“shadow banking”: a forward- looking framework for effective policy

June 2012

2 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY i | institute of international finance institute of international

“shadow banking”: a forward- looking framework for effective policy

June 2012 ii “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY preface policy. hand witheffectivemacroprudentialoversightand coordinated andforward–looking,goeshandin analysis mustbedoneinawaythatisinternationally preserving benefitsfromtheactivitiesinquestion.This ways ofmitigatingthoseriskswhileatthesametime and analyzethemostproportionateeffective investors, financialstabilityandthewidereconomy, bank financialactivitiesthatpresentspecificrisksto industry andregulatorsshouldfocusonthosenon- this workcontinues. regulators tomitigatetheserisksbutitisessentialthat been considerableeffortbyboththeindustryand mitigated effectively. Inthelastfewyears,therehas effects iftherisksfromthemarenotmanagedand have thepotentialtoposesubstantialandevensystemic between themandwiththeregularbankingsystem non-bank financialactivitiesandtheinterconnections and thewidereconomy. can providesignificantbenefitstoinvestors,borrowers managed, non-bankfinancialintermediationactivities are keentocontributethisw policy across jurisdictions,anwe coordination andconsistencyof Commission ongreater international Stability Board anEuropean p or “shado non-b those activities that contributeto financial s addressing risksfromthenon-b increased international focuson The IIFstrongl articular thew The centralmessagefromthispaperisthatthe Nevertheless, thefinancialcrisisshowedthatsome Properly structured,andwithrisksproperly ank financialintermediation w b ystem andinp anking”. Wewelcomein y supportsthe ork oftheFinancial articular ork. ank A Regulation, andthemembersofShadowBanking membership oftheSpecialCommitteeonEffective Banking A this paper, inparticularthemembersofShadow commitment oftheirtimeandresourcesindeveloping forward toengagingfurther. policy communityontheseimportantissues.We look signifies theIIF’scommitmenttoworkingwith and proportionate. regulation whenthesearelikely tobethemosteffective use ofconductbusinessregulationandprudential improved disclosureofriskstoinvestorsthroughthe These toolsrangefromtargetedcommunicationand judge thataspecificactivityposesrisks. mitigation toolsthatcouldbeusedwhenregulators approach wouldworkinpractice. developed anumberofcasestudiesthatshowhowour private sectorinitiativesorbyregulation.We have and whethertheyarebeingsuccessfullymitigatedby posed byaparticularactivity, howthoserisksareposed would allowpolicymakers toassesswhetherrisksare mitigation. type andlevelofrisks,needthesameformsrisk impression thattheyhavethesamecharacteristics, avoid takinganapproachbasedonthemistaken non-bank financialactivities.Policy makers should applying the“shadowbanking”labeltoverydisparate dvisory Groupareincludedinthepaper. The listsoftheIIFBoardDirectors, The Instituteisgratefultomemberfirmsforthe The industryhasamajorroletoplay. Thispaper The paperalsosetsoutseveraltypesofrisk This paperthereforeproposesanapproachthat We strongly believethatthedebatemustgobeyond dvisory Group. iii | Josef Ackermann Peter Sands Chairman of the IIF Board Chair, IIF Special Committee on Effective Regulation Chairman of the Management Board Group Chief Executive and the Group Executive Committee Standard Chartered PLC Deutsche Bank

Charles Dallara Edward Greene Managing Director Chair, IIF Shadow Banking Advisory Group finance institute of international Institute of International Finance Senior Counsel Cleary Gottlieb Steen & Hamilton LLP iv “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY contents Generalfindings fromtheStudies CaseStudy6.SofolesinMexico CaseStudy5.ChineseTrust Companies CaseStudy4.SecuritiesLending CaseStudy3:RepoMarkets CaseStudy2.EuropeanResidentialMortgage-BackedSecurities CaseStudy1.MoneyMarketFundsintheUnitedStates SECTION 4.IMPLEMENTINGTHEPOSSIBLEPOLICYFRAMEWORK: CASESTUDIES Decidinghowtousethetools Usingeffectiveriskmitigationtools Analyzingandassessingnon-bankfinancialactivities:a possible template Identification,DataCollection,andMonitoring RISK MITIGATION SECTION 3.APOTENTIALPOLICYFRAMEWORKFORIDENTIFICATION,ANALYSIS,ANDEFFECTIVE Analternativeapproach Thelimitationsofdata Thelimitationsof“shadowbanking”asaterm Activitiesthatmightbethoughtofas“ShadowBanking” GeneralConsiderationsonPolicytowards“ShadowBanking” SECTION 2.THEPRACTICALITIESOFADDRESSING“SHADOWBANKING” Understandingtherisksinnon-bankintermediation Non-BankFinancialIntermediationandtheCrisis Theexpansionofandrationalefornon-bankfinancialintermediation TheBasicConceptof“Shadow Banking” SECTION 1.“SHADOWBANKING”:THENEEDFOREFFECTIVEPOLICY INTRODUCTION 3 EXECUTIVE SUMMARY CONTENTS iv PREFACE ii 29 28 28 27 26 26 25 23 20 18 15 14 14 13 13 12 11 10 10 7 7 5 4 4 1 CONCLUSION: “SHADOW BANKING”: A JOINT RESPONSIBILITY 31

ANNEX. CASE STUDIES 33 Case Study 1. Money Market Funds in the United States 33 Case Study 2. European Residential Mortgage-Backed Securities 37 Case Study 3. Repo Markets 43 v Case Study 4. Securities Lending 49 | Case Study 5. Chinese Trust Companies 56 Case Study 6: Sofoles in Mexico 62

IIF BOARD OF DIRECTORS 66 IIF SPECIAL COMMITTEE ON EFFECTIVE REGULATION 68 IIF SHADOW BANKING ADVISORY GROUP 72 institute of international finance institute of international vi “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY executive summary

There has long been an awareness that non–bank which should be the mitigation of systemic risk. financial activities can—separately or in combination— 1

Policy makers should use an alternative approach. | supplant and/or complement traditional banking They should focus on those non-bank financial activities. Many of these activities have come to be activities with the potential to create systemic risk and known as “shadow banking.” Properly structured and combine an analysis of the risks from these activities with risks properly managed, many of these activities with a macroprudential view of the risks from the can provide significant benefits to investors, borrowers, system as a whole. and the wider economy by increasing efficiency, providing diversification and mitigation of risk, and In implementing this approach, the IIF believes providing increased liquidity and funding. that policy should focus primarily on the underlying activities involved and their associated risks, should be As the financial crisis has demonstrated though, sufficiently forward-looking, and should take account when the risks from these activities are not managed of the variety and complexity of activities, rather than and mitigated effectively, they have the potential to focusing on the entities that conduct those activities. create substantial and even systemic effects if they Above all, the design of policy should be internationally finance institute of international involve imperfect maturity or liquidity transformation, consistent and coordinated. imperfect credit risk transfer, or the build-up of leverage. The IIF has suggested a policy framework that would implement this approach, on the basis of three stages of Since the crisis, regulators have quite rightly been action: responding to these risks through reforms to non-bank activities, both nationally and internationally. There I. the identification of relevant activities and have been considerable reforms of how securitization collection of relevant information about these is implemented, the consolidation of risks on bank activities; balance sheets, money market funds, and a wide range II. an assessment of whether they could pose of other activities. Nevertheless, until recently, there systemic risk; and has been little comprehensive analysis of the system III. If risks are identified, the appropriate as a whole. The Institute of International Finance (IIF) regulatory response and other risk mitigation therefore welcomes the work of the Financial Stability tools. Board (FSB) on “shadow banking” and the move to greater coherence and consistency of policy across On the collection of information, the IIF agrees jurisdictions. with the FSB’s approach of beginning by casting a wide net to collect data before narrowing its focus to The central issue is how to deliver policy that those activities that could increase systemic risk. It is mitigates risks where they arise while preserving important that authorities have access to high-quality, the benefits of non-bank financial activities for the relevant data and that the industry is open in supplying financial system and wider economy. This balancing it, albeit with a clear understanding that it is not an process will not be easy. automatic precursor to new or additional regulation. In particular, while the terms “shadow banking” On the assessment of whether an activity can or “non-bank credit intermediation” can be broadly pose systemic risk, the IIF has developed a template described, this description is likely to be of limited that macroprudential oversight bodies, regulators, value, and using it to develop practical policy is and supervisors might use, on the basis of a series of extremely challenging. Indeed, starting with the term questions on the nature of the activity; the risks from and then attempting to come up with a definitive list of the activity; and the extent to which these are already “shadow banking” activities or entities conducting these being mitigated through disclosure, transparency, and/ activities, or to come up with a single figure for the size or regulation. of “shadow banking” is unworkable, unnecessary, and risks being a diversion from the real focus of policy, When risks are identified, policy makers should 2 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY bank financialactivities.Thestudiesillustratethe its membershavepreparedsixcasestudiesofnon- and testingitagainstreal-worldexamples,theIIF proposed framework,howitwouldworkinpractice, achieves theobjectiveofriskmitigation. use theleastinvasiveanddistortionarytoolthatstill that policymustbeproportionate.Policy makers should in theirprecisedesignandimplementation.Thekey is of arigorouscost-benefitanalysis,beingverycareful approach, onthebasisofassessmentrisksand Instead, policymakers shouldadoptacase-by-case for whichtoolswillbemosteffectiveinanygivencase. impossible—to determineaprecisesetofrulesexante system. addressing theunderlyingrisksinbroaderfinancial non-bank sector, givingtheillusionofsafetybutnot to creatinga“MaginotLine”betweenbanksandthe bank sector. Sucharesponsewouldbetantamount regulated sector, overlookingactivitiesoutsidethe to concentratepolicyontheexistingprudentially of thisapproach.Itwouldbeparticularlyunhelpful justified, regulatorsshouldrecognizethelimitations banks connectedtosuchactivitiesmaysometimesbe prudential regulation. when clearlyjustified,appropriateandproportionate through toconduct–of–businessregulation;and, firms toinvestors;andeffectivefirmriskgovernance communication ofrisks;adequatedisclosurerisksby ranging fromnon-regulatorytoolssuchasthetargeted make fulluseoftheriskmitigationtoolsavailable, As awaytodemonstratethebenefitsof It wouldbeextremelydifficult—andarguably While increasedprudentialrequirementson these vitalissues. way thattheywishandtocarryoutfurtheranalysisof members arereadytoworkwithpolicymakers inany of theindustry’scommitmenttodothis.TheIIFandits mitigation. Thispapershouldbeseenasastrongsign implementation ofregulationandotherformsrisk them assessrisks,andtocooperateonthedesign them toconcernsandprovideinformationhelp and supervisorstomanageriskseffectively, toalert Financial institutionsneedtoworkwithregulators official sectorandthefinancialservicesindustry. the bankingsystemisajointresponsibilityof bank financialactivitiesandtheirconnectionswith different riskcharacteristics. wide varietyofnon-bankfinancialactivitiesandtheir Effective policyandmitigationofrisksfromnon- introduction

