Thursday, January 9, 2014

Strengthening oversight and regulation of shadow banking – Is the regulator always one step behind?



My own view of the world is: The regulator is always one step behind.”
Alan D. Schwartz – Guggenheim Partners / 12 October 2013


When Alan said this at the Institute of International Finance, the Financial Stability Board (FSB) had already published its recommendations on the shadow banking system, dated 29 August 2013. The FSB is an association that federates national financial regulators. Is it really one step behind?

A shadow is an area where direct light from a light source cannot reach due to obstruction by an object.

In finance, regulators shed light on banks. Financial regulation is then like the rising sun that wakes us up in the morning. Keep that in mind when you read, next time, Basel III or any other nice banking legislation! But behind these banks, where you enter the parking and the garbage leaves the building, lies a dark and cold place. No financial regulation enlightens people here. Financiers do what they want and aren't responsible to anyone!

More seriously, shadow banking is financing done by non-banks. The FSB writes about “credit intermediation involving entities (fully or partially) outside the regular banking system”.

Obviously, strictly regulating banks doesn't really help if the financing activity that regulators intend to protect simply shifts to non-banks. And this is why we need shadow banking regulation, do we?



 Last summer, the FSB has published a series of three documents:
 
  • Overview of policy recommendations
  • Policy framework for addressing shadow banking risks in securities lending and repos
  • Policy framework for strengthening oversight and regulation of shadow banking entities


A. Overview of policy recommendations

Tackling the shadow banking issue is a two step process. It involves

  • tracking financial sector developments outside the banking system and
  • strengthening oversight and regulation of the shadow banking system.

Nothing revolutionary so far: Before regulating, you have to understand what it is that you want to regulate.

Next, the FSB describes more specifically which areas of the non-bank system it intends to tackle:

  • Counter heavy reliance on short-term wholesale funding by reducing the susceptibility of money market funds to “runs”
  • Assess and align the incentives associated with securitization
  • Introduce data collection standards, transparency, minimum collateral valuation, reinvestment, and management standards, and structural elements such as central clearing in securities financing transactions such as repos and securities lending

Beyond, the FSB wants to mitigate the spill-over effect between the regular banking system and the shadow banking system and assess the systemic risk of shadow banking entities. As a matter of fact, these areas of intervention are not part of the shadow banking as such but concern more the intersection between the banking and shadow banking system.


Given the interconnectedness of markets and the strong adaptive capacity of the shadow banking system, the FSB believes that policies in this area necessarily have to be comprehensive.“


Finally, shadow banking should “focus on economic functions and activities rather than on legal forms of entities conducting them”.


B. Policy framework for addressing shadow banking risks in securities lending and repos

Securities lending and repo markets are good for the economy because they support price discovery, secondary market liquidity, and market making.

However, they also represent risks:

  • The sellers' obligations to buy back securities create money-like liabilities, boost credit growth, and facilitate maturity/liquidity transformation outside the banking system.
  • Securities lending is a pro-cyclical activity and, as such, enhances system leverage.
  • Collateral is susceptible to fire sales if the solvency of the underlying firm declines.
  • Collateral reutilization and revaluation amplify the above risks.


To take up the risks in the securities lending and repo space, the FSB recommends the following:

  • Improve transparency: Transparency means better data (counterparty concentration, maturity breakdown, and composition of received collateral). It requires more granular and timely information on securities lending and repo exposure. Transparency needs data on both trade level (flow data) and aggregate market. Transparency implies standardization for data collection and treatment.
  • Limit cash collateral reinvestment: Haircuts should ensure that only a reasonable portion of collateral is reinvested. Reasonable means that haircuts should cover the maximum expected decline in the market price of the collateral asset, calculated at a minimum 95th confidence interval; they can range from 0.5 % to 7.5 %.
  • Impose contingency plans for the failure of important counterparties, including in times of market stress.
  • Inflict daily mark to market and daily collection of variation margin.
  • Favor a wider use of central counterparties (CCP).


C. Policy framework for strengthening oversight and regulation of shadow banking entities

The FSB outlines the economic functions of shadow banking entities, the risks involved, and how to counter these risks.


I. Risk analysis




1. Management of collective investment vehicles (CIV) with features that make them susceptible to runs

CIV are particularly prone to runs as investors oftentimes redeem funds within short periods of time, thus obliging the CIV to roll over its positions in stressed market environments. This risk is amplified because

  • CIV are repeatedly leveraged;
  • CIV investors show low tolerance to absorb losses;
  • CIV investments are oftentimes complex and, therefore, illiquid;
  • CIV investments can be concentrated in market segments or counterparties.


2. Loan provision that is dependent on short-term funding

Shadow banking entities can provide credit to both retail and corporate customers. This activity can be funded by short-term liabilities and be concentrated in specific sectors in which the entity is experienced. Apart from the problem of matching maturities, this activity is especially precarious if it is carried out in cyclical sectors such as real estate, construction, shipping, automobiles, and retail consumers.


3. Intermediation of market activities that is dependent on short-term funding or on secured funding of client assets

This intermediation may consist of securities broking services (i.e. buying and selling of securities and derivatives on and off exchanges including in a market making role) or prime brokerage services to hedge funds. If non-bank entities doing such intermediation are dependent on short-term funding or on secured funding of client assets, they may be vulnerable to runs.


4. Facilitation of credit creation

Facilitating credit creation through credit insurance, guarantees, or credit default swaps may create imperfect credit risk transfer or lead to improper credit risk pricing. The consequence can be excessive leverage in the financial system.


5. Securitization-based credit intermediation and funding of financial entities

Securitization may facilitate or aid in the creation of excessive maturity / liquidity transformation, leverage or regulatory arbitrage in the financial system.


II. Policy toolkits to deal with risks

The FSB first introduces “general principles” and “overarching principles”. You can read about “focus, proportionality, forward-looking measures, effectiveness, and regular adjustment”. I must admit that I didn’t feel much better informed after reading all these honorable principles.

More concrete suggestions from the FSB include:

  • Collect and disclose information
  • Limit and suspend redemption from collective investment undertakings (“redemption gates”)
  • Impose redemption fees on collective investment undertakings
  • Create side pockets of investment portfolios that serve as a safety cushion in case of a run
  • Impose quantitative limits for investments in illiquid assets
  • Put (quantitative) limits on asset concentration
  • Limit leverage of shadow banking entities
  • Restrict the maturity of collective investment portfolios, measured through duration or weighted average maturity
  • Set long-term and countercyclical capital requirements for non-bank entities that provide loans
  • Limit large exposures’ concentration of shadow banking entities
  • Impose minimum capital requirements
  • Restrict the use of client assets (Client monies and unencumbered assets should not be used to finance the entities’ own account activities.)
  • Restrict the scale and scope of shadow banking entities’ businesses
  • Enhance risk management practices such as loss modeling and stress testing to capture tail events
  • Impose quality restrictions on eligible collateral to avoid that a collateral deterioration leads to margin calls and, thus, contagion in the financial system


Now again: Are shadow banking regulators one step behind? I don’t think so, the FSB recommendations show that risks have been identified precisely. Whether such recommendations will be put in practice is another question that does not depend exclusively on regulators.


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