined pillars are needed
- Entities outside the regular banking systems engaged in:
- Accepting funding with “deposit like characteristics”
- Undergoing credit risk transfer
- With the use of direct or indirect financial leverage
- Special purpose entities which perform and/or maturity transformation like securitization vehicles such as asset back commercial paper conduits: Special Investment Vehicles and other Special Purpose Vehicles (SPVs)
- Money Market Funds (MMFs) and other types of investment funds or products with deposit-like characteristics
- Investments Funds, including Exchange Traded Funds (ETFs)
- Finance companies and securities entities that provide credit or are leveraged
- Finance companies and securities entities providing credit or credit guarantees, or performing liquidity without being regulated like a bank
- Other insurances or reinsurances which issue or guarantee credit products
- All activities carried outside the regular banking system which include securitization, securities lending and repurchase transactions (Repo)
The FSB has sized the Shadow Banking at about 46 trillion euro in 2010. This represents 25 – 30% of the total financial system.
Real Benefits…. And Real Risks
The Shadow Banking is deemed to be a useful part of the financial system; for instances:
- They provide interesting alternatives to bank deposits
- They channel resources towards specific needs with more efficiency due to increased specialization
- They constitute alternative funding for the real economy
- Finally they are a possible source of risk diversification away from the banking system.
The risk relate to the complexity of Shadow Banking entities and activities, their cross-jurisdictional reach, the inherent mobility of securities and the fund markets and mainly their non-connection with the regular banking system.
We can summarize the major risks and threads:
- Deposit-like funding structures my lead to “Runs”
- Shadow Banking activities are exposed to similar risks as banks, but without being regulated and supervised in a comparable manner.
- “Build-up” of high hidden leverage
- Due to the lack of supervision, Shadow Banking activities can be highly leveraged with collateral funding being churned several times. This can cause some fragility in the financial sector.
- Circumvention of rules and regulatory arbitrage
- The regular banking system could try to circumvent its applied regulation and supervision by imitating Shadow Banking or outsourcing certain operations into Shadow Banking
- Disorderly failures affecting the banking system
- Due to the close connection between the regular banking system and the Shadow Banking, any failures can lead to an important contagion and spill-over effects.
Challenges for the Supervisory and Regulatory Authorities
To counter these potential risks in an adequate way, it is essential that supervisory and regulatory authorities consider how best to address the Shadow Banking entities and activities. However this task carries several challenges:
First, the relevant Shadow Banking entities, including their activities, have to be identified and monitored. Therefore, all of the existing gaps between banks and non-bank financial institution need to be filled on a global basis. This could require the establishment of permanent processes and close coordination among all EU supervisors, the Commission, the central banks and the national supervisory authorities.
Secondly, the concerned authorities have to determine the approach to supervise the Shadow Banking entities.
Thirdly, any regulatory measure should align the same general principles. In other words these principles imply that regulatory measures should be targeted, proportionate, forward-looking and adaptable, effective and subject to assessment and review. Moreover the Commission considers that a specific approach for each kind of entity and/or activity must be adopted. In this respect, the Commission outlines three possible and complementary measures:
- Indirect regulation of the Shadow Banking activities through the banking and insurance regulations
- Enlarging the scope of the current regulation to Shadow Banking activities
- Implement direct regulation of some Shadow Banking activities. In this area the EU has already adopted measures to regulate the Shadow Banking; such as the “Alternative Fund Managers Directive (AIFMD)
In conclusion we have to be clever, it will not be possible to secure quickly financial operations carried out by the Shadow Banking, let’s keep in mind that according to some researches, they reach in excess 100 trillion USD.
Let’s hope that the financial operators have learnt from the collapse of Lehman Brothers and finally IF the investors avoid too complex financial products it will be a great step ahead!