20 August 2013

Bundesbank/Dombret: Systemic risks of shadow banking

The non-banking financial sector is composed of a very heterogeneous set of agents. Some of them – such as insurance corporations and pension funds – usually have very long-term investment horizons and can therefore potentially serve as a stabilising element for the financial system. To be clear on this point: I firmly believe that insurance corporations can be systemically important institutions, too. Thus, effective resolution regimes for Global Systemically Important Insurance corporations need to be developed and implemented.

The overall effects of the so-called shadow banking system and its activities on financial stability are ambiguous. Theoretically, non-banking financial institutions that perform banklike activities are associated with diversification and specialisation benefits. Therefore, it could be assumed that they contribute to efficiency gains and greater financial system resilience. However, empirical evidence from the financial crisis suggests that the activities of shadow banking entities might often be driven by the motive of exploiting regulatory arbitrage. Altogether, the economically beneficial attributes and systemically stabilising effects of entities and activities of the shadow banking system are not always that obvious. In particular, developments prior to the financial crisis revealed that the activities and entities of the shadow banking system can also pose a threat to the stability of the financial system as a whole.

The risks inherent in the shadow banking system pertain to both dimensions of systemic risk: the cross-sectional (interconnectedness) dimension as well as the time-serial (procyclicality) dimension. I see these potential threats as being caused mostly by maturity and liquidity transformation, the build-up of leverage and credit risk transfer conducted by the shadow banking system. All of those activities are not evil per se, but the ensuing systemic risks need to be contained. All activities must be made transparent, in particular vis-à-vis supervisory authorities, and they must be adequately regulated. In that regard, I welcome the global regulatory initiative on shadow banking – under the leadership of the FSB – and I am closely following initiatives at the regional and national level.

Large exposures of banks vis-à-vis counterparties of the shadow banking system need to be adequately measured and controlled by looking through complex investment structures. Finally, the effectiveness of regulatory requirements with regard to shadow banking must be constantly assessed and their implementation should be peer reviewed at the global level. As outlined, addressing the liquidity risk of money market funds, procyclical credit expansion via securitised financing, and interconnections between banks and shadow banks are key regulatory reforms. Adequately regulated, it should be possible to effectively mitigate systemic risks posed by such non-banking financial institutions and enable them to affect financial stability more positively.

Full speech

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