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Shadow banking is typically the realm of money market funds and hedge funds. These are non-banks which can engage in bank-like business such as lending. For instance, a money market fund can invest in short-term debt securities issued by enterprises. To give another example: if an enterprise sells securities from its own holdings and at the same time buys them back on a forward basis, it is in effect obtaining a secured loan for the term of this repurchase agreement. Transactions like this make for a wider range of financing options and are also a way for enterprises to reduce their dependence on banks.
However, these transactions may also give rise to risks for the financial system. That might be the case, for instance, if financial market participants increase their leverage to such an extent as to create the potential for systemic risk. Furthermore, credit intermediation on the part of non-banks might accentuate cyclical trends in the financial system. Finally, shadow banking may also be used to circumvent banking regulation.
If better control of these systemic risks is to be ensured, we first need transparency. That means keeping a steady watch on activities in the shadow banking system. To this end, the Financial Stability Board (FSB) conducts an annual survey to which 25 countries, including all major financial centres, now contribute, providing increasingly detailed information.
However, the data available on the activities of hedge funds are inadequate at the moment. It is all the more important, then, that the G20, at the behest of Germany, has now agreed that the International Organisation of Securities Commissions (IOSCO) will feed its previously unpublished analysis of the global hedge fund industry into the FSB’s survey. This represents a key initial success in Germany’s lengthy efforts to achieve greater transparency in hedge fund activities.
Obviously, observation alone is not sufficient. If the risks are to be controlled as effectively as possible, we need regulation in all key financial centres which accords with international standards. There must be no gaps in the regulation or ways around it. In this respect, too, progress was achieved at the summit, in that all G20 countries have undertaken to implement the FSB’s regulatory recommendations.
The FSB has put forward recommendations for the regulation of shadow banking entities which include liquidity and capital requirements – as for banks – as well as leverage limits. The G20 countries intend to keep each other up to date on their national implementation of these recommendations from 2014. In addition, next year IOSCO is to review the application of its regulatory standards for money market funds. This undertaking to scrutinise compliance with the agreed rules will lend them the necessary bite, particularly as the results of these reviews will be made publicly available.
Nonetheless, far more is still needed to strengthen the global framework for the financial system. Just what action is required can be seen from the FSB’s recently published progress report. And the G20 countries have undertaken to take the necessary steps. Of central importance is a solution to the “too-big-to-fail” problem. In future, the insolvency of an individual bank must not be permitted to jeopardise the whole system. If we are to prevent the insolvency of a major international financial institution from throwing the financial system into turmoil, we need an effective resolution regime. The blueprints for this have already been formulated; they must now be translated into concrete legislation.
An important requirement of a resilient financial system is a robust infrastructure. Therefore, as much over-the-counter trading as possible is to be shifted onto trading platforms. The aim of this and of settling over-the-counter derivatives trading through central counterparties is to limit the risks, and, in conjunction with a duty to report to central trade repositories, to enhance transparency. International agreements in this regard also now need to be translated into national law.
A stable financial system is essential to stable economic growth. It is therefore a good thing that the G20 countries are working together to achieve better control of risks to the financial system – irrespective of the area of the financial system in which these risks arise and from which entities they emanate.
Nonetheless, far more is still needed to strengthen the global framework for the financial system. Just what action is required can be seen from the FSB’s recently published progress report. In future, the insolvency of an individual bank must not be permitted to jeopardise the whole system. If we are to prevent the insolvency of a major international financial institution from throwing the financial system into turmoil, we need an effective resolution regime.