Wednesday, September 11, 2013

European Commissions Outlines Drive to Regulate Shadow Banking System to Contain Systemic Risk

Concomitant with a proposed Regulation on money market funds, the European Commission issued a statement outlining other reform initiatives in the drive to regulate parts of the shadow banking system that may contribute to systemic risk. In addition to the proposal on money market funds, the Commission indicated that an enhanced framework for certain investment funds could be implemented by strengthening the UCITS framework. In addition, the Commission has been working on a project to reduce the risks associated with securities financing transactions, with a proposal expected in the coming months. The Commission also desires to complete the prudential rules applied to banks in their operations with unregulated financial entities in order to reduce contagion risks and extend the scope of application of prudential rules in order to reduce arbitrage risks.

The Commission defines shadow banking as a system of credit intermediation that involves entities and activities outside the regular banking system. Shadow banks are not regulated like banks, though their operations are like those of banks. The shadow banking system includes ad hoc entities such as securitization conduits, money market funds, investment funds that provide credit or are leveraged, such as certain hedge funds or private equity funds and financial entities that provide credit or credit guarantees. Shadow banking also includes activities, in particular securitization, securities lending and repurchase transactions, which constitute an important source of finance for financial entities.

While the notion of shadow banking has only recently been formally defined in the G20 discussions, the risks related to it are not new. The Commission has already implemented, or is in the process of implementing, a number of measures to provide a better framework for these risks, such as harmonized rules applying to hedge fund activity under the Alternative Investment Fund Managers Directive (AIFMD); and reinforcing the relationship between banks and unregulated actors under, for example, the provisions related to securitization exposures in the revised Capital Requirements Directives.

The European Systemic Risk Board (ESRB) and the Financial Stability Board have shed light on the lack of reliable and in-depth data on repurchase agreements and securities lending transactions. In the Commission’s view, this data is essential to observe the risks associated with interconnectedness, excessive leverage and pro-cyclical behaviors. It will permit the identification of risk factors such as excessive recourse to short-term funding to finance long-term assets, high dependence on certain types of collateral and shortcomings in assessing them.

These gaps are a concern, said the Commission, particularly in view of the opacity of collateral chains which increases the risk of contagion. While actively contributing to international discussions on this issue, the Commission is closely following the current European Central Bank initiative to establish a central repository to collect detailed data on securities repurchase transactions in the E.U. in real time. This work will identify the data necessary for monitoring these transactions and analyze the data already available, particularly in infrastructure.

The ECB recently reiterated the need for a reporting framework at the E.U. level, while the ESRB has concluded that setting up a central repository at the E.U. level would be the best way to collect data on securities financing transactions. The Commission will pay specific attention to this work within the framework of the FSB recommendations. In the light of these developments, it will assess whether transparency at the E.U. level has improved, while reserving the right to propose any appropriate measures to remedy the situation.

The Commission also pointed out that shadow banking entities can, to some extent, be monitored through their relationships with banks. Two sets of requirements are particularly important in this respect: requirements related to transactions concluded between banks and their financial counterparties and the accounting rules on consolidation.

Measures have been taken to ensure that the interests of the persons initiating securitization transactions are firmly aligned with those of the end investors. Since CRD II entered into force at the end of 2010, credit institutions are obliged to check that the originator or sponsor institution of a transaction has an economic interest equivalent to at least 5 percent of the securitized assets. CRD III then reinforced the capital requirements for the risks associated with securitization transactions, particularly when these structures involve several levels of securitization, and increased the prudential requirements for support given to securitization vehicles.

Accounting requirements regarding transparency also play an important role insofar as they allow investors to identify the risks borne by banks and their exposures to the shadow banking sector. The accounting standards on consolidation, in particular, determine whether or not an entity must be included on a bank's consolidated balance sheet. The amendments made by the IASB to the provisions of IFRS 10, 11 and 12, which will enter into force in Europe in 2014, will develop the accounting consolidation requirements and increase disclosure regarding unconsolidated structured entities. Further, the Basel Committee has embarked on a review of prudential consolidation practices and will publish its conclusions by the end of 2014. The Commission is following these developments closely.

Also, in 2010 the IASB strengthened disclosure requirements relating to off balance sheet exposures in the case of transfers of financial assets, which came into effect in Europe on July 1, 2011 pursuant to IFRS 7. During the crisis, observed the Commission, the lack of information on this type of commitment meant that investors and banking authorities were unable to correctly identify all the risks borne by banks.