At the Seoul Summit of November 2010, G20 leaders control any systemic risk that it may pose. called on the Financial Stability Board (FSB) to 3 Section 2 examines the practicalities of addressing | “strengthen regulation and oversight of shadow such risks by setting out some general considerations banking.” The FSB responded to this request with an to guide policy. It looks at the kinds of activities that initial background note in April 2011 and an October might be considered to amount to “shadow banking” 2011 report Shadow Banking: Strengthening Oversight and examines whether an exclusive focus on “shadow and Regulation, in which it set out both a monitoring banking” is sensible. and data collection framework and proposed regulatory measures to address concerns, based on Section 3 offers an alternative approach based on five workstreams, the first three of which are due to be effective data collection and monitoring; rigorous completed in June 2012. In addition, some jurisdictions and ongoing analysis of whether a particular activity, have or are in the process of addressing policy issues entity, or set of interconnections could create systemic that “shadow banking” presents, including the European risk; and an effective and proportionate use of risk mitigation tools where such risk is identified. It

Commission, which has recently issued a Green Paper. finance institute of international includes a template that regulators could use to carry The Institute for International Finance (IIF) out this analysis. welcomes this focus and in particular the push toward a coordinated international approach. In November 2011, Section 4 summarizes the findings from six the IIF’s Special Committee on Effective Regulation indicative case studies of non-bank financial activities (SCER) agreed that the IIF should produce a paper to that apply the suggested framework and thus illustrate contribute to the FSB’s work and to the emerging policy how it would work in practice. These case studies are discussions. attached as an annex to the paper. To assist this process, the IIF established a working group: the Shadow Banking Advisory Group, under the chairmanship of Mr. Edward Greene, Senior Counsel, Cleary Gottlieb Steen & Hamilton. Members of this group include senior participants from a variety of backgrounds and jurisdictions, from both developed and emerging markets. The paper that follows is the output of that group and is aimed at assisting policy makers with their efforts. Most importantly, the paper proposes a framework to assist regulators and supervisors in how to assess whether a non-bank financial activity poses systemic risks and lists some tools that could be used to mitigate these risks. The framework is designed to be forward-looking and sufficiently flexible to allow new and emerging sources of risk to be assessed and mitigated properly. The paper is organized into four sections: Section 1 sets out a basic concept of shadow banking/ non-bank financial intermediation and its expansion over recent decades. It notes the potential benefits from such financial intermediation but agrees that an effective policy approach is needed to assess and 4 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY effective policy section 1. “shadow banking”: the need for BANKiNg” non-bank financial system.Thosewithfunds toplace and/or complementedbyactivities providedbythe are oftendisaggregatedand, insomecases,supplanted functioning ofthepayments system. confidence inthefinancialsystem, asisthesmooth repayment andtheliquidityofdepositsiskey towider the paymentssystem.Maintainingcertaintyof the financialsystemasawhole,includingthrough of theirinterconnectednesswitheachotherand their combinationinsidethesameentity;andbecause these individualactivities;becauseoftherisksfrom are highlyregulatedbecauseoftherisksattachedto These activitiesalsotypicallyinvolveleverage.Banks involves somematurityand/orliquiditytransformation. banking, whichinvolvesthreecoreactivities: it mustbeunderstoodbyreferencetoconventional If theterm“shadow banking”istomeananything, the non-bankfinancialsystemandmove toagreatercoherenceandconsistencyacrossjurisdictions. the systemasawholeorwithoutanyinternationalcoordination.TheIIFthereforewelcomesincreasedattentionpaid to have beencarriedoutunilaterallyandwithoutanycoherent,consistent,comprehensiveanalysisofwhatwentwrong in the consolidationofrisksonbankbalancesheets, moneymarketfunds,However, andarangeofotheractivities. manyreforms effectively addressed.Sincethefinancialcrisis, inindividualcountriestherehavebeenconsiderablereformsofsecuritization, It isessentialthatsuchrisksfromthenon-bank financial systemandtheirconnectivity with thetraditionalbankingsystembe imperfect maturityandliquiditytransformation,thebuild-upofleverage,and/orcredittransfer. adequate riskmitigationisnotinplace.TheIIFagreeswiththeFSBthatsuchrisksareheightenedwhentheyinvolve Nevertheless, thefinancialcrisisshowed thatsomeoftheseactivitiescancreatesubstantialandevensystemicrisksif competition andinnovation. benefits toinvestors, borrowers, andthewidereconomybyincreasingefficiency, providing diversification,andspurring Many oftheseactivitiesdevelopedforbothsensibleanddesirablereasons, andproperlystructured,provide significant activities. Manyoftheseactivitieshavecometobeknown as“shadow banking.” In modernfinancialsystems, traditionalbankingactivitiescanoftenbesupplantedand/orcomplementedbynon-bank Key Messages The III. II. I. In modernfinancialsystems, thesecoreactivities The combinationofthefirsttwoactivitiestypically Basic Extending credit,whethershort,mediumorlong T aking highlyliquiddepositsascapital; Providing apaymentssystem. term (e.g.,mortgageorbusinessloans);and Concept of

“ShAdoW School (14March2012). 2 A risks arewell-understood andaddressedbyregulation. activities, forexample,existoutsidethe regularbankingsystem,buttheir 1 Manybutnotall.Conventionalinsurance,securities,and derivatives the potentialtoincreasesystemic riskiftheyinvolve intermediation activities but notothers.Manyofthesenon-bankfinancial disaggregated, withbanksundertakingsomefunctions timing butmuchlessontheirfunding. institutions’ expertiseindistribution,pricing,and the capitalmarkets, placingrelianceonfinancial are abletotapsourcesoffinancedirectlythrough as investmentfundsorhedgefunds.Someborrowers or investhavemanyalternativestobankdeposits,such multi-step chains.” and theinstitutionsarelinked togetherviamyriad activities, markets, andcontracts,aswellinstitutions; shadow bankingsystemis…essentiallyasetof • • taken toincludeactivities “shadow banking”andmight,asafirstapproximation, be As theFSBhaspointedout,theseactivities have The bankingfunctionmayalsobebroken upor A recentspeechby infrastructure. Provide relatedservicesoraspectsofthenecessary of bankstosomedegreeor “Mimic” orapproximatetothesethreecoreactivities dair TurnerShadow Banking andFinancialInstability, CassBusiness 2 1 dair Turnerarguedthat“he havecometobeknownas

that maturity transformation, liquidity transformation, credit source. risk transfer, and the build-up of leverage. • Greater flexibility and investment opportunities. These activities can give investors greater flexibility over The expansion of and rationale for the duration and risk profile of their investments and non-bank financial intermediation also broaden their investment opportunities, making available assets such as corporate treasury financing Non-bank financial intermediation activities have and mortgage loans, which might otherwise not be existed in some form or other since the origins of available. modern finance. Many have emerged in their current form in the two decades leading up to 2008 and were • Increased liquidity and funding. For borrowers and 5 | a result of arbitrage opportunities stemming from the market participants, such activities can lead to a imposition of regulations and the inevitable tendency greater diversity and supply of funding and liquidity of firms and market participants to minimize the in the market. This option allows firms to reduce impact of regulations and their concomitant cost. The reliance on traditional sources of funding, sometimes wish to manage balance sheets and to minimize the at lower cost. capital charges associated with traditional lending This combination of efficiency, specialization, activities, for example, was a factor in the growth of the diversification and mitigation of risk, flexibility, and securitization market in the period up to 2007. As the increased liquidity and funding can lead to potentially crisis demonstrated, some forms of financial innovation greater safety and financial stability. Indeed, as a recent and, in particular, the ways in which these were International Monetary Fund (IMF) paper4 shows, managed and regulated may have been of questionable much of the growth of this non-bank system may

value and others positively harmful. have been the result of a search for safe and sensible finance institute of international But this result should not obscure the fact that cash management, which, when faced with limits on a large number developed for both sensible and insurable bank deposits and a shortage of short-term desirable reasons and can provide—if risks are properly government-guaranteed instruments such as Treasury managed—major benefits to investors, borrowers, and bills, led cash managers to invest in alternative forms of the wider economy. Box 1 and the case studies annexed short-term debt. to this paper provide some detailed examples of these Part of this increase is also attributable to the benefits. In broad terms, the benefits from non-bank perceived security offered by credit and liquidity financial activities can include enhancements made available by deposit-funded • Efficiency, innovation, and specialization. An banks—which themselves had access to central bank extensive study by the New York Federal Reserve liquidity—combined with the bankruptcy–remoteness argued that “there were also many examples of of the securitized instruments and conduits from those shadow banks that existed due to gains from banks. specialization and comparative advantage over As Bank of Canada Governor Mark Carney has said, traditional banks. … These … could include non- “Properly structured, shadow banking can increase bank finance companies, which are frequently more efficiency, provide diversification, and spur competition efficient than traditional banks through achieving and innovation. It has the potential to make the system economies of scale in the origination, servicing, more robust, provided it does not rely on the regulated structuring, trading, and funding of loans to both sector for liquidity or pretend to provide it with bankable and non-bankable credits.”3 This can liquidity in times of stress.”5 have additional benefits such as aiding financial As such, if subject to proper risk mitigation, non- inclusion. bank financial intermediation can complement banks • Diversification and mitigation of risk. These activities and provide safe alternative sources of funding and can enable investors to diversify and mitigate their a more tailored array of risk/return opportunities for risks, as their deposits are not concentrated on a investors. single bank balance sheet but are spread over a number of investments. They also can enable banks and borrowers to diversify their sources of funding and liquidity and therefore avoid relying on a single

