Shining the light on shadow banking

But rules and regulations are effective only if aimed at the right targets. The question is whether traditional banks should be so much in the regulatory spotlight. Or have the regulators missed some risks lurking in the shadows?  

One of those potential risks is aptly known as “shadow banking”, a term used to cover types of non-bank entities and certain types of activities by non-banks and banks. These are those largely unregulated pools of liquidity and capital that have become increasingly important as our economies come out of recession. 

What is already clear is that shadow banking is here to stay. It can be an important part of a vibrant and safe financial system, if properly understood and regulated. 

Let’s be clear: unregulated non-bank entities that conduct banking activities can pose risks and should be regulated. This need not destroy that sector but should facilitate growth and stability. The regulation could mimic that already in place for building societies and credit unions – some prudent capital requirements, liquidity, competence and reporting requirements.  

In contrast, non-deposit fundraising by banks that does not properly fall within the notion of shadow banking should not be regulated further.  Debt markets funding by banks is already highly regulated by the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (ASIC) and their equivalents offshore. The resurgent debt capital markets are a good example of post-GFC growth despite additional regulation. But enough is enough. 

If we take types of non-bank entities first, in Australia the most important of these have been building societies and finance companies that fund home loans and commercial lending. 

To a lesser extent, investment and hedge funds have expanded the range of equity investors. Offshore, that list would expand to include commercial trusts, mutual funds, sovereign wealth funds, private equity and money market funds. 

The activities that some have suggested can fall within shadow banking include securitisation, securities lending, and repurchase arrangements and structured credit transactions (often involving complex derivatives). Both regulated banks and non-banks entities are involved in those activities. However, much of that activity by banks (not non-banks) is not shadow banking. 

Financial Sector Composition

Click image to zoom Tap image to zoom

Source: RBA Financial Stability Review, 2012

Banks that are involved in those activities are now subject to a range of prudential capital, liquidity, stable (or matched) funding and regulatory risk requirements. It is the non-bank entities that are involved in those activities or in ordinary lending activities that are now of concern to regulators. 

That concern has been intensified by the important role that shadow banking is playing in some economies, particularly those emerging from recession. The scale of shadow banking is also attracting attention; the ANZ Caged Tiger: The Transformation of the Asian Financial System report estimates that China’s shadow banking system is about RMB 15 -17 trillion (US$2.4 – 2.8 trillion) in size, or one third of China’s GDP. 

Shadow banking can often produce more efficient funding solutions for customers because unregulated entities do not incur the cost and time lags that are faced by regulated banks. Securitisation and capital markets funding have been flexible and readily available options for banks and non-banks. 

However, the financial crisis brought the capital markets to a grinding halt and led to particularly heavy losses for customers of, and investors in, non-bank entities.  

Issuance of asset-backed securities

Click image to zoom Tap image to zoom

Source: Financial Stability Review, 2012

That has made regulators suspicious of the benefits of shadow banking and led to greater scrutiny of alternative investment products, the use of special purpose vehicles and disclosure and capital requirements for non-banks entities.  

The European Commission, the European Parliament, the Basel Committee’s Financial Stability Board and the International Organisation of Securities Regulators, have all released working papers on shadow banking. 

The US regulators have enacted the so-called Volcker Rule which will impact both US and foreign banks and bank-like investors that invest in certain “covered funds”, including hedge funds. This is one way of reducing systemic risk to banks from shadow banking entities and shadow banking activities. 

The regulatory response in Australia has been more muted, despite the losses suffered by Australian investors from failures by non-banks entities, most recently in the wake of the collapse of mortgage trusts such as Banksia Securities.  

That was a classic case of a bank-like entity raising funds from retail investors under terms that complied with ASIC disclosure rules but with insufficient capital reserves because the entity itself was not regulated as a bank by APRA. Definitely a case of “mind the gap”.  

Whilst the RBA, APRA and ASIC have been in discussions about how to co-operate in framing our domestic regulatory response to shadow banking, we will probably have to wait for the result of the Financial System Inquiry before any major changes are announced.

Tessa Hoser, Banking & Finance Partner, Norton Rose Fulbright Australia – the views expressed in this article are those of the author alone and do not represent any opinion or advice given by Norton Rose Fulbright Australia or any member of the Norton Rose Fulbright Group.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

editor's picks