27 April 2012

Reuters: European Union to shine light on shadow banking

The European Commission pledged to tighten control of so-called shadow banking on Friday, answering central bank calls for stricter regulation of the sprawling €46 trillion ($61 trillion) sector which has been blamed for aggravating the financial crisis. (Includes quote from Graham Bishop.)

Policymakers fear that as the regulatory net closes on banks, shadow banking will thrive, with activities traditionally carried out by banks escaping the watch of regulators.

Officials see tighter control of the sector in Europe as important in preventing a repeat of the financial crisis that toppled banks over the past five years and rocked the eurozone. "We are interested in the possible dangers for financial stability arising from shadow banking activities", Vîtor Constancio, the European Central Bank's vice president, told officials, lobbyists and experts. "We are concerned about the implications of this activity for global liquidity", he said, calling for the creation of a central database to record information about the repo market, where banks lend on the back of securities.

The man credited with coining the term, former PIMCO executive Paul McCulley, gave a catch-all definition. McCulley said he understood shadow banking to mean "the whole alphabet soup of levered up non-bank investment conduits, vehicles and structures", such as the special investment vehicles that many blamed for the financial crisis.

The shadow banking sector has more than doubled in size over the past decade to the equivalent of half of all bank assets in 2010. Forms of shadow banking can include securitisation, which can transform bank loans into a tradeable instrument that can then be used to refinance credit, making it easier to lend.

In the run-up to the crisis, however, banks such as Germany's IKB stored billions of euros of such instruments in off-balance sheet vehicles, which later unravelled. Another example is a repurchasing agreement, or repo, where a player such as a hedge fund could sell government bonds it owns to a bank, agreeing to repurchase them later. The bank may then lend those bonds onto another hedge fund, taking a position on the government debt. Such agreements are used by banks to lend and borrow. A risk could arise if one of the parties in the chain collapses. 

"The biggest single difficulty is what they mean by the term, which is rather emotional than precise", said Graham Bishop, who advises banks on European regulatory policy. "German covered bonds are an example of good securitisation. They should not be lumped in with the broad definition of shadow banking."

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