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Western EuropeAugust 24 2015

Shadow banking rules prompt gloom in Europe

End-users fear the European Banking Authority’s attempt to control shadow banking via bank exposure limits could backfire.
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Exasperation

What is it?

In June 2015, the deadline expired for a European Banking Authority (EBA) consultation on guidelines for limits on bank exposures to shadow banking entities. These guidelines are mandated by the capital requirements regulation (CRR) and are designed to tackle concerns about opacity, complexity, leverage and the risk of sharp investor withdrawals in the shadow banking sector, and its interconnectedness with banks.

“Institutions’ exposures to shadow banks undertaking bank-like activity may lead to regulatory arbitrage concerns, and worries that core banking activity may migrate systematically away from the regulated sector into the shadows,” the EBA said in its consultation.

The EBA proposed that each bank should set its own limits for individual and aggregate exposures to shadow banking, in line with its risk governance framework. Alternatively, banks that do not have sufficiently sophisticated data or systems in place to manage their shadow banking exposure in this way should apply a 25% aggregate limit either to all exposures, or only to those the bank could not assess individually.

Who’s affected?

The EBA suggested eight different activities, drawn from the annex of the capital requirements directive, that constitute credit intermediation and should therefore be considered part of shadow banking if carried out by a non-bank. Insurers and other non-banks already subject to full prudential supervision would then be carved out from this definition, for instance undertakings for collective investment in transferable securities (Ucits) funds.

Although money market funds (MMFs) may be subject to EU regulation (draft legislation has been agreed by the European Parliament and is being discussed in the European Council), the EBA proposed including all MMFs in the definition of shadow banking. This is despite the fact that the proposed MMF regulation would limit the ability of banks to act as sponsors for these funds.

“The average size of an MMF far exceeds the average size of a Ucits fund and the systemic risks posed by such funds (in particular having regard to their interconnectedness with the banking sector) have not been addressed to an adequate degree through existing regulatory measures,” the EBA explained.

However, this inclusion has triggered inevitable objections from the MMF industry. Francois Delooz, an advisor to the head of BNP Paribas Investment Partners, suggested distinguishing between constant net asset value MMFs, which are more prone to investor runs, and variable net asset value funds, which “can bear systemic risk”. Jacqueline Mills, a director of prudential regulation at the Association for Financial Markets in Europe (AFME), went further still.

“MMFs, which are largely registered as Ucits, as noted by the EBA, face not only similarly robust Ucits standards but will soon also be subject to an enhanced set of standards under the MMF Regulation [MMFR]. Funds covered by the MMFR should clearly not be considered to be shadow banks,” said Ms Mills in her response to the consultation.

Unintended consequences?

The EBA emphasised in its consultation that the eight characteristics of credit intermediation “should not be taken as an exhaustive list of activities within the scope”. In fact, the fear among end-users of the financial system is that the scope will end up becoming so wide that it encompasses traditional bank finance activities.

In particular, industry bodies representing property developers are deeply concerned that the EBA has deviated from the Financial Stability Board (FSB) definitions of shadow banking, by apparently including real estate investment funds in the definition of shadow banking. The FSB has concluded that most real estate funds own physical assets and derive income from rental streams, rather than through credit intermediation.

“Bricks-and-mortar real estate funds do not carry out bank-like activities and are not shadow banks. By saying that they are, the EBA’s new rules could limit lending to the built environment, which is sorely needed if we want to bring about regeneration in our towns and cities,” said Ion Fletcher, director of policy at the British Property Federation, in a joint response from five European property industry associations.

What’s the alternative?

The EBA’s own banking stakeholder group, which includes bankers, end-users and financial academics, outlined a general objection to the approach taken by the regulator. This is the idea of indirectly controlling the risks of shadow banking by limiting bank exposures to the sector.

“Even if the indirect approach might have an impact in mitigating the risk in some areas, [our] view is that a more robust long-term solution includes a regulation covering the shadow banking entities and their intermediation activities,” the stakeholder group suggested.

This would imply that most of the necessary legislation is already in place, in particular the alternative investment fund (AIF) managers’ directive. Ms Mills of AFME suggests that the inclusion of all AIFs in the definition of shadow banking is unnecessary. Finalising the draft MMF and securities financing transaction regulations would then complete the set of direct rules for shadow banks.

“Instead of introducing a new definition of shadow banking exposures, it would be vastly preferable to refer to the concept of 'unregulated financial sector entity' set out in [the] CRR,” said Ms Mills. 

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