4 Zoltan Pozsar Institutional Cash Pools and the Triffin Dilemma of the U.S. 3 Zoltan Pozsar, Tobias Adrian, Adam Ashcraft & Hayley Boesky, Shadow Banking System, IMF Working Paper WP/11/190. Banking, Federal Reserve Bank of New York Staff Report No. 458 (July 5 Mark Carney Some Issues in Financial Reform, Institute of International 2010). Finance (25 September, 2011). 6 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY published 2012). 7 ErikFGerding The Shadow BankingSystemand(tobe itsLegalOrigins Investment Management Conference,Phoenix (15March,2010). Company Institute,andFederalBarA ssociation MutualFundsand Market FundReform 6 CommissionerLuisA.guilar, MakingSureInvestorsBenefitfromMoney diversification. Asarecentacademicpaper asset-backed securitiesoffershigherreturns,liquidity,and optimizing fundingcosts.Forinvestors,thepurchaseof enabling bankstospreadtheirfundingovermoresources, makes financingavailableforawidevarietyofpurposes, financing andofferadditionalloans.Properlydone,it used asahelpfultool.Itenablesbankstoofferlowercost Securitization can,hasbeen,andshouldcontinuetobe Securitization investments andminimizetransactioncosts. funds provide investorswitheasyaccesstohigh-quality investors inseparatetransactions.Likewise,moneymarket in bulktransactionsratherthantoamultitudeofindividual municipalities, andotherissuers toreadilyselltheirsecurities market fundsenablethefederalgovernment, corporations, issuers ofhigh-qualityshort-termdebtandinvestors.Money Commissioner (SEC)LuisAguilarnotedthat, investment. AspeechbyU.S.SecuritiesandExchange institutional cashmanagersasarelativelysafeshort-term MMFs canprovidesignificantbenefitstoinvestorsand Money MarketFunds securities lendingandrepo. mitigated. ThreeexamplesareMMFs,securitization,and provide ifproperlymanagedandtherisksareeffectively the financialsystemandwidereconomythatsuchactivities should notlosesightofthepotentialeconomicbenefitsto In lookingatnon-bankfinancialactivities,policymakers Bank FinancialIntermediation Box 1.ThreeExamplesoftheBenefitsNon- issued …thesecuritiescanbe “structured” tocreatedifferent diversification throughtheterms ofthesecuritiesbeing investments intheirportfolios. …Third,investorscanachieve risk, andtheycandiversifythisriskawaythroughother investors …areonlybuyingasliverofthemortgagepool’s mortgages inthepoolwillcontinuetopayout.…Second, default onanyonemortgageisoffsetbythefactthatother this diversificationoccursinthreeways: Study 1intheannexexploresthesebenefitsmoredetail. concentration ofriskinthetraditionalbankingsystem.Case They alsoallowinvestorstodiversifyriskandreducethe invest fundsonashort-termandrelativelyliquidbasis. a relativelysafenon-bankalternativeforthoselookingto These fundsprovide ahighlyefficientconduitbetween First, thepoolingofmortgagesmeansthatrisk As such,ifrisksareadequatelymitigated,theycanoffer , U.SecuritiesandExchange Commission, Investment 7 haspointedout, 6

Tucker market efficiency. and arbitragingofpricedifferentials,thuscontributingto would beverydifficulttoexecuteandenablesthehedging many tradingandinvestmentstrategiesthatotherwise and balancesheetmanagement.Indoingso,itsupports shorts andpreventingfailshelpsfinanceinventory borrowers tocoveroperationalneedssuchascovering security offered by the collateralization of the loan. It allows increase theperformanceoftheirportfolio,butwith return ontheirinvestmentsandforfundmanagersto Securities lendingallowslenderstoachieveanadditional Securities LendingandRepo more detailsofthesebenefits. savings forborrowers.CaseStudy2intheannexprovides the financingofinfrastructureprojects;andofferingcost residential homeownership;providingthepotentialfor companies; providinganexpandedsourceoffinancingfor of fundingforbanks,financecompanies,andindustrial gains totheeconomybyprovidinganadditionalsource different levelofriskandareward. classes or“tranches”ofsecurities, witheachclasshavinga Controls (6October, 2008). 9 ColumbiaManagement, RepurchaseA remarks attheBernie GeraldCantorPartners Seminar(21 January, 2010). 8 Paul Tucker Shadow Banking,FinancingMarketsAndFinancialStability detail. the market,aswellincreasemarketefficiency. down asfundcashflowsdictate. because theprincipalamountofreposcanbeadjustedupor deposits, oragencydiscountnotes.Theyofferflexibility money marketinstrumentssuchasTreasurybills,time tend toprovideadditionalyieldcomparedtraditional improving liquiditymanagement.Intermsofyield,they liquidity, theyprovidetheabilitytoinvestincashovernight, liquidity, (ii)yieldadvantage,and(iii)flexibility.Intermsof purpose becausetheyofferthreedistinctbenefits:(i) markets.” to effectivemarketmaking,andthuscapital their transactions.Securitieslendingisabsolutelyvital sellers whoneedtodeliversecuritiesinordersettle the loanofsecurities…byassetmanagerstoshort lending “isstraightforwardandimportant:itintermediates A speechbyBankofEnglandDeputyGovernorPaul In thisway,securitizationofferssignificantpotential Case Studies3and4gointothesebenefitsinmore Repurchase agreements(repo)serveanequallyvaluable 8 recognizedthat,ifcarriedoutproperly,securities greements: Benefits, Risksand 9 Bothinjectliquidityinto , Non-Bank Financial Intermediation prudentially-regulated banking sector and beyond. and the Financial Crisis Nevertheless, policy makers should keep in mind Nevertheless, these benefits to investors, borrowers, and that, while there were problems with specific parts of the wider economy come with potentially significant the non-bank financial system, there were other parts risks and are therefore conditional on effective risk that not only did not contribute to the crisis but also mitigation by those carrying out the activity, those performed well, such as many securitization activities. interacting with entities carrying out the activity, regulators, and supervisors. Understanding the risks in non- As has been well documented, market, risk bank intermediation 7 | management, regulatory, and supervisory failures Activities associated with non-bank financial connected to non-bank financial intermediation intermediation may, on their own, be desirable and activities all have played a major role in the origins economically beneficial if carried out correctly and and development of the financial crisis. Fundamental with proper diligence and with high risk management weaknesses were revealed that both provoked and and supervisory standards. The lesson of the crisis aggravated the crisis, including however, is that, absent these safeguards, they can • Declining lending and due diligence standards in create substantial risks separately, in combination with the U.S. mortgage-backed securities markets, which other activities inside the entity undertaking them, or as undermined the “originate-to-distribute” model; a result of their interactions with the financial system as a whole. These risks can manifest themselves in two • Inadequate understanding of the underlying main ways: assets, contractual structures, and other aspects of institute of international finance institute of international vehicles, especially those that performed maturity • Direct risks to depositors/investors, and transformation by financing longer term assets not • Risks from the interconnectedness within the non- fully supported by committed liquidity lines; bank financial system and between it and the • Excessive reliance by investors on credit ratings for regulated banking system, including increased structured products aggravated by the failure of the procyclicality from what has been termed “self- agencies to assess independently or communicate referential approaches to credit pricing, combined the full array of risks embedded in such products, with inherently myopic and unstable assessment of the assumptions behind the modeling of particular tail risks.”10 Where non-bank channels come to be structures, or the sensitivity of outcomes to changes relied upon as a critical source of liquidity in the in assumptions; and financial sector as a whole, including the regulated banks, this risk from interconnectedness can be • Inadequate internal risk management in banks, particularly problematic. especially with regard to off-balance-sheet commitments and the failure to develop worst-case If these risks are not managed and mitigated scenarios and provisions that would deal with a tail- effectively and become sufficiently material, they risk event. may destabilize the financial system and/or lead to a widespread loss of confidence. As the FSB has pointed • Linked to these weaknesses, there was an often out, short-term and myopic approach to risk. Maturity/liquidity transformation within the shadow In addition, there were other shortcomings such as banking system, especially if combined with high leverage, excessive leverage in parts of the system, over-reliance raises systemic concerns … because of the risk that short- on short-term money markets to finance longer term deposit-like funding … can create “modern bank runs” term loans, and a relaxation of collateral and margin if undertaken on a sufficiently large scale. … the shadow requirements. banking system’s interconnectedness with the regular These market failures were aggravated by others banking system can raise systemic concerns.11 in regulation, supervision, and oversight such as In assessing activities involved in non-bank inadequate data collection and analysis of risks, financial intermediation, it is therefore essential that the and insufficient coordination between prudential activities being undertaken are understood properly and and conduct-of-business supervisors and between the risks created, including those risks resulting from jurisdictions. Above all, there was a failure on all sides, connections with the traditional banking system, are both official and private, to monitor, identify, and mitigate build-ups of systemic risk (see Box 2) in the 10 Turner, ibid. 11 FSB Shadow Banking: Scoping the Issues (12 April 2011). 8 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY their obligationsisdrivenby“failures”inothers,and(iii)hassignificantmacroeconomicconsequences. meet theirobligationsinfullandontime,(ii)hasacontagiouselementsothattheinabilityofsomeinstitutionsto financial institutionsarefundamentallyunderminedinawaythat(i)threatenstheabilityofconcernedto interconnectedness andissufficientlyadaptive. It isneveronething,italwaystheinterconnectionofanumberfactors. dynamic andevolving.Itinvolvesmultiplepartsofthefinancialsystem,occurrencesseldomornevertakesameform. • • • give justafewexamples, measures torespondmanyoftheseweaknesses.T internationally havealreadytaken anumberof The emergingpolicyresponse become primarilyadministratorsofloansorfunds). reputational, oroperationalrisks(e.g.,iftheywereto an unwarrantedconcentrationofriskssuchaslegal, too specializedandfragmented,theycouldendupwith financial servicesbyregulatedfirmsweretobecome functions maybequitelegitimate,iftheprovisionof And, whiledisaggregationoftraditionalbanking lead themtoweaken internalcontrolsandstandards. pressures onprudentially-regulatedentitiesthatmight unregulated non-banksystemmayputcompetitive regulated bankingsystemandanunder-regulatedor For example,regulatoryarbitragebetweenanover- out ofinterconnectedness,otherrisksmaybepresent. banking sector. Inadditiontotherisksarisingdirectly right orastheresultoftheirimpactonregulated financial activitiesmaybeasourceofriskintheirown 12 IIFSystemicRiskandSystemicallyImportantFirms:AnIntegratedpproach Box 2.WhatisSystemicRisk? effectively addressed. For thepurposesofthispaper,therefore,IIFtreats The IIFhasconsistentlyurgedanapproachthatavoidsexcessiverelianceonindicatorssuchassizeand There isnosingle,simpledefinitionofsystemicrisk…Systemicidentifiednotbyitssourcebuteffects.It securitization structures havebeentightened—the Capital requirements ofliquidityfacilitiessupporting standards; as wellnewduediligence andtransparency mandate minimumriskretention requirements Dodd-Frank A Second CapitalRequirementsDirectiveandthe2010 including Article122aoftheEuropeanUnion’s Linked tothesereforms,newrulesonsecuritization, risk-based requirementsforliquiditylines; consolidation rulesforbank-sponsoredconduitsand requirements forsecuritizedexposuresandon Basel 2.5reforms,imposingcredit-relatedcapital Regulators andsupervisorsbothnationally It isparticularlyimportanttonotethatnon-bank In itsreportSystemicRiskandSystemicallyImportantFirms, ct intheUnitedStates,bothofwhich o systemic riskasoccurringwhencorefunctionsprovidedby (May2010). 12 Regulation ofCertain NonbankFinancialCompanies(October2011). 12CFR part1310, RIN4030-AA00,A uthority toRequireSupervision and 13 FinancialStability Oversight Council,Noticeofproposedrulemaking • • • • • out. However, theywouldbemoreeffectiveif theIIFhasarguedthat, the UnitedStates” could poseathreattothefinancialstabilityof activities oftheU.Snon–bankfinancialcompany, concentration, interconnectedness,ormixofthe financial company, orthenature,scope,size,scale, material financialdistressattheU.Snon–bank prudential standardsifthe[FSOC]determinesthat by the[FederalReserve]andshallbesubjectto non–bank financialcompanyshallbesupervised states thattheFSOC“maydetermineaU.S Oversight Council(FSOC)inctober2011 (which important issuedbytheFinancialStability non-bank financialcompaniesassystemically Rulemaking (SecondNP)onthedesignationof In theU.S.,econdNoticeofProposed Commission onBankingintheUnitedKingdom;and United StatesandtheproposalsofIndependent Structural reforms,suchastheVolcker Ruleinthe European Union’sCreditRatingAgencyegulation; Reform ofCreditatingAgencies,suchasthe to Rule2a-7(seeCaseStudy1); Work bytheSEConMMFs,suchasitsamendments institutions; The developmentofmacroprudentialoversightand to conduitswillbeintroduced; requirements withregardtoliquidityenhancements under oneyearwasraisedto50%andliquidity 20% creditconversionfactorforliquidityfacilities Some ofthesereformshavebeen wellthought financial entities). prudential regulationandsupervision tonon-bank potentially leadtotheapplicationofbank-like 13 ; thisdeterminationwould were based on a more thorough analysis of the risks; The IIF Perspective were more proportionate to the risks being addressed; The IIF welcomes the increased attention to this area were consistent and connected with each other as part and the move to greater coherence and consistency of a system-wide macroprudential appraisal of the across jurisdictions. The central issue is how to turn risks; and were more internationally consistent and this need for effective policy into practice in a way coordinated. that mitigates risks where they arise while preserving Implicitly acknowledging these problems, in the benefits of non-bank financial activities for the October 2011, the FSB issued a report Shadow Banking: financial system and wider economy. Strengthening Oversight and Regulation in which it For the purposes of clarity and simplicity, the focus 9 developed a conceptual approach, set out a monitoring of this paper is on the identification, analysis, and | framework to assess “shadow–banking” risks, and mitigation of activities that could lead to material provided recommendations ahead of the outcome of systemic risk to national markets rather than with five regulatory work streams on (i) the regulation of other risks and detriments such as mis-selling and banks’ interactions with “shadow banking” entities; (ii) non-systemic failures. Such risks need to be addressed, the regulatory reform of MMFs; (iii) the regulation of but the Shadow Banking Advisory Group concluded other “shadow banking” entities; (iv) the regulation of that attempting to cover all forms of risk would likely securitization; and (v) the regulation of activities related confuse an already difficult conceptual framework. This to securities lending/repos, including possible measures approach is similar to that adopted in the October 2011 on margins and haircuts. Work on many of these is FSB paper. nearing completion. Both the International Organization of Securities Commissions (IOSCO) and the FSB Task

