But Financial Stability Board still struggles with writing regulation, defining what shadow banking is.
Lacking a definitive classification of what the shadow banking system is, the Financial Stability Board (FSB) Tuesday suggested authorities “cast a wide net” and offered up four regulatory responses to controlling it.
“While authorities should start by casting the net wide, they then should focus on those elements of non-bank credit intermediation where important risks are most likely to emerge,” the FSB said in its report, “Shadow Banking: Scoping the Issues.” To do this, it said, regulators should concentrate on any activity that poses systemic risk, or those resulting from “activities that generate maturity and/or liquidity transformation” and that involve “flawed credit risk transfer.” It should also focus on “regulatory arbitrage concerns” where some activities work to circumvent and undermine banking regulations.
For treasury, this could crimp any ambitions to cultivate shadow or parallel bank relations alongside the company’s core credit banks, as ultimately, new regulation will make entering the shadow world a bit more expensive (see related story here). Tapping the shadow market was thought to be a way to avoid the fallout of banks, pressured by new capital and liquidity rules, decreasing their appetite for lending. The FSB now wants to block those exits by regulating the shadow banking system as well.
A wide varietyBecause shadow banking includes a wide variety of activities and entities, the FSB said that forming a single regulatory approach “for all components of the shadow banking system” likely wouldn’t work. Therefore, it suggests more finesse and less blunt trauma regulation:
“The regulatory response to shadow banking should be carefully balanced and targeted to the risks the system creates, taking into account the expected costs and benefits of potential policy interventions in a comprehensive way and using appropriate criteria on which to judge their efficacy. In addition, regulatory responses need to be forward-looking and flexible, so they should not focus solely on the recent crisis but also address issues and problems that may arise as financial markets adapt and evolve, for example, as institutions adjust in response to the changes in incentives provided by the Basel III framework.
To that end, the FSB recommends that the proposed regulatory response should fit into four categories:
- Indirect regulation that would regulate banks’ interactions with shadow banking entities.
- Direct regulation where shadow banking entities are regulated to reduce the risks they pose to the system.
- Target the risks affecting particular instruments, markets or activities so as to facilitate sound credit intermediation through the shadow banking system.
- Macro-prudential measures where regulators focus on “certain entities or activities.”
The FSB will produce draft recommendations by the summer of 2011, with final recommendations made in time for the G20 summit in November.