Shadow banking and the regulatory capital question

In the wake of the global financial crises, a number of directives and regulations have been drafted and implemented with the end goal of creating safer financial markets. One key provision in the banking sector has been the imposition of capital requirements under Basel III as proposed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector.

Banking

The aims of Basel III, as noted by the Bank for International Settlements (BIS) are to: improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source; improve risk management and governance and; strengthen banks' transparency and disclosures.

The most recent reports from BIS (http://ds.thomasmurray.com/news/basel-iii-monitoring-results-shows-banks-are-track) suggest that banks are on track to meet the proposed capital ratio of 4.5% by 2019. In addition to this, there is a requirement upon the banks to achieve a minimum liquidity ratio of 100% by 2019.

This is a response to try and ensure, where possible, banks do not need to rely on public funding in times of severe market stress; to protect taxpayer money going forward.

Shadow banking

A problem with this, and one that created the US liquidity crisis that sprawled into the global financial crises, is that many entities provide banking services, but are not classified as banks. The lines have become blurred and are open to the interpretation of definition. The shadow banking industry, which is worth approximately $68 trillion globally, is not subjected to the same rules as those faced by traditional banks, primarily because, in the chain of events in the shadow banking world, there are no traditional banks in sight.

Shadow banking needs a light shining on it since it comes in many guises – money market funds, securities lending and repos are familiar, well used services, but are not always provided by banks. Other non-banking activities such as pay day loans deserve all that they get, but money market funds and repos are vital to the functioning of capital markets.

Money market funds were the source of the liquidity crisis in the US banking sector in 2008. They intermediate short term cash flows between manufacturing conglomerates, hedge funds and pension funds, with custodian banks often acting as intermediaries. They provide short term loans and investments at better rates than the money centre banks.

Securities lending and repos is much like the OTC derivatives market used to be – non-transparent, off exchange and very grey. Some of the participants have a vested interest in keeping it this way, whilst the regulators view things otherwise. Pushing it in the same direction as OTC derivatives will have interesting consequences.

One might expect shadow banking to be supervised by, say, the securities regulators as a result of the amount of securities that are loaned and collateralised through the shadow banking map. If this were the case, however, it would stimulate a turf war between securities regulators and bank regulators.

Shadow banking is a growing concern for bank regulators and central banks. "Such proactive measures as applying systemically-important financial institution definition and extending that regulation and supervision also to the shadow banking sector could be taken if necessary," said Eriik Liikanen, head of the Bank of Finland. Shadow banking and appropriate regulation and capital requirements are very much on the agenda.

FMIs

It is all well and good imposing capital requirements upon the banks and entities offering banking services. It makes a great deal of sense in response to the crises, but what of other systemically important Financial Market Infrastructures (FMIs)? Central counterparty clearing houses (CCPs), central securities depositories (CSDs) and trade repositories are all operating in competitive markets. If one falls into default, it will impact other areas of the wider economy.

This is a particular issue where CCPs are concerned, especially as some of them are banks themselves, or offer banking services. There is no global standard for capital ratios like there is with banks. In Europe, under the European Market Infrastructure Regulation (EMIR), CCPs are required to hold at least 25% ‘Skin-in-the-Game’. The idea is that the CCP itself puts up a capital buffer in its default waterfall to protect the collateral of non-defaulting members at the CCP. The European Banking Association has also put forward capital requirements for CCPs.

This 25% figure, however, is not a global standard. Indeed recently in Korea at KRX, the Korean clearing house, a clearing member went into default and the other clearing members, in this case the non-defaulting members, were hit with a far larger bill than they anticipated.

“In Europe, EMIR has introduced several new layers of protection in order to avoid any spill-over effects from defaulting clearing members and in order to increase the integrity of markets,” explains Marcus Zickwolff, senior advisor at Eurex Clearing and chairman of the European Association of CCP Clearing Houses (EACH). “First, the liable equity capital of CCPs was raised. In addition, also the CCP has to contribute to the default fund – the so-called ‘Skin-in-the-Game’. That is an amount that should cover such losses as occurred at KRX.

“As CCPs compete in a global market, at EACH we believe that the European Commission should not deviate from the upcoming Basel proposal. This should ensure a robust and competitive landscape for CCPs across the globe.”

Basel has only proposed capital requirements in the banking industry. It should, argues Tim Reucroft, director at Thomas Murray Investor Data Services, expand its reach into FMIs. “There are no uniform capital requirements for FMIs and the regulators responsible for overseeing them do not have a great track record with capital requirements. The only body that specialises in this area is the Basel Committee and they should be encouraged to work in this area.”

This would have the benefit of creating a global standard. Given that harmonisation is a key concept of all of the new regulation, it is something of a surprise that no such notion exists where FMIs and capital are concerned.

It is also an increasingly important issue where CSDs are concerned. Changes in their landscape are forcing CSDs up the value chain and the pressure is on for them to embrace risk and enter areas that will put them in competition with banks. This is a new era for CSDs and there are no proper capital requirements in place for them to mitigate the increased appetite for risk that will be necessary for their survival.

“It is a complete unknown in the CSD space. This makes it very difficult to impose capital requirements,” says Jim Micklethwaite, director of capital markets at Thomas Murray Data Services. One response to this, via UCITS V, has been to make depositary banks responsible for the restitution of UCITS assets that are lost at CSD level. This places further pressure upon the banks and makes them responsible for underwriting entities that they will, in part, be competing with. This raises further questions about moral hazard.

Capital requirements in the FMI space need to go beyond making those with the deepest pockets responsible for everything down stream of them. Unintended consequences are one thing, but prudent capital frameworks will go a long way to ensuring responsibility and harmonisation.

We will be taking a closer look at the shadow banking industry and the regulations that affect it going forward; liabilities under AIFMD and UCITS V, the impact of MiFID and EMIR and the individual parts of this industry that are facing up to increasing regulatory scrutiny. The big question is; how can the regulators contain this industry and are they aware of the consequences of their intervention?

Tags: AIFMDUCITS VPensionsRegulationShadow BankingbanksLiquidity