02 May 2012

EPFSF Briefing: “Shadow Banking”

The FSB has defined shadow banking as “the system of credit intermediation that involves entities and activities outside the regular banking system”. As the FSB observes, systemic risks can stem from four key factors, i.e. maturity transformation, liquidity transformation, imperfect credit risk transfer, and leverage. As financial sector is dynamic, FSB suggests, it is advisable that supervisors cast their net wide in monitoring the activities within the shadow banking system so as to gain a complete overview about potential risks to the financial system. Based on a broad overview of the system, the scope of supervisory and regulatory activity can then be narrowed down to those institutions/structures that appear to pose particular risks to financial stability. Supervision should not be limited to the identification and monitoring of non-bank financial institutions, but cover all financial activities that count towards shadow banking in case they pose a systemic risk from a credit intermediation process.

Given the difficulty of properly defining the shadow banking system, it is unsurprising that there is no commonly agreed estimate of the shadow banking system either. The Commission estimates of the size of the sector may vary between a fourth and a third of the regular banking system, or around €46 trillion in 2010. For Europe, this would estimate the size of the shadow banking system at between €10-17 billion.

Shadow banking activities can have a number of beneficial effects:

• first, they enlarge the available spectrum of assets for investors;
• second, shadow banking can help to re-allocate risk within and beyond the financial system;
• third, the same purpose is served by attuning financing structures more closely to the financing needs of firms and to the preferences of investors.

Risks within the shadow banking sector are as varied as the sector itself; their relative relevance varies across the different parts of the shadow banking system. First, there is a concern about a lack of transparency about shadow banking activities. While some shadow banking entities are monitored regularly, others are outside the scope of regular financial supervision. This is, secondly, compounded by the concern that some shadow banking activities comprise complex entities and transactions. Thirdly, the interconnection between the regular banking system and the shadow banking system is critical, as difficulties in the shadow banking system could contaminate the former.

The scope of attention is very much aligned at both the global and the European level. The G20 has established five workstreams: (i) the Basel Committee will look into the interaction between banks and shadow banking entities; (ii) IOSCO is tasked to examine regulatory action related to MMFs; (iii) IOSCO and the Basel Committee will jointly review securitisation requirements; (iv) an FSB Subgroup will examine other shadow banking entities; and (v) another FSB subgroup securities lending and repos.

The term “shadow banking” suggests potentially dangerous activities. However, the balance between benefits and potential risks clearly differs across activities and will differ even more in future in response to regulatory activity and industry efforts. To draw up a more complete and more detailed picture of the shadow banking sector, supervisors plan to enhance their data collection efforts. This will include a number of measures: (i) linking existing national and international databases, such as credit registers and data gathered by clearing houses and CCPs; (ii) enquiries to regulated entities; (iii) in the longer run, supervisors consider directly identifying and mapping non-bank financial institutions that are marked part of the shadow banking system.

Full information

Notes on shadow banking from Barbara Frohn, Banco Santander

© EPFSF - European Parliamentary Financial Services Forum