Wednesday, September 11, 2013

German Central Banker Says Regulation of Shadow Banking Must be Cross-Border to Prevent Arbitrage

The regulation of the non-bank entities in the shadow banking system, including money market funds, must be harmonized across jurisdictions in order to avoid regulatory arbitrage, emphasized Andreas Dombret, Member of the Executive Board of the Deutsche Bundesbank. In remarks at the Alpbach Financial Market Symposium, he said that regulatory measures must be developed and agreed upon in international cooperation. As the regulation of banks tightens, he continued, there is a real risk of regulatory arbitrage as activities shift to the shadow banking system, which he predicted would constantly challenge policy makers because it adapts very quickly in order to evade regulatory measures.

In addition, as regulations are developed, policymakers need to have a thorough understanding of their implications. For example, the repo markets are an important source of leverage and pro-cyclicality. In order to thoroughly assess the effects of envisaged numerical floors on haircuts for the securities lending and repo market, a quantitative impact study is just being launched, an approach he strongly supports. It facilitates early recognition of inadequate measures and unintended side-effects, he said, thereby allowing for the introduction of effective measures.

As an aside, the central banker noted that he does not favor the commonly used expression of shadow banking, since the activities of the shadow banking system are not bad per se. He would prefer to call it non-bank banking. However, the term shadow banking has become something of a term of art. The European Commission recently observed that many respondents to its Green Paper on shadow banking expressed displeasure with the term "shadow banking," which they felt has negative connotations. While noting these concerns, the Commission said that it uses the term neutrally and free of connotations. At this stage, concluded the Commission, it is very difficult to introduce alternative terminology, since this is by now a well-established term in the international debate.

The Commission defines shadow banking as a system of credit intermediation that involves entities and activities outside the regular banking system. 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.

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