As directed by the G-20 leaders, the Financial Stability Board is developing recommendations to strengthen the regulation of the shadow banking system, which includes hedge funds and money market funds. The FSB currently has five major projects under way devoted to understanding the risks of shadow banking, including money market funds, securitization, securities lending and the repo market, banks' interactions with shadow banks, and other shadow banking entities.
The shadow banking system can broadly be described as credit intermediation involving entities and activities outside the regular banking system. The global shadow banking system grew rapidly before the financial crisis, from an estimated $27trillion in 2002 to $60 trillion in 2007, and remained at around the same level in 2010. The financial crisis demonstrated that the shadow banking system can 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. Since hedge funds and other shadow banking entities can create cross-border intermediation chains, recently noted Ferd Chair Ben Bernanke, it is appropriate that international regulatory groups have focused on addressing the financial stability risks of shadow banking
The Financial Stability Board’s project on bank interactions with shadow banking entities is being handled by the Basel Committee on Banking Supervision, which will examine enhanced consolidation for prudential regulatory purposes, concentration limits, large exposure rules, and risk weights for banks’ exposures to shadow banking entities, by July of 2012. The International Organization of Securities Commissions (IOSCO) will examine regulatory action related to money market funds by July of 2012. A Financial Stability Board Task Force will examine hedge funds and other shadow banking entities other than money market funds by September of 2012.
The Task Force will also examine securities lending and repurchase agreements, including possible measures on margins and haircuts, by the end of 2012. IOSCO, in coordination with the Basel Committee, will examine securitization retention requirements and transparency by July of 2012. All five projects will report their proposed policy recommendations to the FSB pursuant to the time lines.
In the Board’s background note, hedge funds and money market funds are listed in the credit intermediation chain under distribution/wholesale funding. The Board noted that the focus on credit intermediation encompasses not only on-balance sheet transactions but also derivatives and other off-balance sheet transactions that can constitute the credit intermediation chain.
The Board believes that it is essential to cast the net wide by considering the system of credit intermediation that involves entities and activities outside the regular banking system. This will allow regulators a broad view on the credit intermediation that is occurring outside the regular banking system, so that they can monitor the overall provision of credit and in particular identify any adaptations or mutations that may be of potential concern.
The FSB assured that, while the definition is broad, credit intermediation is limited to entities and activities involved in extending credit either directly or as part of a chain of credit intermediation, or involved in facilitating its intermediation, are included. Thus, pure equity trading and foreign currency transactions by entities outside the regular banking system would be excluded, noted the Board, unless they constitute part of a credit intermediation chain. However, the trading of credit-related financial instruments such as bonds and structured hybrid financial products would be included in the definition.
A shadow banking system can be composed of a single entity that intermediates between end-suppliers and end-borrowers of funds, or more usually it could involve multiple entities forming a chain of credit intermediation. Banks can be funded by entities which form part of the shadow banking system, such as money market mutual funds. Thus, while the focus is on identifying activities which are not covered by regular bank regulation, it is also important to examine connections between non-bank and bank activities.
Systemic risk concerns are fueled by the interlinkage of the shadow banking system and the regular banking system, with banks often composing part of the shadow banking chain or providing support to the shadow banking entities to enable maturity/liquidity transformation, and thus facilitating shadow banking activities. Furthermore, banks invest in financial products issued by shadow banking entities alongside other suppliers of funds. They are also often exposed to common concentrations of risks in financial markets through asset holdings and derivative positions even where there is no clear direct connection.
As part of the project, the FSB asked the Basel Committee to review the capital treatments for investment in hedge funds and short-term liquidity facilities beyond the Basel II/III securitization framework, and develop policy recommendations as necessary. In fulfilling the Board’s request, the Committee is trying to determine if the rules for bank liquidity lines to securitization vehicles should be extended to apply to shadow banking entities; and whether the Basel II framework appropriately accounts for the risk inherent in various equity investments. For example, the treatment of equity investments in hedge funds is insensitive to the risk of hedge funds, which can vary greatly.