Force on Securities Lending and Repos recently issued finance institute of international consultation papers.14 In addition, there has been considerable analysis and work at a European level. In March, the European Commission issued a Green Paper on “Shadow Banking”, followed by a conference in April, and the European Central Bank issued a research paper on the issue.15 Further, there has been notable recent commentary on “shadow banking” from Federal Reserve Chairman Ben Bernanke and UK Financial Services Authority Chairman Adair Turner.16

14 IOSCO, Money Market Fund Systemic Risk Analysis and Reform Options: Consultation Report (April 2012); FSB Securities Lending and Repos: Market Overview and Financial Stability Issues” (April 2012). 15 ECB, Shadow Banking in the Euro Area: An Overview, ECB Occasional Paper No. 133 (April 2012). 16 Fostering Financial Stability: Remarks by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System at the 2012 Financial Markets Conference, Atlanta, Georgia (9 April, 2012); and Adair Turner, Cass Business School idem, Securitisation, Shadow Banking and the Value of Financial Innovation, Rostov Lecture on International Affairs, SAIS (19 April, 2012). 10 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY “ Section 2. The Practicalities of Addressing Shadow B entity thatintermediates betweenend-suppliers and shadow banking maybeconductedbyasingle system. AstheFSBhasacknowledgedthat“ connections totheprudentially–regulated banking with thewiderfinancialsystem, includingits oversight notjustoftheactivity butofitsinteraction mitigation. or otherregulationaswellgapsinoversightandrisk of prudentialregulationontopconduct-of-business could leadtoregulatoryduplicationorover-layering focus inordertoavoidaconfusionofapproachesthat undertake it.Itisimportanttoidentifytheprimary bank financialintermediationorontheentitiesthat focus shouldbeonactivitiesthatcomprisenon- into practical policy both nationally and internationally. between ensuringthebenefitsandmitigatingrisks mitigated. Thedifficultycomesinturningthatbalance with itarenotproperlyidentified,monitored,and of creatingsystemicupheavaliftherisksassociated However, asnotedinSection1,suchactivityiscapable accounted forasignificantpartofthefinancialsystem. Non-bank financialintermediationhasinthepast overview of theentirefinancialsystemandpotentialriskstostability. What isimportanttohavedataattherightlevelonindividualactivitiesandtheirtrendsaspartofamacroprudential In thesamevein,tryingtocomeupwithasinglefigureforsizeof“shadow banking”isneitherfeasiblenornecessary. view oftheriskstosystemasawholeifrealized. potential tocreatesystemicriskandcombiningananalysisoftherisksfromtheseactivitieswithamacroprudential Instead, policymakersshoulduseanalternativeandwiderapproach—focusingonnon-bankfinancialactivitiesthathave the a diversionfromtherealfocusofpolicy:mitigationsystemicrisk. definitive listof“shadow banking”activitiesorentitiesengagedintheseisunworkable,unnecessaryandrisksbeing limited value,andturningsuchgeneralityintopracticalpolicyisextremelychallenging.Attemptingtocomeupwitha In particular, whiletheterm“shadow banking”,or“non-bankcreditintermediation”,canbebroadlydescribed,thisisof internationally consistentandcoordinated. and takeaccountofthevarietycomplexitynon-bankfinancialactivities.Above all,thedesignofpolicyshouldbe policy toward suchactivitieswillultimatelyneedtobeappliedspecificentities.Itneedssufficientlyforward-looking Policy shouldfocusprimarilyontheunderlyingactivitiesinvolvedandrisksassociatedwiththem,keepinginmindthat financial activitieswhileeffectivelyidentifyingandcontainingtheriskstheyposetosector. The centralissueforpolicyon“shadow banking”ishow inpracticetopreservethebenefitsandefficienciesfromnon-bank Key Messages A furtherissueistheneedto have effective One immediateissueiswhethertheprimary anking” Although Recommendations of theFinancialStabilityBoard(27October, 2011), p.3. 17 Shadow Banking: StrengtheningOversightandRegulation: will bekey: potential risks.Indoingso,thefollowingconsiderations while effectivelymonitoring,analyzing,andcontaining intermediation andothernon-bankfinancialactivities and efficienciesassociatedwithnon-bankfinancial policy shouldbetopreservethepotentialbenefits intermediation.” entities andactivitiesformingachainofcredit end-borrowers offunds,itofteninvolvesmultiple General towards I. The IIFbelievesthattheprincipalobjectiveof

some ofwhichmayhavethe potentialto will oftencarryoutanumber ofactivities, for thisconclusion,including that:(i)entities those activities.Thereareanumberofreasons risk elementsinorintrinsic characteristics of and withinthispolicyonthefundamental rather thantheentitiesthatconductthem, The policyshouldfocusprimarilyonactivities Considerations “Shadow 17

Banking on ” Policy

create systemic risk, while others may not; concerns. Section 3 suggests a template for an approach that focuses on the entity alone such an approach. may not distinguish adequately between V. Policy should make use of the whole range these different activities; (ii) a number of very of tools available to mitigate any potential different entities may be engaged in the same risks and, where necessary, act to correct any financial activity (e.g., securities lending), so investor myopia. These tools range from the focusing on types of entity would risk different targeted communication of risks by regulators; treatment of the same activity; and (iii) there adequate disclosure of risks by firms; and is a danger that a focus on entities would effective risk governance to conduct–of– create incentives for them to mutate to avoid 11 business regulation, prudential regulation, and | regulation without changing the underlying macroprudential policy. Policy should build on risk. existing regulation and consider which tool is this is not to say that entities should be likely to be most effective and proportionate to ignored. Any regulation or laws relating to a the risks identified and whether it is consistent financial activity will ultimately have to be with the approach taken to similar activities applied to entities conducting them. Regulators either within the prudentially-regulated sector will also need to pay attention to whether there or beyond. Further details are provided in are additional risks from the combination of Section 3. activities inside a particular entity. It will also VI. Above all, the design of policy should be be necessary to examine linkages between internationally consistent and coordinated in activities and firms and the rest of the financial such a way that similar activities posing similar institute of international finance institute of international system, including the prudentially–regulated risks in different jurisdictions are addressed in banking system, as these linkages may have an a similar and consistent way. important bearing on the risks. These issues are examined in Section 3. Activities that might be thought of II. Policy should be forward-looking and adaptive, guiding a rational response to new types of as “shadow banking” activities and risks that will emerge in future, As noted in Section 1, activities that have come to including in emerging markets. The IIF agrees be known as “shadow banking” or might amount to with the FSB that it should position itself so as non-bank financial intermediation individually or to be able “to capture important innovations collectively might, as a first approximation, be taken to and mutations in the financial system.”18 In include activities that doing so, regulators should be alert to the • “Mimic” or approximate to the core activities of ways in which activities will evolve not just in banks to some degree or response to innovation or market conditions, but crucially in response to regulation. Case • Provide related services or aspects of the necessary Study 5 on trust companies in China below infrastructure. gives a very strong example of this. As noted earlier, these activities have the potential III. Policy should be premised on effective to increase systemic risk if they involve maturity macroprudential oversight and analysis. Such an transformation, liquidity transformation, imperfect approach must be based on adequate data that credit risk transfer and for the build-up of leverage. enables regulators and policy makers to get Examples of activities that could be said to mimic a comprehensive view of the emergence and or approximate to the deposit-taking functions of banks build-up of risks in the wider financial system. are operating MMFs, the sale of Commercial Paper, or IV. Policy should take account of the variety the pooling of funds by non-bank trust companies. and complexity of non-bank forms of The obligations created in these activities all have some intermediation and avoid the temptation of the characteristics of deposits in terms of ability to to adopt a “one-size-fits-all” approach. A redeem and the creation of an expectation – even if case-by-case approach is needed focusing unwarranted - of returns at or beyond par. The same on specific types of transactions or financing may be true of other obligations such as the liabilities structures that raise clear systemic risk of hedge funds, but to a much lesser extent.

