The role of shadow banks in banking and capital markets union

Notwithstanding the important progress on the European Banking Union (EBU), which began in November 2014, important challenges remain for the EU banking system. Non-performing loans (NPLs) of European banks are estimated to be worth about €1000bn according to recent estimates by the International Monetary Fund, and there are serious doubts about the credibility of the bail-in mechanism for unsecured creditors within the Single Resolution Mechanism (SRM) if a large bank faces insolvency or a systemic banking crisis erupts. It may take another crisis to establish the credibility – or lack thereof – of the SRM.

Another challenge for Europe is setting up a framework for a capital markets union (CMU). Transforming European finance from a primarily bank-based financial system into a system under which more of the funding is channelled directly to firms and households through non-bank financial institutions and securities markets encourages a shadow banking system. Work towards a CMU seems even more complex and politically difficult than the building of the EBU, given the extremely diverse legislative and regulatory climate regarding non-bank finance in EU countries and the resistance of national authorities to release powers to European authorities.

Contributions good and bad

Shadow banking can be viewed as credit intermediation outside the conventional and highly regulated banking system and activities are mostly performed by non-bank financial institutions.

This shadow banking system is very diverse and some parts perform important roles in the credit intermediation process, especially with the conventional banking system being constrained by its legacy of NPLs, as well as an increasingly intrusive and complex regulatory framework. Structured finance (securitisation), markets for repos, specialised finance companies, hedge funds, money market mutual funds and other entities involved in asset management are all parts of the shadow banking system.

After the financial crisis of 2007 to 2009, shadow banking received much negative attention because securitisations, special purpose vehicles and investment banks within the shadow system contributed substantially to the crisis that followed the fall of Lehman Brothers in September 2008. It appeared that Lehman was strongly interconnected with the conventional banking system as an important counterparty for hedging and trading activities, notably in the credit default swap market.

Despite the experiences during recent financial crises, the shadow banking system can be a valuable source of financial innovation and competition and a more elastic supply of credit and liquidity, while helping to diminish the concentration of financial risk.

Too much, or not enough?

Many observers argue that the expansion of the less regulated shadow banking system is the result of an uneven playing field regarding competition with the heavily regulated conventional banking system, which some see as over-regulated. They propose a rebalancing that could be arrived at through deregulation and, at the same time, more strict monitoring and regulation of shadow banking.

As the European Shadow Financial Regulatory Committee (ESFRC) has argued before, the regulatory structure for the banking system can be simplified substantially with a combination of a relatively high leverage ratio and measures to improve market discipline on risk taking. It would be a serious mistake to expand an overly complex regulatory structure to the shadow system with its less distorted incentives.

Controlling systemic risk

During the past five years or so, international and EU regulators have delivered an impressive set of legislative proposals to mitigate the consequences of the interconnectedness between conventional and shadow banking activities. We applaud increasing macro-prudential attention to mapping and monitoring of interconnectedness along with analysis of sources of systemic shocks. Central clearing facilities in the market for derivatives also help reduce contagion through these markets.

Regulation of shadow banking institutions can be motivated by potential contagion from firesales of assets, which can affect both asset prices and liquidity in money markets. The funding liquidity of banks can be threatened by such firesales in the shadow system, especially if a distressed shadow institution is large. We support efforts in the EU to strengthen liquidity requirements for money market funds in particular, because they are important sources of funding for banks. Liquidity problems arising in the shadow sector are of particular concern, because non-bank financial institutions do not have access to a central bank as a lender of last resort.

The recent legislative proposals for banks add complexity to an already complex regulatory structure and should not draw attention away from the fact that bank capital ratios are still historically low, even after the increase implemented under Basel III. Following previous recommendations by the ESFRC, we advocate a minimum Tier 1 capital requirement of 10%. This non-risk weighted capital requirement may consist of at least 5% common equity, while the remaining 5% may take the form of additional Tier 1 capital instruments such as contingent convertible (CoCo) bonds which automatically convert into equity when the financial position of a bank deteriorates. The 10% leverage ratio is to be implemented gradually during a transitional phase of five to seven years.

The advantage of a higher capital requirement is that it provides a credible buffer against unexpected losses associated with interconnectedness. Moreover, it supplies incentives for risk monitoring by shareholders and holders of CoCo bonds, thereby mitigating moral hazard and limiting the risk to taxpayers.

Harald Benink is professor of banking and finance at Tilburg University in the Netherlands. He is also chairman of the European Shadow Financial Regulatory Committee.