16 March 2012

Ian Wishart: Shining light into the shadows

European Union regulators are targeting shadow banking as the next part of the financial services industry to come under scrutiny, determined that tighter rules imposed on traditional banking should not simply push problems elsewhere. Shadow banking... has grown rapidly over the past few years, to the extent that it is now estimated to be worth about €50 trillion worldwide, representing nearly one-third of the global financial system.

One of the first things that regulators will have to do – and this is central to the questions in the European Commission's consultation document... – is to decide exactly what should be classed as shadow banking. From special purpose vehicles to money market funds and repurchase transactions (‘repos'), all mentioned in the Commission's document, pinning down exactly what should be regulated will not be an easy task.

A different approach

Regulators have a careful balance to strike. Shadow banking has become increasingly important in keeping the wheels of finance well oiled over the past few years, particularly as traditional banks, restrained by tighter rules, a loss of confidence and unhealthy balance-sheets, have struggled to gain access to funding in the ways that they once did.

The EU's financial legislation has already regulated a certain amount of shadow-banking activity, either directly or indirectly. Banking and insurance regulation, notably the international Basel rules and the EU's capital requirements directives, which obliged banks to carry more capital if they engaged in shadow-banking activity, has attempted to limit the involvement of traditional banks in unregulated behaviour. The Directive on Alternative Investment Fund Managers, adopted in 2010, which clamped down on hedge funds, took a more direct approach to one part of the shadow banking sector.

The Commission's work will run in tandem with that carried out by the Financial Stability Board (FSB), the organisation established after a summit of the G20 group of advanced and emerging economies in London in 2009. The FSB's recommendations for G20 Member States are expected to be concluded by the end of 2012.

There is a long way to go. If part of the growth of the shadow banking sector can be directly attributed to the increase in regulation on traditional banks, then regulators must guard against merely pushing problems elsewhere again. Companies involved in shadow banking fear that what they see as vagueness of the term could lead to sweeping regulation being introduced, with unintended consequences. However, most observers are agreed: shadow banking is a sector whose time for regulation has come. The hard part will be working out exactly what that means.

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