14 November 2014

BIS: What kind of regulation for the (European) shadow banking system?

Notes by Mr Pentti Hakkarainen, Deputy Governor of the Bank of Finland, for the panel discussion at the SAFE Summer Academy 2014 "Shadow Banking: Evolution, Background, Perspectives", Brussels, 3 September 2014. 

First, there is need to ensure that regular banking activities and shadow banking activities should not be mixed or confused with each other. It should be crystal clear for investors in for example money market funds that they do not enjoy any coverage comparable to a deposit insurance system. Similarly, it should be clear to entities in the shadow banking system that they will not be supported by the government (the same applies to banks as failing banks will not be supported or bailed-out as the new recovery and resolution framework has been fully implemented) nor that they have access to the liquidity support of the central bank.

If shadow banking entities were under similar regulation and supervision as regular banks, this might give a misleading signal to the market that they implicitly also enjoy a similar safety net. Formal surveillance by authorities can also reduce the incentives of outsiders to monitor shadow banking entities.

Shadow banking entities have to earn the trust of investors and counterparties on their own merits. They have to be able to compete independently by prudently managing the business and maintaining sufficient buffers. Appropriate disclosure of information and sufficient transparency of operations enable efficient monitoring and are instrumental in building trust.

Secondly, in spite of the best efforts, supervisors tend to follow a step or two behind the actions of those they supervise. This is the case also with regular banks, which operate in and adjust to a continuously changing environment. Still Mr. Hakkarainen argues that the banking business is more stable. Moreover, there are more similarities across regular banks than there are across the heterogeneous group of shadow banking entities, making regular banks easier to supervise. Thus regulating and supervising the shadow banking system might be particularly challenging, if not even impossible. A better option might be to make sure they have the right incentives to do their job well.

In principle, shadow banking system is beneficial, and one must be careful with its regulation. As professor Bengt Holmström has reminded: "Of special concern is the tendency to demonize or ban innovations that backfired, not because they were fundamentally wrong, but because the particular implementation was flawed. The originate-and-distribute model and MBSs [or securitisation in generally] will certainly have an important place in the future." Thus, there is need to learn from the fundamental analyses of what went wrong last time, and keep restoring the confidence to the securitisation market.

Finally, one thing that should be kept in mind is a possible post-crisis reinvention of the financial system that Andy Haldane, Chief Economist of Bank of England, talks about in his recent publication. As a consequence of the crisis, some part of financial activities will migrate outside the banking system, inducing the shape and form of risk itself to change. This could have further implications for stability of the financial system and the broader economy. Haldane continues that as risk changes its composition, not its quantum, the financial system may exhibit a new strain of systemic risk that is even more related to shadow banking entities.

Therefore, regulators must follow intensively the development of the post crisis financial system that might result in new type of systemic risks, and be ready to adjust regulation accordingly in a proactive manner.

Full speech

© BIS - Bank for International Settlements