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While systemic risk analysts are glad regulators are finally beginning to address a previously ignored but crucial source of leverage for the financial sector, they say the EC’s dual focus on increasing availability of long-term funding while reining in shadow banking activities could lead to conflicting and contradictory regulatory outcomes.
With the traditional banking sector reducing long-term lending to households and companies in the wake of increased regulatory capital costs, the EC is promoting alternative sources of long-term financing to fill the void left by banks. Rather than relying on bank intermediation, Europe could embrace “a more diversified system with significantly higher shares of direct capital market financing and greater involvement of institutional investors and alternative financial markets”, states the Commission.
According to Frederic Hache, a former derivatives salesman and now senior policy analyst with Finance Watch – a Brussels-based think tank focused on financial regulation – these two objectives are a source of potential policy confusion. “It is important to look at shadow banking in conjunction with the current initiative on long-term financing”, he says. “The current push from European regulators for more market-based financing can provide a useful alternative source of funding, but requires addressing the related potential systemic risks.”
Indeed, the potential providers of market-based long-term funding are the very shadow banks regulators are concerned about, namely bank securitisation vehicles, insurance companies and investment funds. “The Commission is pushing for more market-based financing, which is essentially coming from a revival of securitisation and new long-term investment funds, or shadow banks”, says Hache. “At the same time the Commission is thinking about a possible extension of the scope of prudential rules to other non-bank entities. We hope that the latter will lead to a direct prudential framework of securitisation going beyond industry quality labels.”
Manmohan Singh, senior economist with the IMF and a leading authority on shadow banking, says that, given the genuine economic demand for non-bank sources of funding, a fuller understanding of shadow banking is a key priority for policymakers. “Current regulatory approaches are actively pushing banks away from short-term, secured, wholesale funding markets and incentivising them to issue more deposits and term funding”, he says. “The likely result would be that riskier activities move outside the banking system. Thus, understanding and correctly mapping the shadow banking system will become even more important for policymakers.”