RegTech Intelligence

Jurisdictions lacking the tools for shadow banking oversight

On 25 May, the Financial Stability Board (FSB) reported on jurisdictional progress in implementing their policy framework for strengthening oversight and regulation of shadow banking entities.

Shadow banking emerged as a financial stability priority following the events of the financial crisis in 2008, when a number of non-bank financial entities entered into liquidation due to excessive risk taking and a lack of regulatory oversight.  The bailout of these entities cost billions of government money and a subsequent recession, triggering renewed efforts to ensure such an event would not happen again.

The FSB deemed shadow banking oversight a central aspect of their reform efforts, and set out a number of principles for jurisdictions to use when introducing related legislation.

In practice, the principles from the FSB’s policy framework require authorities to:

  1. Establish the coverage of institutions which fall under regulatory scope for shadow banking
  2. Identify the risks posed by these institutions, e.g., leverage, credit exposure
  3. Improve the transparency of such risks so they are visible to the market
  4. Attempt to mitigate such risks through new requirements.

Yet, similar to the statements from the FSB’s progress report last year on implementation and effects of the G20 financial regulatory reforms, it appears that the supervision of shadow banking entities, as a key item on the G20 reform agenda, is significantly lagging.

These were the findings from the FSB’s information sharing exercise between jurisdictions in 2015, which aimed to focus the scope of analysis on those parts of the financial sector where shadow banking risks may occur.  The exercise revealed how most jurisdictions were still at an early stage of implementing the policy framework set out by the FSB, due to a lack of access to the right data and inadequate risk assessments that were not consistent with one another.  Below we have outlined the findings made under each of the principles.

The regulatory perimeter

The first principle promotes assessing entities that could present a risk to financial stability by their economic function.  Only a few jurisdictions currently have a systematic process in place for scoping out the financial stability risks posed by non-bank financial entities.  In most cases, reviews were found to be ad hoc in nature and undertaken as a reaction to particular activities or entities that supposedly pose a risk.

The FSB suggested that the need for a systematic process could be addressed by building on guidance from standard-setting bodies, involving recurrent assessments of the regulatory perimeter to ensure it encompasses all non-bank entities that pose financial stability risks.

Risk identification

Current jurisdictional arrangements for the collection of information needed to assess shadow banking risks were judged to be not really up to the task.  These arrangements were not usually designed for collecting shadow-banking specific information, and the data used was often not granular enough to properly assess risk.  Gaps in the availability of data were particularly pronounced for non-regulated entities who did not fall within the scope of the regulator’s data collection powers.

Many jurisdictions highlighted the challenges of sharing confidential information at an entity level and, thus, the difficulties in assessing the interconnectedness of non-bank financial entities across borders.

Improving transparency and disclosure

Again, the FSB were unclear whether existing disclosure requirements for non-bank financial entities would enable market participants to properly identify the risks they pose.  It was decided that better information will be needed to keep market participants informed.

Policies for risk mitigation

The 2015 information-sharing exercise included classification of non-bank financial entities into economic functions and a risk mapping tool.  However, as this method involves a degree of judgment, differences in approach between jurisdictions and gaps in the data available skewed the overall perception of where systemic risks were coming from. This has further delayed the classification required if shadow banking entities are to be regulated properly.

The FSB also set out policy toolkits for mitigating the risks presented by non-bank financial entities, separated by economic function; including tools for managing redemption pressures in stressed market conditions, tools to manage liquidity risk, limits on leverage, credit creation and intermediation and collateral restrictions.  The exercise concluded that the sharing of information on members’ experiences with the development and adoption of these policy tools would be greatly beneficial in honing their effectiveness. Several jurisdictions had adopted additional policy tools, and it was seen as important to share these with the group. Despite this, it was made clear that tools cannot be implemented effectively without proper assessment of where the risks lie beforehand.

Next steps

A major survey of European academic experts has recently added another voice to the growing concern that unregulated growth of the shadow banking sector poses the next major risk of a global financial crisis.  As a result, it is imperative that effective regulation is put in place to prevent another crisis from occurring.

The FSB has recommended that jurisdictions adopt a systematic process to assess shadow banking risks, address all identified gaps in data availability and remove impediments to cooperation and information-sharing between authorities.  Only through this can the entire industry be fully aware of the shadow banking risks facing each jurisdiction.

In order to address the disparities between different jurisdictional measures of what constitutes a shadow banking risk, the FSB plan to publish implementation guidance on the approach to economic classification, the risk mapping approach and the reporting of policy tools.  They will also collaborate with standard-setting bodies on information-sharing, monitoring and the sharing of approaches used to identify and resolve gaps in public disclosures by non-bank financial entities.

The plan is to review the progress made in 3-5 years.  Hopefully, by then, the systemic risk posed by the $36 trillion shadow banking sector will be thoroughly mapped out.

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