18 FSB, ibid. 12 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY School (14March2012). 19 A number ofreasons: list of“shadowbankingactivities”isunworkablefora term used,attemptingtocomeupwithadefinitive it. comprise “shadow banking”ortheentitiesthatundertake intermediation”, eitherintermsoftheactivitiesthat term suchas“market-basedfinancing” attempts havebeenmadetodefineitorsomeother or legislationisextremelychallenging.Anumberof detailed andprecisewayforthepurposesofregulation the FSBhasdone,tryingtodefineitinasufficiently and activitiesoutsidetheregularbankingsystem”as described as“credit intermediationinvolving entities While theterm“shadow banking”canbebroadly banks andnon-bankinstitutions.” within thefinancialsystemitself,includingbetween real economy, andasentailingfarmorecomplexlinks bank interactionbetweenthefinancialsystemand as involvingbothinsomecasesnewformsofnon- observation that“shadowbankinghastobeunderstood of loansbybroker-dealers. lending, collateral transformation, and the securitization way. Suchservicesorinfrastructureincludesecurities critical partofafinancialintermediationprocessinsome mimicking corefunctionsofbanks,neverthelessforma activities. enormously bothbyactivityandwithinindividual Nevertheless, thedegreeofthisapproximation varies company-to-company loans,andthepurchaseofrepo. vehicles (whicheffectivelyactsasadirectloan), purchase ofinstrumentsfromstructuredinvestment corporates, micro-financeinemergingmarkets, the private lendingbyassetmanagementcompaniesto term lendingbynon-bankssuchasfinancecompanies, include theprovisionofloansandothertypesshort- to thelendingfunctionsofbankssomeextentcould banking The creatingsuchalistwouldimply“one-size- i. However, theIIFbelievesthat,irrespectiveof The IIF Further, therecanbeactivitieswhich,whilenot A dair TurnerShadow Banking andFinancialInstability, CassBusiness ctivities thatcouldbesaidtomimicorapproximate limitations overly generalorblunt. independent financecompanies, andwouldbe and directlendingtoretailborrowers by monoline insurance,theuse ofhedgefunds, with diversecharacteristics and riskssuchas fits-all” approachtoverydifferentactivities , agrees,thoughwithA ” as a term of “ shadow dair Turner’s 19

or“non-bankcredit

subject toprudential regulationsimilarto thatfor that entitiescarryingoutthese activitiesshouldbe term “shadow banking” createsanimplicitassumption “shadow bankingentities”instead. Indeed,usingthe v. equally, whetheranactivityformspartofa iv. iii. ii. There aresimilardifficultieswith attemptingtolist side ofit. characteristics soastomovethemselvesone could createincentivesforfundstoadjusttheir this linebeingcompletelyarbitrary?Any shadow banking”,andhowwouldoneavoid line between“shadow banking”and“non- demand? Whereexactlywouldonedrawthe at oraboveparandisnotredeemableon guarantee ofanyinvestmentbeingredeemed though, unlike abankdeposit,itmightofferno for ittobetreatedasa“shadowbank”even sufficiently deposit-takingcharacteristics banking”. Forinstance,doesahedgefundhave a corefunctiontobeclassifiedas“shadow how closelyanactivitywouldneedtomimic would needtoinvolveajudgmentonjust functions ofbanks,anydefinitionorlist close tomimickingoneormoreofthecore banking” asnotedisthatsomeactivitiescome Given thatthepremiseofterm“shadow these variations. A hardwiredlistwouldnotbeabletopickup much largerandifthemarket reliesonthem. but maybesystem-threateningiftheygrow financial systemifcarriedoutatalowlevel Some activitiesmaypresentlittlerisktothe it iscarriedout,whichwillvaryovertime. systemic riskwilldependonthescaleatwhich financial intermediationprocessandcreates between theseuses. It wouldbeimpracticaltomake adistinction purposes suchasgeneratingincreasedyield. financial intermediationandothermarket instance, securitieslendingcanserveboth context withinwhichittakes place.For risk willdependtoalargeextentonthe intermediation processandcreatessystemic Whether anactivityformspartofafinancial risk. characteristics andthusnotpresentsystemic on itsownitmighthaveonlysomeofthese risk transfer, orthebuild-upofleverage, maturity andliquiditytransformation,credit bank financialintermediationinvolving an activitymightresultinasystemofnon- While incombinationwithotheractivities, banks when this may be neither justified nor the most global figure for “shadow banking”. What is important effective and proportionate option. is to have data at the right level on the amount of There is a way to avoid these difficulties while still securitization, repo, and so forth, in their own right and mitigating the risks from activities that could play a as part of a macroprudential overview of risks. role in credit intermediation and that could involve maturity and liquidity transformation, the build-up An alternative approach of leverage, and/or imperfect credit risk transfer. The As noted earlier, these limitations with definitions and solution is to take an alternative – wider – approach, data suggest that an alternative approach is needed, focusing on non-bank financial activities with the focusing on non-bank financial activities with the 13 potential to create systemic risk and combining an potential to create systemic risk regardless of whether | analysis of the risks from these activities with a they are deemed to be “shadow banking” activities macroprudential view of the risks to the system as a or not and combining an analysis of the risks from whole. By taking this approach, policy makers would the activity with a macroprudential view of the risks inherently include those activities that could play a role from the system as a whole. In Section 3, we suggest a in credit intermediation but would also include any detailed way to do this. non-bank financial activity creating systemic risk in other ways. Thus, not only is an exclusive focus on “shadow banking” unworkable; it is also unnecessary. Indeed, attempting to come up with a list of activities or entities would represent a diversion from the real focus of institute of international finance institute of international policy on the mitigation of risk.

The limitations of data There are also difficulties and limitations in coming up with consistent data across jurisdictions. The IIF agrees with the FSB October 2011 paper that there would be real advantages to consistent and convergent data collection across jurisdictions and would in principle support the idea of coming up with a single figure for macroprudential purposes. However, even if data were available and were consistently collected across jurisdictions, there would be a problem in coming up with a single global or even national figure for the size of the “shadow banking” system. First, there is the difficulty of determining the purpose of activities. Linked to the point made earlier, how, for instance, would it be possible to capture data for securitization used for the purpose of non-bank credit intermediation as opposed to that used for other purposes? Second, even if an entity-based approach were used to generate a figure, would the focus be only on those entities engaged in securities lending that were recognizably “shadow banks”, ignoring the cash management operations of, say, insurance companies or corporates? Given these difficulties, the IIF believes that a single figure, derived from Flow of Funds data or other data, would be at best meaningless and at worst misleading. Indeed, there is no inherent need to have a national or 14 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY Identification, Analysis, and Effective Risk Mitigation Section 3. A risk shouldbebasedonthreestagesofaction: The policyresponsetoemergingsourcesofsystemic proportionate. Policy makersshouldusetheleastinvasiveanddistortionarytool thatachievestheobjectiveofriskmitigation. on arigorouscost-benefitanalysis, andbeverycarefulintheirprecisedesignimplementation.Thekeyisthatpolicy effective inanygivencase.Instead,policymakersshouldtakeacase-by-caseapproach,basedontheassessmentofrisks and It wouldbeextremelydifficult—andarguablyimpossible—tocomeupwithaprecisesetofrulesforwhichtool(s)willmost system. between banksandthenon-banksector, givingtheillusionofsafetybut notaddressingtheunderlyingrisksinfinancial activities—“indirect regulation”—maysometimesbejustified,regulatorsshouldavoidtryingtocreatea“MaginotLine” and regulators, andfirmriskgovernance. Whileincreasedprudentialrequirementsonbanksconnectedtosuchnon-bank including theuseofeffectivecommunicationrisksbyregulators, voluntaryincreaseddisclosurebyfirmstothemarket including conduct-of-businessregulationand,whereclearlyjustified,theuseofbank-likeprudentialregulation,butalso Once riskshavebeenidentifiedandassessed,policymakersshouldmakefulluseoftheriskmitigationtoolsavailable, transparency, andregulation. of theactivity;risksfromandextenttowhichthesearealreadybeingmitigatedthroughdisclosure, that macroprudentialoversight bodies, regulators, andsupervisorsmightuse,settingoutaseriesofquestionsonthenature This informationshouldbeusedtoassesswhetherthereareneworgrowing systemicrisks.TheIIFhasdevelopedatemplate precursor toneworadditionalregulation. The industryneedstobeopeninsupplyingthisinformationbutwithaclearunderstandingthatisnotanautomatic authorities, regulators, andsupervisorshave accesstohigh-quality, relevantinformationtoenablethemassesstheserisks. the focustoactivitiesthatcouldincreasesystemicriskorleadregulatoryarbitrage.Itisimportantmacroprudential The IIFagreeswiththeFSBapproachofbeginningbycastingawidenetfordatagatheringandsurveillancebeforenarrowing risk mitigationtoolsincludingregulation. information; (ii)theassessmentofwhethersuchactivitiescouldposesystemicrisk;and(iii)ifrisksareidentified,use Any policyframeworkshouldbebasedonthreestagesofaction:(i)theidentificationrelevantactivitiesandcollection Key Messages III. II. I. theanalysisofthoseactivitiesandan theidentificationofactivitiesthatmight Where risksare identifiedthatarenot and currently sufficientlycontrolled ormitigated; whether therisksposedbythese activitiesare potential systemicrisksand theassessmentof context inthewiderfinancial systemtheypose combination insideentities,and/orintheir assessment ofwhetherseparately, in made aboutthis; information toallowinformedjudgmentsbe systemic riskandthecollectionofsufficient be judgedaprioritoemergingsourcesof Potential PolicyFramework for banking” ornot. The FSBapproachas currentlydrafted irrespective ofwhetherornot theyamountto“shadow of monitoringalldevelopments inthefinancialsystem, even widermacroprudential approachshouldbetaken Indeed, consistentwiththeanalysis inSection2,an increase systemicriskorlead toregulatoryarbitrage. before narrowingthefocustoactivitiesthatcould casting thenetwidefordatagatheringandsurveillance The IIFagreeswiththeFSBapproachofbeginningby Identification Monitoring monitoring toactiveprudentialregulation. risk mitigationtools,whichmayrangefrom effective andproportionateapplicationof sufficiently controlledormitigated,the , Data Collection , and risks missing activities that could create systemic risk or Analyzing and assessing non-bank where there is regulatory arbitrage. The IIF agrees with financial activities: a possible the seven principles listed in the FSB’s October 2011 paper: template I. Having “an appropriate system-wide oversight It is important to use this information effectively to framework in place”; assess whether there are new or growing systemic risks. While the October 2011 FSB paper proposed II. identifying and assessing the risks on a “narrowing down the focus to credit intermediation continuous basis; activities that pose systemic risks and/or arbitrage that III. Collecting all necessary data and information; undermine the effectiveness of financial regulation” and 15 | that authorities should focus on four key risk factors— IV. Being flexible and adaptable to capture maturity transformation, liquidity transformation, credit innovations and mutations in the financial risk transfer, and leverage—the IIF believes that there system; would be benefit in taking a more nuanced approach, V. Being mindful of regulatory arbitrage; focused on examining a wider range of individual VI. Taking into account the structure of financial activities. markets and regulatory frameworks within With this in mind, the Institute has developed a different jurisdictions; and draft template designed as a “filter” to enable regulators VII. Ensuring appropriate information exchange and supervisors to identify those activities that might across the relevant jurisdictions. create systemic risk. The template is set out below (see Figure 1), together with a diagram showing how such a In doing so, it is important that microprudential framework might be used. In Section 4, the paper sets finance institute of international and macroprudential authorities have access to high- out the results of six case studies designed to show how quality, relevant information and that the industry—in this framework would work in practice. the regulated banking sector and beyond—is open in supplying related data. It is in the industry’s own best In analyzing activities, though, it is important to interest to alert authorities to emerging risk. There define them tightly rather than in a general sense, such should be a clear and stated understanding, though, as “carrying out securitization.” Policy makers need to that specific ad hoc data requests will be issued only look closely at the constituent activities and chains of where there is a reasonable a priori case for judging activities contained in such broad descriptions and their that there may be a source of systemic risk and that its attendant risks. collection is not an automatic precursor to regulation. It is also essential that this analysis is integrated Regulators and supervisors should ensure that with a wider macroprudential analysis of risks to the information is gathered in the most efficient manner economy and the interconnections between activities. possible and communicated to other macroprudential In the lead up to the crisis, there was no systematic and authorities and national regulators. The creation of a integrated assessment of these interconnections. global Legal Entity Identifier (LEI) would be a welcome The IIF agrees that “the system can for a period contribution to this effort, and the IIF welcome the of time appear to promise combinations of lower FSB’s work here. risk, higher return, and greater liquidity that cannot Regulators and supervisors should engage in regular objectively in the longer term be sustained.”20 discussions nationally and internationally with industry, Macroprudential oversight bodies need to be alert to in the regulated banking sector, and beyond. Banks this and ready to act to deflate such expectations. and other service providers have a vested interest from a sound risk governance perspective and from a competitive perspective in alerting regulators and supervisors to new activities or developments that could pose risks, and providing relevant information on these, and indeed they have a duty to do so.

