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Monday, May 7, 2012

Policymakers go Gaga on Shadow Banking

The great and the good of the European political and financial communities came together in Brussels last month to discuss the European Commission’s Green Paper on Shadow Banking previously released in March.

Conference moderator Gillian Tett (US Editor of the Financial Times) billed the event as the regulatory equivalent of a Lady Gaga concert as it was the hottest ticket in town.

Over 200 people gathered to listen to senior policymakers from the region’s central banks & national regulators, as well as prominent politicians, trade unionists, financial market representatives and academics.
Opening the conference was Michel Barnier, Member of the European Commission for the Internal Market and Services who outlined the theme of the conference ‘‘Towards better regulation of the shadow banking system’’.

Barnier commented that he wanted to make shadow banking one of his main priorities for 2012; it was not about penalising players in the shadow banking system who play an important role in financing the real economy. He described the aim of the consultation paper was to obtain a clear definition of shadow banking – this was a key topic throughout the day as each and every speaker or commentator offered many differing viewpoints on the term ‘‘shadow banking’’.

Barnier referred to the recent work carried out by the Financial Stability Board (FSB) Task Force on Shadow Banking that had identified two key areas that required regulators’ attention: securitisation and securities lending or borrowing with repurchase (repo).

In addition to clarifying the definition of shadow banking, he outlined that the other objectives of the Green Paper were to:

  • Review the numerous measures already adopted in relation to certain activities and players in the shadow banking system.
  • Enable the Commission to consult all concerned stakeholders.
  • Aim to assess the risks presented by "shadow banking" and list the issues that need to be addressed.

Barnier then focused on what he hopes to achieve by regulating the shadow banking system and established four general principles:

  1. Ensure that regulators and supervisory authorities can have a complete overview.
  2. Not to repeat the mistakes made of previous regulatory regimes - the aim this time around is to prevent rather than cure.
  3. Be very careful not to call into question the alternative financing chains, which complement bank lending and are of direct benefit to the real economy.
  4. Ensure consistent regulation across the various financial sectors to avoid any form of supervisory arbitrage.

Barnier closed by saying ’’All these elements are to be used as a starting point for targeted sectoral consultation exercises, which will most probably be followed by proposals for regulations. The aim is to have these measures take effect as early as possible, chiefly to avoid too great a time-lag in relation to the Basel III rules and the European Market Infrastructure Regulation (EMIR).’’

The second keynote of the morning was given by the Bank of England’s Paul Tucker, Deputy Governor, Financial Stability, Member of the Monetary Policy Committee and Member of the Financial Policy Committee. Tucker gave an insight into some of the proposals that might be considered for a concrete policy agenda on shadow banking regulation.

He started off by framing the term shadow banking employed by the FSB and the EU Commission as ‘‘Credit intermediation, involving leverage and maturity transformation, that occurs outside or partly outside the banking system.’’

And then stated ‘‘non-bank intermediation of credit is not a bad thing in itself. Indeed, it can be a very good thing, helping to make financial services more efficient and effective and the system as a whole more resilient. We must remember that as we make policy.’’
He then highlighted the main areas of consideration that policymakers should focus on and hinted at the possible measures to be discussed (I have only listed the reference to securities lending and repo):

Securities lending, repo and collateralised-financing markets

  • There should be greater market transparency, perhaps ideally via a Trade Repository with open access to aggregate data, so that the world can see what is happening in these very important but opaque financing markets.
  • Financial firms and funds should not be able to lend against securities that they are not permitted or proficient enough to hold outright.  
  • Non-bank financial firms should be regulated in how they employ cash collateral.·       
  • The authorities should be able to step in and set minimum haircut or margin levels for the collateralised financing markets (or segments of them). (That would need to be pursued at international level. It might be linked to central bank haircuts.)
Tucker summarised by saying ’’the financial system will evolve, and needs to permit innovation. A policy framework on shadow banking therefore needs to be adaptive. And it mustn’t try to shut everything down. Non-bank finance is not intrinsically a bad thing. Regulators need effective surveillance of what is going on and what concentrations of risk are emerging – through outfits like the FSB’s committee on vulnerabilities and, in the EU, through the European Systemic Risk Board. And will need to make discerning policy judgments that are explained and consulted upon. That is exactly what the EU, alongside the FSB, is now embarked on.’’

The conference then focused on the publication of the FSB Interim Report on Securities Lending and Repos, which was explained by David Rule, Head of department, Financial Services Authority, and Chair of FSB Shadow Banking work stream on Securities Lending and Repo.

The report describes the segments, operations and practices of these securities financing markets, which may constitute an important element of the shadow banking system. The segment classifications are categorised into four main, inter-linked segments:

(i)           A securities lending segment which comprises lending of securities by institutional investors to banks and broker-dealers against the collateral of cash or securities.
(ii)          A leveraged investment fund financing and securities borrowing segment which comprises financing of leveraged investment funds’ long positions by banks and broker-dealers using both reverse repo and margin lending secured against assets held with the prime broker, as well as securities lending to hedge funds by prime brokers to cover short positions.
(iii)         An inter-dealer repo segment which comprises primarily government bond repo transactions amongst banks and broker-dealers that are typically cleared by central counterparties (CCPs).
(iv)         A repo financing segment which comprises repo transactions primarily by banks and broker-dealers to borrow cash from “cash-rich” entities, including central banks, retail banks, money market funds, securities lenders and increasingly non-financial corporations.

