European Union to shine light on shadow banking

April 27
3:34 PM 2012

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 euro ($61 trillion) sector which has been blamed for aggravating the financial crisis.

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 euro zone.

"We are interested in the possible dangers for financial stability arising from shadow banking activities," Vitor 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.

Michel Barnier, the EU official responsible for financial regulation and who is examining rule changes for shadow banking, said he aimed to give regulators "a complete overview".

But first officials need to have a better understanding one of the most complex and opaque parts of finance.

"What exactly is shadow banking?" Barnier asked. "How can we clarify it? We have to understand before we act...shadow banking is an extremely complex ecosystem."

Hedge funds and private equity are often cited as examples of shadow banking. But the term can also take in investment funds, insurers and even cash-rich firms that lend government bonds to banks, and which in turn use them as security when taking credit from the European Central Bank.

Even 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.

Some were keen to move the debate forward.

Paul Tucker, deputy governor of the Bank of England, urged prompt regulatory action to tackle the sector and avoiding getting bogged down in definitions.

"This should not be about eliminating shadow banking," he told the meeting. "We need to be able to monitor the system and respond flexibly."


Tucker, seen as one of the favorites to become the next head of the Bank of England, underscored the shadow system's close relationship with traditional banking, recommending that banks should reflect the risk of any such activities they undertake with extra capital safeguards.

"There are degrees of shadow banking. Many examples of shadow banking... are part of banks," he said. "They should be consolidated onto the balance sheets of banks."

His comments were echoed by Manmohan Singh, an economist with the International Monetary Fund. "Even within a bank, you have shadows," he said.

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 securitization, 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 unraveled.

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 European Commission will propose EU-wide rules for shadow banking next year after a global regulatory body, the Financial Stability Board (FSB) completes work on policy recommendations for world leaders by November.

The FSB, of which Tucker is a member, said in an interim report on securities lending and repos there was a lack of transparency, potential risks from fire sales of collateral assets, and insufficient rigor in tracking the value of securities.

"The biggest single difficulty is what they mean by the term, which is rather emotional than precise," saidGraham Bishop, who advises banks on European regulatory policy.

"German covered bonds are an example of good securitization. They should not be lumped in with the broad definition of shadow banking."

This article is copyrighted by Reuters

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