20 Adair Turner, ibid. 16 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY financial activities Figure 1.Outlinetemplateforassessmentofnon-bank How, if all, is the activity currently How good is The broader financial system The entity What are the intrinsic risks What is the activity? How does it work, and regulated? disclosure? context context associated with it? how extensive is it? 2. • • • 1. Natureoftheactivity • • • 8 • 7 Disclosureandtransparency • • 6 • 5 Risksposedbyentitiesundertakingtheactivity • • 4. Risks posedbytheactivity 3. Scale oftheactivity • • • • • T o whatextentdoestheactivityinvolve Generic characteristicsoftheactivity Regulationandotherriskmitigation system Risksposedbylinkageswiththerestoffinancial and howthishasevolved? Are thereanyestimatesofthecurrentscaleactivity What servicesdoesitprovideandtowhom? Who engagesinit? What istheactivity? customers? in conductdetrimental tomarkets, counterpartiesor that theentityundertaking activitydoesnotengage o Conduct–of–businessregulation–which seekstoensure financial resourcestoprotectit againstfailure;or entity undertakingtheactivity has adequatecontrolsand o Prudentialregulation–which seeks toensurethatthe principally: Is theactivitysubjecttodirectregulation? Ifso,isthis Is theactivitycurrentlyregulated? to effectivesupervision? mitigate therisksfromit?Canthisbereliedupon,subject What doestheentitycarryingoutactivitydoto activity andwherethesereside? and regulatorstoassesstherisksassociatedwith Is thereadequatetransparencytoallowmarket participants of entitiesengagingintheactivityconcerned? Are potentiallysystem-wideriskscreatedbythenumber o Withretailcustomers o Withunregulatedentities o Withregulatedentities interaction withtherestoffinancialsystem? In whatwaysandtoextentdoestheactivityinvolve account istaken oftheentitiesinwhichitistypicallycarriedout? Are therereasonstobelievethattherisksassociatedwithactivity maybesignificantlymodifiedwhen detriment wouldensue? .Who wouldbeaffectedbysuchafailure,andwhat how doesithappen? .What wouldcharacterizea“failure”inthisactivityand entities The facilitationofoneormoretheabovein“receiving” The useofcredittransferbytheprovidingentity The useofmaturitytransformationbytheprovidingentity The useofleveragebytheprovidingentity

• • • • • • • • • • • • • wider economy? What potentialbenefitsdoesitprovidetothe financial system? What potentialbenefitsdoesitprovidetothe or thattheindustryhasputin place? entity carryingouttheactivity hasputinplace Are thereotherformsofriskmitigation thatthe potentially systemicdimensions oftheactivity? regulation, doesthistake accountofany o Iftheactivitiesaresubjecttodirect orindirect concentration rulesforregulatedentities? risk management,capital,liquidity, or o Isit,forexample,reflectedincounterparty regulation)? in theregulationofcounterparties(indirect Are theactivitiesinvolvedspecificallyreflected activity/product? encourage market disciplineinthe useofthe .Are disclosuresgenerallyadequateto system? of thelinkageswithrestfinancial significantly modifiedwhenaccountistaken the risksassociatedwithactivitymaybe .In general,aretherereasonstobelievethat activity? interdependencies createdorintensifiedbythe Are thereparticularinterconnectionsor participants inthefinancialsystem? (c) Underminethecorefunctionsofother and/or exposures elsewhereinthefinancialsystem; (b) Createdisproportionateorunanticipated and/or (a) Erodeconfidenceinthefinancialsystem; would therebeforsuchfailureto: market infrastructure?Specifically, whatscope .Could failurehaveadetrimentalimpacton Who currentlycollectsharddataonit? entities’ (regulatedorunregulated)riskprofiles failure canhaveamaterialimpactonother The provisionofservicesorproductswhose customers The provisionof“deposit-like” facilitiesto The useofcollateralbytheprovidingentity entities The facilitationofcredittransferbyother DO WE UNDERSTAND THE GET THE DATA ACTIVITY? Q1 & 2 AND OTHER NO INFORMATION DO WE HAVE THE DATA WE NEED? Q3

YES 17 |

DOES THE ACTIVITY POSE SYSTEMIC RISK? Q4 AFTER ALLOWING TIME FOR ACTIONS TO TAKE EFFECT ARE THE RISKS MODIFIED BY THE ENTITY THAT AND MONITORING THEM, CARRIES IT OUT? Q5 REVIEW WHETHER ACTIONS ARE THE RISKS MODIFIED WHEN ACCOUNT IS HAVE WORKED TAKEN OF THE LINKAGES WITH THE REST OF THE FINANCIAL SYSTEM? Q6 IS THERE ADEQUATE DISCLOSURE AND TRANSPARENCY? Q7 NO IS THIS SUFFICIENT TO ALLOW RISKS TO BE institute of international finance institute of international ADEQUATELY ADDRESSED? Q7

IMPROVE DISCLOSURE YES

SEEK MEASURED POLICY RESPONSE IS THE ACTIVITY CURRENTLY REGULATED? Q8 IS CURRENT REGULATION EQUAL TO THE RISK? Q8

NO YES

NO SYSTEMIC RISKS IDENTIFIED AT THIS STAGE. CARRY OUT CONTINUED MONITORING. ASSESS REGULARLY OR IN THE LIGHT OF MATERIAL CHANGES TO THE SCALE OR NATURE OF THE ACTIVITY TO SEE WHETHER THIS CONCLUSION IS STILL JUSTIFIED 18 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY the choicemade, theroleofeffectivesupervision guidance ontheir usage.Inaddition,irrespective of Micro- orMacroprudentialRegulationTools Conduct-of-Business Tools Non-Regulatory Tools tools thatcouldbeused,includingthefollowing: not bethemostcost-effective.Thereareanumberof but clearlynottheonlyone,andsuchanapproachmay interdependency thatmostexposesthesystemtorisk. regulators shouldattempttotargettheactivityor needed. Intacklingrisksthatemergesystem-wide, and proportionateuseofriskmitigationtoolswillbe absent orinadequatetoaddresssuchrisk,aneffective of activitiesandifitrevealsthatregulationiseither of systemicriskinaparticularactivityorcombination tools Using VIII. VII. VI. V. IV. III. II. I. We exploreeachofthesebelowand provide Prudential bank-styleregulationisanoptionhere If theaboveassessmentidentifiespotentialsources

thisapproachcouldinvolveinsistingon improveddisclosureofrisksbyfirmsto t The useofmacroprudentialtools. activity (indirectregulation); and banks connectedtoentities engaging inarisky Increased prudentialrequirementsonregulated banks; consistent withtheregulatoryapproachto The prudentialregulationofnon-bankentities business regulation. altogether; orotherformsofconduct-of- necessary limitingorproscribingtheactivity of activitieswithinthesamefirm,where conflicts ofinterests;rulesontheseparation effective disclosure;rulesontheavoidanceof regulated banks. sector orinentitiesconnectedtoit,including outside theprudentially–regulatedfinancial standards forentitiesengagedintheactivity The creationandadoptionofindustry-wide to it,includingregulatedbanks;and engaged intheactivityorentitiesconnected Improved firmriskgovernanceeitherinentities investors; public bysupervisors; effective argeted communicationofriskstothegeneral risk mitigation

