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Why shadow banking reforms matter

A CFA Institute study called (27 April 2015) for standardisation, simplification and transparency within the shadow banking sector to support the healthy functioning of the capital markets.

Shadow banking usually is defined as a term for the cluster of non-bank financial intermediaries that provide services similar to traditional commercial banks. Former US Federal Reserve Chair Ben Bernanke famously defined shadow banking in April 2012 as “a diverse set of institutions and markets that, collectively, carry out traditional banking functions—but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions.”

Securitization vehicles, asset-backed commercial paper (ABCP) conduits, money market mutual funds, markets for repurchase agreements (repos), investment banks, and mortgage companies are all generally included in the category.

As banks address new capital regulatory requirements and slow balance sheet growth,  the FCA Institute says its study on alternative channels for capital from shadow banking—a broad activity relating to all nonbank credit intermediation—provides a unique investor perspective on what it will take for these financing vehicles to take hold and support economic growth.

The report makes recommendations for improved transparency and simplification in securities financing, including management of collateral and reforming the securitisation market. The study also includes the results of a CFA Institute member survey which finds that 55 per cent of professional investor respondents globally identified a need for greater standardisation and simplification of issuance structures in securitisation markets.

Shadow banking grew in importance to rival traditional depository banking in recent years but was a primary factor in the subprime mortgage crisis of 2007-2008 and global recession that followed.

The institute says its report, Shadow Banking: Policy Frameworks and Investor Perspectives on Markets-Based Finance (Shadow Banking), is unique in its global analysis of regulation as it applies to the different entities and activities within the shadow banking system across regions, and its subsequent exploration of risks and investor perspectives.

In the wake of the financial crisis, shadow banking—in the form of opaque or lightly regulated financing vehicles—was seen as a potential systemic risk for the finance and investment industry. Against a backdrop of constrained bank lending, markets-based finance is now being viewed as a potential solution to help channel capital to productive enterprises in order to revive the real economy; in the broadest terms, the shadow banking sector globally is estimated to be approximately $75 trillion by the Financial Stability Board. The policy recommendations contained in the study have particular relevance for Europe and the Capital Markets Union initiative as they relate to the broader policy agenda of how to enable markets-based finance to revive the economy. In particular:

1.       Securitisation: policy initiatives should focus on increasing standardisation and simplification of issuance structures as well as improving transparency via initial and ongoing disclosures to investors. Standardisation of legal frameworks across markets would also improve the ease and certainty of enforcing ownership rights and creditor protections.

2.       Securities financing transactions and collateral: a robust framework surrounding the reuse of collateral is needed to mitigate the build-up of excessive leverage and to prevent associated financial stability risks. Key elements include greater transparency for securities financing transactions via reporting transaction data to trade repositories and to investors.

Rhodri Preece of the CFA Institute
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Rhodri Preece of the CFA Institute

Rhodri Preece, CFA, head of Capital Markets Policy EMEA at CFA Institute and author of the study (pictured), commented: “Amid the myriad of shadow banking policy initiatives, the challenge facing regulators is to achieve coherence in the implementation of these measures and to minimise regulatory gaps and overlaps.  Shadow banking feeds directly into the capital markets union agenda because there is a desire from the policy perspective for markets-based finance to flourish and deepen the sources of finance available for European companies. Nonbank finance has the potential to deliver many benefits to the financial markets in Europe and indeed globally if the right measures are put in place to stimulate demand and justify investor confidence.”

Shadow Banking is informed by a CFA Institute member survey which identifies the perspectives of more than 600 investment professionals globally on the risks and policy priorities surrounding shadow banking. Key findings include:

  • The potential default of Chinese trust and wealth management products poses the greatest potential systemic risk according to 25% of members, followed by collateral management risks as cited by 23% of members
  • Improving transparency and disclosures over shadow banking activities should be the highest priority for regulators, according to respondents in APAC and EMEA
  • 55% of survey respondents globally identified a need for greater standardisation and simplification of issuance structures in securitisation markets
  • 47% of survey respondents globally agree that the risks associated with securities financing transactions would be mitigated most effectively with greater transparency, through reporting of transactions to trade repositories and to investors.

Shadow Banking examines the perimeter of shadow banking—the entities, activities and components within the shadow banking system—and how they vary across different jurisdictions. The analysis covers the United States, the European Union, and Asia-Pacific (focusing on China) and illustrates that the concept of shadow banking differs across regions. In developed financial markets, the term is synonymous with “markets-based finance” such as certain types of investment funds and securitisation vehicles, as well as activities such as securities financing transactions,  whilst in other jurisdictions, “shadow banking” largely comprises alternative lending channels such as peer-to-peer lending and other forms of nonbank direct loan provision. To see the report, click here.

The survey of the CFA Institute membership was conducted in April to obtain the perspective of investment professionals on the risks and policy issues concerning shadow banking. The survey examined issues related to securitisation and securities financing in particular, given their relevance to current shadow banking policy initiatives. The response rate was 1.7% with a confidence interval of ±3.89% at the 95% confidence level.

CFA Institute is an international association of investment professionals seeking to set the standard for professional excellence and credentials. The organization champions ethical behaviour in investment markets. It says it aims to create an environment where investors’ interests come first, markets function at their best, and economies grow. CFA Institute has more than 130,000 members in 147 countries and territories, including 123,000 CFA charterholders, and 144 member societies. www.cfainstitute.org.

 

Author: Editor

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