The Workstream views the following aspects of securities financing markets as constituting potentially important elements of the shadow banking system, as defined by the FSB:

  • Repo financing by non-bank entities to create short-term, money-like liabilities, typically collateralised by longer-term securities
  • Leveraged investment fund financing that may lead to further leverage and maturity transformation
  • Securities lending cash collateral reinvestment by which the cash proceeds from short sales are used to collateralise securities borrowing and then reinvested by securities lenders into longer-term assets, thus constituting a long credit intermediation chain with maturity transformation
  • Collateral swaps (also known as collateral downgrade/upgrade transactions) that can further lengthen transaction chains or allow banks to meet liquidity requirements

The Workstream has preliminarily identified seven issues arising from the securities financing markets that might pose risks to financial stability and/or need further investigation by the Workstream:
(i)               Lack of transparency
(ii)             Procyclicality of system leverage and interconnectedness
(iii)            Other potential financial stability issues associated with collateral re-use
(iv)            Potential risks arising from fire-sale of collateral assets
(v)              Potential risks arising from agent lender practices
(vi)            Securities lending cash collateral reinvestment
(vii)           Insufficient rigour in collateral valuation and management

Following this panel was a keynote address given by Vitor Constâncio, Vice-President, European Central Bank and aired the view of the ECB on policy issues concerning securities financing.

He outlined the relevance of shadow banking for European financial stability and suggested some preliminary considerations on three policy issues that are currently at the centre of the international debate on repo markets:
(i)           The pro-cyclical nature of margin requirements used in securities financing
(ii)          Encourage the use of CCP in repo markets
(iii)         Repo and securities lending market practices raise concerns from a financial   stability point of view

He then focused on how to enhance the monitoring of repo and securities financing markets and proposed the creation of an EU Central Database on Euro Repos. ‘‘A central database fed by infrastructures and custodian banks to the extent that they internalise repo settlement in their own books, would be the place for the much needed central view on repo market and its participants, both banks and non-banks. ‘‘

Next it was the turn of Sharon Bowles (UK MEP), the influential Chair of the European Parliament's Economic and Monetary Affairs Committee who gave a very well informed speech. She mentioned the initiatives previously discussed on securities lending and repos as well as MMF.

Prior to the close of the conference, there were two additional panels on Money Market Funds and ETFs. Amongst the discussion were topics such as how to reduce the risk of runs on money market funds, other systemic risks that MMF may pose, how to address them at global level, improving disclosure and transparency to better protect investors and the changes needed to the EU regulatory regime. For ETFs, it included dealing with collateral and securities lending in asset management, the framework needed for derivatives in investment funds and avoiding excessive or hidden leverage.

The closing keynote speech was delivered by Lord Adair Turner, Chairman of the UK Financial Services Authority. He reiterated the main themes previously highlighted by Tucker and Rule but stated that a move to CCPs for securities lending and repo transactions in line with OTC derivatives should also be ‘‘up for consideration’’.

Not present at the conference but important to note were the comments this past week from two other significant players on the regulatory front. Firstly, Andreas Dombret a member of the Bundesbank’s executive board said shadow banking is the greatest concern to regulators, who still do not fully understand its impact on the financial system. He reinforced the perception that the so-called shadow banking system is at the forefront of European regulators’ concerns. He stated that what he prefers to call “non-bank banking” is the greatest challenge facing regulators today. “There is also an obvious interlinking of the banking system and non-bank banking, including hedge funds,” he says. “We want to understand where those risks are, how concentrated they are and how correlated they are.”

Dombret also expressed his hopes that a new focus on macro-prudential regulation will enable supervisory authorities to lean against speculative bubbles and systemic risk. “The supervision of individual institutions is important and needs to be done in a rigorous w ay,” says Dombret. “But one of the important lessons from the crisis is that the sum of all of the individual risks is less than the systemic risk, the threat to the integrity of the system overall.”

Secondly, US Fed Governor Daniel Tarullo specified that more must be done on shadow banking; “Although some elements of pre-crisis shadow banking are probably gone forever, others persist," Tarullo said in remarks delivered at the Council on Foreign Relations in New York. "Moreover, as time passes, memories fade, and the financial system normalizes, it seems likely that new forms of shadow banking will emerge." Tarullo singled out money market and tri-party repo markets as areas where action should be taken in the "short-run."
The comments aired during and after the conference underline that the political momentum is in full swing and that any moves by market participants against any proposals currently mentioned in all consultation papers and subsequent reports will be very difficult to prove given the general feeling that action needs to be taken. Of course it is now up to the market participants and regulators to prove that these are the correct actions to take.

Links to consultation papers and speeches:

European Commission:

Financial Stability Board:

Bank of England:

European Central Bank:

Federal Reserve:

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