had regulatedbanksstronger riskmanagement goes intomoredetailonthis approach.Forexample, (November 2011). 22 FSB Supervision: AnIndustryPerspective 21 InstituteofnternationalFinance(IIF)Report, A A should notbeoverlooked. AstheIIF’sJuly2011 paper on theIntensityandEffectiveness ofSIFISupervision management. TheNovember2011 FSBProgressReport that theyputinplacemoreeffectivesystemsand Supervisors caninsistonfirmsdoingthisandverify in waysthatallowthembettertocontainrisks. to strengthentheirriskmanagementandgovernance supervision orregulation,theremaybeaneedforthem to increasedisclosure. regulation. Onthisbasis,theindustryshouldbeready disclosure shouldnotbeanautomaticprecursorto least asafirststep.Aswithdatacollection,increased arrangements mayhaveavaluableroletoplay, at clear, andrelevant.Wheretheyarenot,voluntary can insistondisclosurebeingmademoreprominent, where firmsarealreadysubjecttoregulation,regulators in thediscussionofconduct-of-businessregulation, the risks,andpotentialdownsides.Asnotedbelow have aclearunderstandingofwhattheyarebeingsold, investment products,forexample,investorsshould not adequate,itmustbesteppedup.Inthecaseofall is essentialinanycircumstances.Wheredisclosure that isusedtosupportsuchcommunications. confident inthequalityofanalysisandjudgment financial products.Market participantsneedtobe among thepublic,thusstigmatizingpotentiallyuseful communications toavoidstokingunwarrantedconcerns regulators shouldbecarefulintheformoftheir certain activities,orbetterpricerisks.Nevertheless, the industrytoputsafeguardsinplace,limitorcease explanation ofconcerns,regulatorscanencourage By disclosingrelevantinformationtogetherwithan and immediatewaytomitigatethematanearlystage. by regulatorsand/orsupervisorscanbeaneffective company. alternative perspectiveonwhatisgoinginthe at anearlystageandgivingmanagementavaluable as awhole,identifyingpotentialrisksandproblems effective oversightoftheriskmanagementfirm compliance withregulationsandmustprovidean supervisory system.Supervisiongoesbeyondensuring improved industrypracticesandastrengthenedglobal financial system,andneedstobepartneredwith underlined, regulationalonecannotcreateasafer chieving EffectiveSupervision:AnIndustryPerspective In casesinwhichfirmsarealreadysubjectto A The useoftargetedpubliccommunicationrisks dequate disclosureofrisksandotherinformation Progress Reportonthe IntensityandEffectivenessofSIFISupervision (July 2011). chieving Effective 22

21

processes in place to monitor and mitigate their There may be occasions in which increased exposures to off-balance-sheet vehicles, the crisis prudential requirements on regulated entities connected might not have developed in quite the way it did. Had to entities engaging in a risky activity—indirect managers of institutional cash pools conducted more regulation—will be the most effective option, as has effective assessments of the risks of a collapse of the been done, for instance, on rules on risk retention in repo or securities lending markets and adjusted the securitization. This regulation may be effective in cases haircuts or margin that they were prepared to accept at in which there is a clear or perceived linkage between an earlier stage, much of the damage could have been the bank and the entity engaged in the activity and averted. in which the bank provides either a “guarantee” or is involved in the selection of the assets underlying the 19 The development of industry-wide standards and | agreements may have a role to play, particularly in securitization. the case of entities that are not subject to regulation, While indirect regulation may sometimes be the subject to effective verification by supervisors that these most appropriate response, there are limitations to such are being complied with. an approach. In some cases, because of its indirect Going beyond these approaches, there may be a case nature, it may be less effective than direct regulation for the use or increase of conduct-of-business regulation in addressing the inherent risks embodied in the focused on the activity. This regulatory option could activity. This may be compounded by the fact that vary from requiring investors to be given timely, imposing additional indirect regulation will have cost/ accurate, and effective information on the nature of the competitiveness implications, putting further pressure product or instrument that they are investing in, such on banks’ business models. Further regulation on that they are aware of potential risks, to the avoidance the already regulated sector may, other things equal, institute of international finance institute of international of conflicts of interests and the separation of activities actually increase the incentives for the non-bank sector within the same firm, to, at the other extreme, limiting to develop. or proscribing the activity altogether. The intensity Policy makers should therefore be extremely careful of this regulation can be adjusted (i.e., by increasing in considering whether to use indirect regulation. mandatory reporting requirements or disclosure). Otherwise, it risks becoming a “Maginot Line” between If regulators are still concerned about the risks, banks and the non-bank sector, giving the illusion of where the systemic risk assessment identified particular safety but without addressing the underlying risks. risks from certain aspects of the activity rather than Alongside addressing the risks from activities, the activity itself as a whole, there may be a case for and as Question 6 of the above template suggests, regulators insisting on the alteration of certain limited regulators will need to be attentive to system-wide aspects of the activity or how it is conducted, or of risks and interconnectedness, together with any certain limited aspects of the infrastructure supporting potential procyclicality that these might lead to. While the activity, as a condition for allowing it to take place. good risk governance in firms and indirect regulation In all this, effective supervision has a major role to play. may mitigate these to some degree, regulators and If a strong case can be made that such measures are supervisors should pay close attention to the potential unlikely to be fully effective in mitigating potential of macroprudential tools, which if properly designed, systemic risks, prudential regulation should be can be highly effective in tackling system-wide risks. considered. There are two main routes for this: direct Nevertheless, in designing such macroprudential and indirect regulation. tools, policy makers need to be aware of the need to Where the assessment indicates risks from the entity target them effectively and to avoid unintended or carrying out an activity that would not be effectively perverse consequences just as much as they would mitigated by action focused on that activity or where when designing prudential or conduct-of-business other measures have failed, direct regulation may be requirements. justified. Nevertheless, this should not be an automatic One potential macroprudential tool that has been response to any new market innovations outside suggested, for instance, is the use of minimum initial the regulated banking sector. Neither should it be margins or haircuts to dampen the procyclicality of assumed that it is intrinsically preferable to, or more secured finance markets such as repo. The principle effective than, other tools for risk mitigation. It should that haircuts should remain broadly risk based while be introduced only once regulators have sufficient also being calculated on a basis that makes them less information and analysis to satisfy themselves that it is procyclical is sound. However, in practice, devising indeed the most balanced and cost-effective approach. a formula for the setting of such haircuts is likely to 20 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY of it. supervisor shouldbereadytobantheactivityorparts costs andrisks.Inextremecases,theregulatorand/or any suchbenefitismorethanoutweighedbythe inevitably becasesinwhichtheregulatorjudgesthat clear benefitsandshouldbeencouraged,therewill banking sector. ensure consistencywithapproachesadoptedtowardthe scenario isassumedateachturnandtheneedto in adownturnwithoutrequiringthattheworst-case against theriskisappropriatelyreflectiveof the rightbalancebetweenensuringthatcapitalheld be extremelydifficultbecauseoftheneedtostrike Table 1.TheApplicationandEffectivenessofTools Solutions Non-Regulatory Solutions Conduct–of–Business Solutions Microprudential Solutions Macroprudential While manyformsoffinancialinnovationbring activities. and monitoringof Increased disclosure management. Enhanced risk standards. Industry-wide risks. communication of T aspects. alteration ofcertain intensification or necessary, require requirements. If conduct–of–business Make subjectto prudential regulation. Make subjectto buffers). additional capital to entities(e.g., prudential measures Application of measures toactivities. Application of entities. interactions withother Closer regulationof argeted public Activities Largely Unregulated Encourage. Encourage. Yes, butverify. Yes. benefit analysis. nature subjecttocost- If justified—scopeand benefit analysis. If justifiedandaftercarryingoutrigorouscost- microprudential tools). regulation (butwithmacroprudential not T E.g., marginrequirementsthatapplytoallmarket participants. If justifiedandlikely tobemosteffective solution. antamount tomakingsubject prudential designing aframeworkandtoolsdynamicenoughto damages goodandbadformsofinnovation,butinstead analysis. Therightanswerisnotabluntrulethat the abovetemplateandonarigorouscost-benefit approach, basedontheassessmentofrisksmadeusing Instead, policymakers shouldtake acase-by-case which toolswillbemosteffectiveinanygivencase. impossible—to comeupwithaprecisesetofrulesfor effectiveness oftoolsmightdiffer. regulation. T it issubjecttoconduct-of-businessorprudential out theactivityisalreadyregulated,andifso,whether depending onwhetherornottheentitythatcarries These toolswillhavedifferentimplicationsandeffects, Deciding It wouldbeextremelydifficult—andarguably Regulation Conduct–Of–Business Activities SubjectTo supervision. of regulation/ Require aspart Encourage Yes andsupervise. Yes Yes able 1showshowtheapplicationand how to use the Regulation Subject ToPrudential Activities/ Entities supervision. of regulation/ Require aspart supervisions. a focusofenhanced Require and/ormake Yes andsupervise. Yes. and supervisors. prudential regulators coordination with Yes, subjectto increased.) Requirements couldbe (Already subject. Yes. tools incentivize good forms of innovation and penalize bad Where possible, policy makers should initially opt ones. for the approach that is least likely to distort markets In making the broad choice of risk mitigation tools, and undermine benefits and thus allow less burdensome policy makers should ask themselves the following: and market-based solutions to be tested first, and having monitored the effects of this approach and • Where does the risk assessment in Questions 4-6 of only where it has demonstrably not succeeded or is the template indicate that the systemic risk primarily clearly unlikely to succeed, proceed to more aggressive resides? Is it in the activity, the combination of approaches such as (more) regulation. Table 2 shows a activities inside the entity, or in the system as a tentative typology for how they might do this. whole? 21 Nevertheless, the choice of policy response | • What were the answers to Questions 7 and 8 on should always depend on its effectiveness and not disclosure, transparency, and existing regulation? the seriousness of the problem. So, if it could be Are disclosure and transparent sufficient? Have demonstrated that even where there was a severe other regulatory solutions been tried? How effective concern, non-regulatory tools would be more or as have they been? effective as regulatory tools, it would be more sensible • How severe is the risk? to use them on the grounds that they would be less likely to distort markets and undermine benefits. • How have other national policy makers and regulators addressed similar risks from similar activities, including in the prudentially-regulated sector?

