International shadow banking is a term that originated from pre-recessionary period in 2007 and was popularised in pose recession period. The term invited the attention of financial experts and researchers towards the emergence of non-banking entities playing banking role. Hence, the Financial Stability Board (FSB) formally identified their existence and role by defining the term shadow banking system (Pozsar et al., 2012).
It regarded non-banking entities as intermediaries in the financial system but external to the banking system. It is not only because they perform banking activities, but also because they perform certain other activities which are not part of the banking system. The definition was considered as valid and readily accepted (Pozsar et al., 2012).
No objection was raised upon the point that there are certain entities which are not banks but playing an active role in credit risk transfer, providing financial leverage, and maturing transformation. The activities like repo transaction, securities lending and securitization are also played by non-bank entities (Pozsar et al., 2012).
A set of policy recommendations addressing shadow banking issues at the international level.
As FSB realised the existence of non-banking entities and their activities in financial sector, it rightly identified the need to regulate presence and role of these entities. The major goal behind this regulation was to legalise and provide regulatory control on the activities of these entities. It goes without saying that there was certain risk associated with the activities performed by these entities, and that the FSB needed to protect the market from that risk (FSB, 2012a).
It was in the real interest of entire market that all financial activities are regulated under one umbrella that provides guidelines to financial sector of the economy.
The FSB recommended two-stage approach for monitoring and responding to the newly regulated entities (FSB, 2012a).
The first step is to identify all the entities and activities performed by them. It is crucial to design a surveillance plan to cover entire shadow banking related activities. The data related to entities, activities and related risk is important to gather.
The next step is to focus attention on the activities that are purely external to banking domain and have high risk. These activities may belong to liquidity transformation and credit risk etc.
In lieu of regulating shadow banking, collective efforts by the Basel Committee on Banking Supervision (BCBS), the FSB, and the International Organization of Securities Commissions (IOSCO) were started. As a first step, they identified five areas which were prone to high financial risk. Then, these areas were analysed in detail and recommendations were designed (FSB, 2012c). Mentioned below are the key identified areas.
Financial instruments traded in secured contracts like securities and repos, which are prone to high risk and take cyclical business volume trend (FSB, 2012b).
Securitization and its associated risk (IOSCO and BCBS)
Systematic risk created by entities of shadow banking (FSB sub-group)
Money market funds which pose serious threats to market because of their unpredictable behaviour (IOSCO)
Spill-over effect emerging between traditional banking sector and entities of shadow banking system (BCBS)
Keeping in view the identified key areas and their issues, five guiding principles are devised to provide foundation for policy framework. Below are the guiding principles.
Assessment and Review: As regulations are implemented, the regulators will be assigned the responsibility to assess how the implemented measures behaved, what are the drawbacks and how to remove them (FSB, 2012c).
Effectiveness: The regulator will ensure that new systems are effective both in terms of market performance and jurisdictions. As operations will be carried out across the borders, consistency must be maintained. Furthermore, differences between jurisdictions and financial structures will also be considered.
Forward-looking and adaptability: As there is possibility of emergence of other risk factors, the new system will cater for them in advance and ensure adaptability.
Proportionality: The new regulatory system will calculate the risk of shadow banking system created for financial sector and the counter measures will be proportionate in quantum.
Focus: The new system will carefully focus on the desired objectives and analyse the shadow baking system accordingly (FSB, 2012c).
In order to comply with the mentioned guidelines, it is necessary that authorities redefine their data collection methods and contact international financial institutions to join hands in this project (FSB, 2012d).
A support can be provided by the trade repositories (TR), which can portray the image of the entire market. Keeping in view the scope and geographical representation, the FSB can calculate meaningful data about these TRs and the new system.
Transparency is an important requirement of new system. It is, therefore, mandatory that desired goals are made public and the concerned bodies collectively design the survey methods (FSB, 2012d).
As international financial bodies enjoy sound credibility in this regard, the FSB can take benefit from their exposure and experience by including them in the process of regulation.
As careful evaluation of the Workstream proposal is required, authorities should consult with end-investors and fund managers to reach at a win-win situation (FSB, 2012d).
Regulatory authorities should calculate collateral cuts in the light of defined standards, at least, at a minimum level. To start with, a framework should be introduced to analyse pro-cyclicality risk in securities transactions on numerical floors (FSB, 2012d).
It can help control liquidity risk which is mainly posed by activities of non-banking entities. As regulations are imposed and enforced, the requirement of compliance with standards can help develop systems in jurisdictions.
The other required activities include test of harmonisation of client asset rules for likely achievement of client asset protection objectives. As the risk is spread over operational, economic and legal aspects, there is strong need to focus on hypothecation (FSB, 2012d).
Furthermore, all the entities involved in repo market and security lending must be identified so that regulatory standards can be developed for all. The regulatory standards will be based on certain guidelines uniformly controlling all the entities (FSB, 2012d).
In this regard, introduction of the CCPs in an important initiative and all necessary entities should be invited to participate in it. In addition to this, the Repo Resolution Authorities (RRA) must be developed to align them with bankruptcy law (FSB, 2012).
Lastly, as noted above, since a policy should be based on key identified areas and guiding principles, 2 examples of a specific policy are noted below:
Restrictions on maturity of portfolio assets
The risks arising due to maturity transformation created by funds are well mitigated by restrictions imposed upon the maturity of portfolio assets. These restrictions comprise of restrictions on the residual maturity of portfolio securities and limits present on duration or weighted average maturity of the portfolio of funds. The risk levels linked to fund's investment objective are reflected via tailoring these restrictions. These restrictions are helpful in limiting the degree to which these funds can assume risk inconsistent to their investment objective and also cater the reduction in susceptibility to "runs." Not only this, these restrictions limit fund investors' desired risk-return profiles by limiting a fund's yield. These measures are relevant especially for vehicles or funds which are perceived at having low risk. Moreover, their investment objectives are also assumed to provide investors with the expectation that their investment is not going to lose upon its value, such as short-duration ETFs, unregulated liquidity funds, bank-sponsored short-term investment funds and ultra short-term bond funds. (FSB, 2012f).
Limits on leverage
Leverage may be employed by some funds for the enhancement of their returns. However, such type of leverage might serve as a threat to financial stability if it is employed by large funds or if it results in severe risks for investment vehicle's interconnectedness to banks. This may result in the imposition of limits on leverage by the authorities employed by the entities. These…