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European Commission’s sudden interest in “shadow banking”

September 6, 2013

Published in ‘New Europe’ print & digital editions

EC's sudden interestOne cannot but be puzzled by the announcement, on September 4, 2013, of the European Commission’s two separate initiatives to regulate what it calls the “shadow banking” sector. By this term, the Commission refers to about half of the world’s financial activities, encompassing among others: money market funds, hedge funds, private equity funds, institutions providing credit guaranties, insurance, securitization and so on.

All these activities are estimated at about half the size of the “regulated” banking system, amounting to more than 50 trillion euro in 2011. In terms of geographical distribution, the biggest share is concentrated in the United States (around 17.5 trillion euro), in the Eurozone (16.8 trillion), and the United Kingdom (around 6.8 trillion euro).

According to Commissioner Michel Barnier, the new proposals for shadow banking aim not to abolish the sector, but to impose more regulation. “Risks should be hedged with precaution,” he said. The intention behind the Commission’s two new initiatives was to “target the areas where there is the greatest urgency,” he added. The Commissioner didn’t contest the importance of financial markets as the main mechanism of efficient allocation of capital, but he insisted that there was a need for “tight surveillance,” as the shadow banking sector should be able to “contribute to a dynamic sector, but which is well supervised.”

The Commission’s  Communication on shadow banking goes on to affirm that such regulation is much needed because of the systemic risk posed by this “sector” mainly due to its size and to the “interconnectedness” between the shadow banking system and the regulated sector, particularly the banking system. In other words, it aims to address the inherent risk of contagion between the two sectors, in case of a major problem in the so far unregulated funds market. The main beneficiary of improved regulation, according to the Communication, would be “society as a whole.” (sic) What supposedly triggered these initiatives was the 2007-2008 financial crisis, and the Commission has been working on this field since 2010.

More specifically, regarding Money Market Funds, which are a close equivalent to bank deposits and are largely used by corporate treasurers in order to get a slightly higher yield than bank deposit rates, the Commission proposes regulations that require the Funds to maintain at least 10 percent of their assets in instruments that mature on a daily basis and an additional 20 percent of assets that mature within a week, in order to face emergency redemptions from investors (the equivalent of a “bank run,” or better in this case a “run on the fund”). More to that, the Funds will be required to state their nature with regard to time (clear labelling on whether the fund is short-term Money Market Fund or a standard one), to establish clear customer profiling policies to help anticipate large redemptions, and finally to keep a “a capital cushion” (the 3 percent buffer) that can be activated to support stable redemptions in times of decreasing value of the fund’s investment assets.

The whole issue raises a number of questions, that the technical side of the proposed regulation shouldn’t mask. First, why is the Commission only now addressing a problem that caused a worldwide economic disaster six years ago? Second, the term “shadow banking”, that even Michel Barnier felt obliged to rectify, includes half of the world’s financial activity; thus it’s not about something “shadowy” or even accessory to the regulated banking sector, but a substancial part of the mechanisms and instruments providing an efficient allocation of capital internationally. As a consequence, this “sector” or more precisely this large collection of financial activities and products has long been regulated. Also, a big part of these activities and instruments are located outside of the European Union. Will that sort of regulation apply here anyway? Will, for instance, corporate treasurers of multinational companies located in the EU be allowed to invest their monies in “non-regulated” funds outside EU’s regulatory reach?

What will be the real possibility of applying such regulations and monitoring in the complex world of modern financial markets, where creative financial engineering leads to new products and instruments every day? The American experience with its difficulties in applying the Dodd-Frank legislation and the Volcker Rule to their banking system, is not encouraging in this respect.

Finally, why has this over-emphasizing of the risks associated with panic redemption and “run on the fund” come all of a sudden? Are there real risks ahead, or is it the European Commission’s DNA to regulate everything?


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