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CommentMarch 26 2012

Shedding light on shadow banking

The rise of non-bank intermediaries in Europe is an opportunity, not a threat
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In March 2012, the European Commission planted a flag to mark its latest campaign of regulatory territorial expansion, publishing a consultation green paper on the 'shadow banking' sector. While recognising that it can be a useful part of the financial system, the paper warned of the risks of “high, hidden leverage”, “regulatory arbitrage” and “disorderly failures”.

The European Commission estimates the sector to be worth €46,000bn, and its participants seem to be rather eclectic, including money-market funds, special-purpose vehicles, asset-backed securities conduits, credit insurance undertakings, exchange-traded funds, repo markets and in fact anything that is “performing liquidity and/or maturity transformation without being regulated by a bank”.

Industry groups are trying to alter the terms of the debate by giving these activities the less murky name of 'parallel banking'. But the Americans already have another term for it. They call it the financial market, and it has been doing its job for a few centuries.

The European Commission acknowledges that these alarming new developments in Europe are not necessarily very new at all – and in fact rather mainstream across the Atlantic. “In Europe, the proportion of these other financial intermediaries' assets is lower than the global average,” the green paper notes, at 25% to 30% of the total financial system, compared to 35% to 40% in the US. One banker in this edition estimates that bank lending is as little as 25% of total credit available in the US.

The sharp increase in 'shadow banking' in Europe, at a time when it has shrunk in the US, is a reason for concern says the European Commission. But context is everything. The scale of new regulatory requirements in Europe, culminating in the European Banking Authority’s higher capital ratios, restricts what the regulated banking sector can do. If European authorities want both a highly regulated banking sector and a revival of moribund economic growth, then the rise of non-bank financing is not concerning – it is essential.

What will cause Europe’s banks more concern is if non-banks such as the leading fund managers start eating into bank fee-generating capability as well, turning financial advisors and deal arrangers to cut investment banks out of the picture. While it is too early to know for sure, the reputational beating that the largest investment banks have taken since the crisis – which is even intensifying at the moment – may accelerate the rise of the 'shadow investment bank'.

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