European Commission schizophrenic on shadow banking

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As the European Commission (EC) moves forward with its first regulatory engagement with the shadow banking sector, policy experts argue that more work needs to be done to understand the relationship between banks and non-banks, and the ways in which shadow lenders – previously beyond the regulatory perimeter – contribute to the financial infrastructure as a whole.

The EC’s new proposals to increase oversight and control of European money market funds by requiring constant net asset value (CNAV) funds to hold a 3% capital buffer to protect against investor withdrawals during market crises could effectively eliminate the CNAV fund sector – thereby removing a key asset management sector and cutting off an important source of funding for European SMEs.

However, while systemic risk analysts are glad regulators are finally beginning to address a previously ignored but crucial source of leverage for the financial sector, they say the EC’s dual focus on increasing availability of long-term funding while reining in shadow banking activities could lead to conflicting and contradictory regulatory outcomes.

With the traditional banking sector reducing long-term lending to households and companies in the wake of increased regulatory capital costs, the EC is promoting alternative sources of long-term financing to fill the void left by banks.

Rather than relying on bank intermediation, Europe could embrace “a more diversified system with significantly higher shares of direct capital market financing and greater involvement of institutional investors and alternative financial markets”, states the commission.

According to Frederic Hache, a former derivatives salesman and now senior policy analyst with Finance Watch – a Brussels-based think tank focused on financial regulation – these two objectives are a source of potential policy confusion.

“It is important to look at shadow banking in conjunction with the current initiative on long-term financing,” he says. “The current push from European regulators for more market-based financing can provide a useful alternative source of funding, but requires addressing the related potential systemic risks.”

Indeed, the potential providers of market-based long-term funding are the very shadow banks regulators are concerned about, namely bank securitization vehicles, insurance companies and investment funds.

“The Commission is pushing for more market-based financing, which is essentially coming from a revival of securitization and new long-term investment funds, or shadow banks,” says Hache. “At the same time the Commission is thinking about a possible extension of the scope of prudential rules to other non-bank entities. We hope that the latter will lead to a direct prudential framework of securitization going beyond industry quality labels.”

Nevertheless, Brussels financial sector lobbyists suggest that, rather than a considered, moderate approach to these highly complex and interdependent systemic questions, key European legislators are seeking to fast-track the passage of shadow banking regulation as a vote-generating tool in view of upcoming elections in May 2014.

The sinister connotations of a ‘shadowy’ financial system that operates beyond the reach of regulators continues to fuel populist politics and mainstream media stories.

While the role of shadow banks during the crisis as a source of off-balance sheet leverage and systemic risk arising from OTC derivatives positions is by now well explored, there are encouraging signs the debate in Europe has moved on from accusations of regulatory arbitrage to an acceptance that non-banks are an important source of funding to the real economy.

However, recent comments from Federal Reserve governor Daniel Tarullo indicate that US regulators remain pre-occupied with the banking sector’s historic reliance on short-term funding at the risk of ignoring the bigger picture.

Manmohan Singh, senior economist with the IMF and a leading authority on shadow banking, says that, given the genuine economic demand for non-bank sources of funding, a fuller understanding of shadow banking is a key priority for policymakers.

“Current regulatory approaches are actively pushing banks away from short-term, secured, wholesale funding markets and incentivizing them to issue more deposits and term funding,” he says.

“The likely result would be that riskier activities move outside the banking system. Thus, understanding and correctly mapping the shadow banking system will become even more important for policymakers.”