- Communication on shadow banking: frequently asked questions
- Parlementair Documentatie Centrum
1. What is shadow banking?
Shadow banking can be defined as a system of credit intermediation that involves entities and activities outside the regular banking system. Shadow banks are not regulated like banks, though their operations are like those of banks, as they:
- Take in funds similar to deposits;
- Lend over long periods and take in deposits that are available immediately (known as maturity and/or liquidity transformation);
- Take on the risk of the borrower not being able to repay; and
- Use borrowed money, directly or indirectly, to buy other assets.
They may include ad hoc entities such as securitisation vehicles or conduits, money market funds, investment funds that provide credit or are leveraged, such as certain hedge funds or private equity funds and financial entities that provide credit or credit guarantees, which are not regulated like banks or certain insurance or reinsurance undertakings that issue or guarantee credit products.
Shadow banking also includes activities, in particular securitisation, securities lending and repurchase transactions, which constitute an important source of finance for financial entities.
2. Why is there a need to address shadow banking?
The shadow banking sector needs to be better monitored because of its size, its close links to the regulated financial sector and the systemic risks that it may pose. There is also a particular need to prevent the shadow banking system being used for regulatory arbitrage.
In addition to the risks associated with circumventing the rules and the fact that these shadow banking entities/activities can lead to high levels of debt being built up in the financial sector, authorities should monitor this sector for two main reasons:
1. The first factor is size. Even if not entirely accurate, the estimates of the size of the shadow banking system, both in absolute terms and as a share of the global financial sector, show that some of its components could be systemically significant.
The latest studies by the FSB indicate that the aggregate shadow banking assets, reflected in the statistical category ‘other financial intermediaries’, are about half the size of the regulated banking system. Despite the fact that shadow banking assets have decreased slightly since 2008, the global figure in 2011 was €51 trillion. In terms of geographical distribution, the biggest share is concentrated in the United States (around €17.5 trillion) and in Europe (Eurozone with €16.8 trillion and the United Kingdom with around €6 . 8 trillion)
2. The second factor which increases risk is the high level of interconnectedness between the shadow banking system and the regulated sector, particularly the banking system. Any weakness that is mismanaged or the destabilisation of an important entity in the shadow banking system could trigger a wave of contagion that would affect the sectors subject to the highest prudential standards.
3. How does the Commission address risks inherent to shadow banking?
While the notion of ‘shadow banking’ has only recently been formally defined in the G20 discussions, the risks related to it are not new. The Commission has already implemented, or is in the process of implementing, a number of measures to provide a better framework for these risks, such as harmonised rules applying to hedge fund activity and reinforcing the relationship between banks and unregulated actors.
4. Who will benefit from the measures outlined in the communication?
The main beneficiary of improved regulation is society as a whole. Ultimately, preventing systemic risk being created by the financial sector will increase stability and avoid situations where states, governments and citizens are responsible for repairing damage to the financial system.
5. What is the timeframe for the measures indicated in the communication?
The first measure to be taken is the proposal for a regulation on money market funds presented today along with this communication (see MEMO/13/764 ).
Other measures will follow as soon as possible. All dates mentioned in the text of the communication are indicative.
6. Why now? Should the Commission not wait until the reform of the regulated financial sector is fully implemented?
The financial crisis, especially in 2007 and 2008, highlighted the need to improve regulation and monitoring outside the regulated banking sector, because the volume of transactions carried out outside the core banking sector had increased tremendously and risks created could be systemic.
The Commission has been working on measures in this field since 2010 and it is important to act now. The measures that will be put in place respond to the risks identified in the past, but are also pro-active in order to make sure that new activities or techniques do not create systemic risk. The measures announced are also fully compatible with other measures taken.
The European Parliament also adopted an own initiative report on shadow banking in November 2012.
7. Why is additional regulation necessary in view of the ongoing extensive reform of the financial sector?
The Commission has undertaken the biggest ever reform of financial services regulation with the aim of restoring sustainable health and stability to the sector. The approach consists of tackling all financial risks and ensuring that the benefits achieved by strengthening certain actors and markets are not diminished by financial risks migrating to less regulated sectors. Room for regulatory arbitrage should be avoided in all cases. Therefore, it is necessary to strengthen regulation, also outside the regulated banking sector.
8. How does the communication fit in with work at international level?
Financial markets are global, hence systemic risks created by shadow banking entities and activities need to be tackled in an internationally coordinated manner. The Commission is therefore following very closely the work of the Financial Stability Board (FSB), which is in charge of identifying risks and coming forward with recommendations addressing those risks.
All major jurisdictions are members of the FSB and are working with the FSB on putting a harmonised international framework in place. Since 2011, the Commission has been an active participant in the FSB’s work focusing on shadow banking. The Commission proposals are fully in line with the recommendations issued so far at international level. Final FSB policy recommendations are to be endorsed by the G20 leaders in Saint Petersburg on 5-6 September 2013.
9. What are the main elements of today’s communication?
This communication provides a comprehensive overview of the Commission’s measures addressing existing and potential systemic risk in the area of shadow banking. It explains in detail the measures already undertaken that address some elements of those risks, such as measures aimed at financial entities and measures undertaken to strengthen market integrity.
While they do not deal with all the risks, the reforms implemented through the revised requirements on banks in Europe make it possible to lay down clearer rules for shadow banking (indirect regulation). These measures relate to the regulatory requirements imposed on transactions concluded between banks and their financial counterparties and the rules on the consolidation of risk.
Other measures already underway include additional regulatory requirements for insurance companies, a harmonised framework for alternative investment fund managers (AIFMD), a framework for risk transfer instruments (known as EMIR — European Market Infrastructure Regulation), strengthened securitisation arrangements and an enhanced framework for credit rating agencies (CRAs).
Furthermore, the communication provides an overview of additional measures providing a framework for the risks associated with shadow banking. These include increasing the transparency of the shadow banking sector, improving the framework for certain investment funds, reducing the risks associated with securities financing transactions, strengthening the prudential banking framework in order to limit contagion and arbitrage risks and supervising the shadow banking sector more effectively.
In order to increase transparency the communication suggests:
- supplementing initiatives regarding the collection and exchange of data;
- developing central repositories for derivatives within the framework of EMIR and the revision of the Markets in Financial Instruments Directive (MiFID) (see IP/11/1219);
- implementing the Legal Entity Identifier (LEI), an initiative established by the FSB;
- increasing the transparency of securities financing transactions.
In addition to the proposal on money market funds, the communication indicates that an enhanced framework for certain investment funds could be implemented by strengthening the UCITS framework.
Other elements of the communication include the reduction of risks associated with securities financing transactions, a project the Commission has already been working on for some time. A proposal will follow in the coming months.
The communication suggests completing the prudential rules applied to banks in their operations with unregulated financial entities in order to reduce contagion risks and potentially extending the scope of application of prudential rules in order to reduce arbitrage risks.
Finally, improved supervision at national and European level should help to monitor this dynamic and diverse sector and help prevent the accumulation of (systemic) risks.
10. What preparatory work has been done before coming up with this communication?
This communication was preceded by extensive consultation with the relevant industry players and stakeholders back in 2010.
A special working group was set up under the auspices of the Financial Services Committee. A Green Paper was published in 2012, which launched a public consultation.
The Commission organised a public conference in Brussels on 27 April 2012. The Commission published a summary of the submissions received in the context of the public consultation in December 2012.