The Financial Stability Board (FSB) published today a report on Shadow Banking:Strengthening Oversight and Regulation. This report provides the FSB’s recommendations on this subject that were requested by the G20 Leaders at the November 2010 Seoul Summit.
The “shadow banking system” can broadly be described as “credit intermediation involving entities and activities outside the regular banking system.” According to one measure, the global shadow banking system grew rapidly before the crisis, from an estimated $27 trillion in 2002 to $60 trillion in 2007, and remained at around the same level in 2010.1
Intermediating credit through non-bank channels can have advantages, for example by providing an alternative source of funding and liquidity. However, as the recent financial crisis has shown, the shadow banking system can also be a source of systemic risk both directly and through its interconnectedness with the regular banking system. It can also create opportunities for arbitrage that might undermine stricter bank regulation and lead to a build-up of additional leverage and risks in the overall financial system. Enhancing supervision and regulation of the shadow banking system in areas where systemic risk and regulatory arbitrage concerns are inadequately addressed is therefore important.
The FSB issued a background note in April to invite views from the public and a press release in September on progress and next steps. Today’s report, which has been prepared by an FSB task force and reflects comments received on the background note, sets out practical recommendations in more detail. The report has been informed by a detailed monitoring exercise by the task force during summer 2011 to review recent trends and developments in the global shadow banking system, as well as a thorough regulatory mapping exercise to take stock of existing national andinternational initiatives.
The report’s recommendations for effective monitoring set out high-level principles for the relevant authorities and a stylised monitoring process. This process calls on authorities to first assess the broad scale and trends of non-bank credit intermediation in the financial system, drawing on information sources such as Flow of Funds and Sector Balance Sheet data, and complemented with other information such as supervisory data. Based on this assessment, authorities should narrow down their focus to those types of non-bank credit intermediation that have the potential to pose systemic risks, by focusing in particular on those involving the four key risk factors: (i) maturity transformation; (ii) liquidity transformation; (iii) imperfect credit risk transfer; and/or (iv) leverage. Authorities should then assess in detail the potential impact that the severe distress or failure of certain shadow banking entities/activities would pose to the overall financial system through looking at other factors, such as the inter-connectedness between the shadow banking system and the regular banking system.
Drawing on this enhanced monitoring framework, the FSB will continue to conduct annual monitoring exercises to assess global trends and risks. Such assessments will improve over time as more data become available through initiatives by the FSB and its member authorities.
The report’s recommendations to strengthen regulation set out general principles for designing and implementing regulatory measures to address the risks identified by the monitoring process. The report also describes work plans for the five workstreams, which were announced in September, that will assess in more detail the case for further regulatory action:
- Banks’ interactions with shadow banking entities (indirect regulation)– The Basel Committee on Banking Supervision (BCBS) will examine enhanced consolidation for prudential regulatory purposes, concentration limits/large exposure rules, risk weights for banks’ exposures to shadow banking entities, and treatment of implicit support by July 2012
- Money market funds (MMFs) – The International Organization of Securities Commissions (IOSCO) will examine regulatory action related to MMFs by July 2012;
- Other shadow banking entities – A new workstream set up under the FSB Task Force will examine shadow banking entities other than MMFs by September 2012;
- Securitisation – IOSCO, in coordination with the BCBS, will examine retention requirements and transparency by July 2012; and
- Securities lending and repos - A new workstream set up under the FSB Task Force will examine securities lending and repos (repurchase agreements) including possible measures on margins and haircuts by the end of 2012.
All five workstreams will report their proposed policy recommendations to the FSB, which will continue to review the workstreams so as to provide consistency to the overall project.
As shadow banking is complex and will likely evolve over time, the FSB emphasisesthe importance of building and sharing experience internationally in monitoring and regulating the shadow banking system. This sharing of experience is also important to analyse the risks of contagion from cross-border shadow banking activity as well as to assess the risks that shadow banking activities pose to the global financial system.
Adair Turner, the Chairman of the FSB Standing Committee on Supervisory and Regulatory Cooperation, said, “With regulation on banks tightened, it is important to address systemic risks – such as maturity transformation and leverage – arising from the shadow banking sector and its interaction with the regular banking system. The detailed recommendations that will be produced by the five workstreams during 2012 are thus fundamental to the stability of the global financial system.”
Jaime Caruana, the Chairman of the FSB Standing Committee on the Assessment of Vulnerabilities, said, “This is an important step towards understanding developments, trends and risks in the complex world of shadow banking. Through the annual monitoring exercises, authorities should continue their efforts to fill the gaps in their understanding, through improvements both in terms of data availability and in termsof the consistency and comparability of data across national financial systems.”
