FSB seeks to strengthen regulation of shadow banking

“Like banks, a leveraged and maturity-transforming shadow banking system can be vulnerable to ‘runs’ and generate contagion risk, thereby amplifying systemic risk,” the FSB says. “Such activity, if unattended, can also heighten procyclicality by accelerating credit supply and asset price increases during surges in confidence, while making precipitate falls in asset prices and credit more likely by creating credit channels vulnerable to sudden losses of confidence.”

It notes that these risks became evident during the crisis with the disruption of asset-backed commercial paper (ABCP) markets; the failure of the originate-to-distribute model employing structured investment vehicles (SIVs) and conduits; runs on money market funds; and a sudden reappraisal of the terms on which securities lending and repos were conducted. “But whereas banks are subject to a well-developed system of prudential regulation and other safeguards, the shadow banking system is typically subject to less stringent, or no, oversight arrangements,” it notes.

The FSB says that the objective of its work is to ensure that shadow banking is subject to appropriate oversight and regulation to address bank-like risks to financial stability, without curtailing sustainable non-bank financing models.

According to the FSB, shadow banking grew rapidly before the crisis, from an estimated $26 trillion in 2002 to $62 trillion in 2007. It has continued to increase since then, although at a slower pace, it says, to $67 trillion at the end of 2011. And, while data on the shadow banking sector is improving, it says that “further improvements are needed in jurisdictions that still lack granular data to adequately capture the magnitude and nature of risks in the shadow banking system.”

The FSB’s recommendations focus on five specific areas where it believes policies are needed to mitigate the potential systemic risks, in order to: to mitigate the spill-over effect between the regular banking system and the shadow banking system; reduce the susceptibility of money market funds to ‘runs’; mitigate systemic risks posed by other entities in addition to money market funds; align the incentives associated with securitization; and, dampen risks and pro-cyclical incentives associated with secured financing contracts and securities lending that may exacerbate funding strains.

To that end, the group published a trio of reports today. One report sets out its overall approach to shadow banking issues and provides an overview of its recommendations. A second report proposes a high-level policy framework; and, the third report makes 13 recommendations to enhance transparency, strengthen regulation of securities financing transactions, and improve market structure.

It also notes that the Basel Committee on Banking Supervision (BCBS) will develop policy recommendations for mitigating the spill-over between the traditional banking world and the shadow banks by mid-2013. The International Organization of Securities Commissions (IOSCO) has established its final policy recommendations to deal with money market funds and securitization risks.

Comments on the FSB’s reports are due by January 14, 2013.