Table 2. Use of Risk Mitigation Tools finance institute of international Degree of Activity Entity System Systemic Risk Low • Warn industry informally of concerns. • Informally call for greater disclosure both to investors and supervisors. • Tell regulated entities to increase risk governance. • Promote industry standards. Moderate • Communicate concerns • Communicate concerns • Communicate concerns publicly. publicly. publicly. • Increase supervision of • Increase supervision of • Increase supervision of regulated entities engaged in regulated entities connected regulated entities. activity or connected to entities to entity. engaged in activity. Growing • Consider altering certain parts • Increase supervision of • Increase supervision of of the activity. regulated entities connected regulated entities. • Make activity subject to to entity. • Make limited use of some conduct–of–business • Consider the use of macroprudential tools. requirements—disclosure to prudential supervision. investors, registration and reporting requirements etc. • Increase supervision of regulated entities engaged in activity or connected to entities engaged in activity still further. Elevated • Increase supervision and regulation. • Increase supervision of • Give serious consideration to the use of prudential supervision. regulated entities. • Make increased use of macroprudential tools. High • Make any entity engaged in activity subject to prudential • Increase use and severity supervision. of macroprudential tools. • Give consideration to the use of indirect regulation on prudentially–regulated entities. Severe • Increase capital and other requirements, intervene, or ban activity. 22 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY Recommendations of theFinancialStabilityBoard(27October, 2011). 23 over another. unnecessary layeringoverofoneformregulation of-business regulatorstoavoidpolicyconfusion,orthe authorities, micro-prudentialregulatorsandconduct- needs tobeclosecoordinationamongmacroprudential system. and forboththenon-bankregulatedbanking and implementationofriskmitigationtoolsasawhole principles listedintheOctober2011 FSBReport: design andimplementation.TheIIFagreeswiththe tools, policymakers shouldbecarefulontheirprecise V. IV. III. II. I. Further, indesigningandimplementingthem,there This approach,though,shouldapplytothedesign Once thedecisionhasbeentaken onthechoiceof Shadow Banking: StrengtheningOversightandRegulation: A light ofexperience. adjustments toimprove themasnecessaryinthe measures afterimplementationandmake assess theeffectivenessoftheirregulatory structures andsystemsacrossjurisdictions. take dueaccountofdifferencesbetweenregulatory border arbitrageopportunitiesagainsttheneedto address commonrisksandtoavoidcreatingcross- balancing theneedforinternationalconsistencyto designed andimplementedinaneffectivemanner, Effectiveness: Regulatorymeasuresshouldbe to emergingrisks. measures shouldbeforwardlookingandadaptable Forward-looking andadaptable:Regulatory the financialsystem. proportionate totherisksshadow bankingposesto Proportionality: Regulatorymeasuresshouldbe shadow-banking systemcreates. designed totargettheexternalitiesandrisks Focus: Regulatorymeasuresshouldbecarefully ssessment andreview:Regulatorsshouldregularly 23 economy. the benefitstoinvestors,borrowers,andwider objective ofriskmitigation.Thatisthewaytopreserve invasive anddistortionarytoolthatstillachievesthe it beproportionate.Policy makers shouldusetheleast and implementation,thekey toeffectivepolicyisthat cost-benefit orimpactanalysis. balanced againsttheriskcontrolbenefitsbyusinga system andwidereconomypolicyshouldbe should considerthecumulativeimpactonfinancial from onepartofthefinancialsystemtoanother. They arbitrage andwhethertheywillsimplydisplacerisk measures, including whethertheywillleadto regulatory implies carefullyconsideringtheimpactofpotential including thosesubjecttoprudentialregulation.This with thetreatmentofsimilaractivitiesorentities, effectiveness ofthewholeapproach. international regulationcouldjeopardizethe the veryleast,absenceofconflicts.Fragmented jurisdictions toensureinternationalconsistencyor, at should consultwiththeFSBandpolicymakers inother However, aboveall,andlinkinganalysis,design, Policy shouldalsobedesignedsoastoconsistent In linewithPrincipleV, nationalpolicymakers Section 4. Implementing the Possible Policy Framework: Case Studies

Key Messages 23 As a way to demonstrate the potential value of the framework proposed in Section 3, illustrating how it would work in | practice, and testing it out against real-world examples, the Shadow Banking Advisory Group explored how the framework could be applied in six cases. The choice of these case studies should not be taken to suggest that the IIF sees these activities as “shadow banking”. Indeed, what the studies underline is that policy makers would be much better advised to focus on non-bank financial activities and assess whether they present systemic risk rather than trying to decide whether the activities should attract the label “shadow banking”. The case studies demonstrate the wide variety of non-bank financial activities. They underline that non-bank financial activities often – indeed usually – emerge for sensible and practical reasons but can also emerge as a direct response to regulation.

Some—but not all—cases show that, without proper risk mitigation, there is a potential for systemic risk. Nevertheless, in finance institute of international all six cases, since the financial crisis, there have been changes to regulation, risk governance, and disclosure designed to address weaknesses revealed by the crisis or by earlier problems. While these studies are not exhaustive, they do show that a considerable number of measures have already been taken in this area. The studies demonstrate, though, that policy makers and industry need to keep monitoring the situation and assessing the risks, including from the size of the market as a whole.

The IIF believes that the policy framework outlined felt that even in the relatively condensed versions in Section 3 could be effective and if adopted set out in the Annex, the cases shed useful light on internationally, avoid many of the pitfalls in this the different nature of activities and potential risks difficult area. involved. The Group will indeed rely on the framework As a way of demonstrating its benefits, illustrating in developing its responses to any detailed national, how it would work in practice, and testing it out against regional or international initiatives on non-bank real world examples, the Shadow Banking Advisory financial activities including “shadow banking”. Group explored how its proposed policy framework The choice of these studies should not be taken to could be applied in six cases. suggest that the IIF sees these activities as “shadow The cases were selected with a view to covering banking”, which, as Section 2 has shown, has severe both a wide range of activities in this area and also limitations as a practical concept. Indeed, what the to testing the global applicability of the approach in studies underline is that policy makers would be much both developed and emerging markets. In line with better advised to focus on non-bank financial activities the IIF’s rejection of the attempt to produce lists of and assess whether they present systemic risk rather “shadow banking” entities or activities, and given the than try to attach particular labels to them. many non-bank financial activities, the IIF opted for The six cases are a representative sample. For each case, there is an I. MMFs in the United States, explanation above the summary of why it was chosen. II. european residential mortgage-backed Further, the IIF would not claim that the individual securities (RMBS), studies represent a full application of the framework. Any assessment by regulators of a particular activity III. Repo markets, would have to go into considerably more detail and be IV. Securities lending, considerably more exhaustive. Nevertheless, the Group V. chinese trust companies, and 24 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY Exchange-Traded Funds(ETFs) 24 FSB Effective riskmanagement,disclosure, andtransparencyare nature ofthecollateralheldby referencetoitscreditrating. the collateraltomarketonadaily basis,anddisclosingthe mitigated throughover-collateralizing therisk,marking exist inseveralotherinvestment fundsandareeffectively counterparty risksfromETFs.Nevertheless,thesefeatures such assets. fund assets.InEurope,ETFsaccountforlessthan3%of account forapproximatelyonly9%ofglobalinvestment despite theattentionthattheyhavereceived.ETFassets in generalcancreatesystemicriskorETFsasasubset, fixed incomesecurities. extensions ofcredittakeplaceintheformpurchasing a significantconnectionwiththepaymentsystem.Most bank does.Investmentfundsdonottakedeposits,orhave Most investmentfundsdoverylittlethatmimicswhata certain extent,mostothersdosotoamuchlesserextent. or approximatethedeposit-takingfunctionsoffundstoa investment fundsbeyondMMFs. purposes ofthepapertherewasnoneedforacasestudyon was aneedtoexaminethembutconcludedthatforthe debate, theShadowBankingAdvisoryGroupfeltthatthere types ofinvestmentfunds,mostnotablyMMFs. noted inSection1,therehavebeenconcernsaboutother investment fundsindustryratherthanspecificallyETFs.As issues raisedareonesthatgenerallyexistintheentire ETFs.” complexity andrelativeopacityofthenewestbreed they mayalsogeneratenewtypesofrisks,linkedtothe easier accesstospecificassetclassesorriskexposures, participants, includingcostefficiency,diversificationand ETFs bringanumberofbenefitstoinvestorsandmarket risks posedbyETFsinparticular.TheFSBarguedthat“While Securities MarketsAuthority(ESMA)consideredthepossible leveraged” Exchange Traded Funds(ETFs)thatprovide creditorare Commission GreenPaper“InvestmentFunds, including in someanalyses,mostnotablytherecentEuropean identified sofarintheFSB’sworkon“shadowbanking”, Even thoughinvestmentfundshavenotbeenexplicitly Box 3. VI. We agreewiththeFSBinpointingoutpotential Secondly, thereislittletosuggestthatinvestmentfunds As Section2notes,whileMMFscouldbesaidtomimic Given thecentralityofMMFsin“shadowbanking” Even wherethefocushasbeenonETFs,though, Further, two2011analysesbytheFSBandEuropean 24 Potential FinancialStabilityissuesarising fromrecenttrendsin Investment Funds Sofoles inMexico; havebeenincludedunderthislabel. (12April,2011). summarized below. risks. template willput theminastrongpositionto analyzethese become concernedaboutincreasing risksinthisarea,the Group in2011wasanexcellent example.Ifregulators the workofFSB,ESMAand theSeniorSupervisors’ monitor developingtrendsinthese markets.Inthisregard, analyzing riskstothefinancialsystem. they provideanexampleofwhythislabelisunhelpfulin Nor dotheyseemtoamount“shadowbanking”.Indeed systemic risktothefinancialsysteminnearfuture. of marketmakersingeneralcoversthisactivity. making activityinlistedsecurities,andprudentialoversight Authorized Participants)issimilartoanyothermarket– (including theETFcreationandredemptionprocessvia credit exposure.Further,market–makingactivitiesinfunds well astoBaselriskweights,andistreatedlikeanyother by bankstofundsissubjectsupervisoryoversightas being thoseoftheinvestor.Inaddition,creditextension for investmentfunds,astherisksareclearlyviewed and MMFs,thereisverylittleevidenceofsponsorsupport systemic risk.UnlikethecontroversysurroundingSIVs of thefinancialsystemdonotseemtobesources MMFs CaseStudy. regularly updatesrulesrelatedtofunds,asnotedinthe provisions willalsoaffectinvestmentfunds.TheSEC non-UCITS fundsinEurope,andexpectedrevisionstoUCITS Investment FundManagersDirective(AIFMD)willcoverall reviewed andupdated.Forexample,theEU’sAlternative also benotedthatfundregulationsarecontinuallybeing as wellthepublicationofnetassetvalues.Itshould evidenced byprospectuses,semi-annualandannualreports, (CFTC). Fundsalsohavetransparencyobligations,as regulated bytheCommodityFuturesTradingCommission commodity-based ETFsthatinvestincommodityfuturesare SEC andmustcomplywithitsapplicablerules.Inaddition, held investmentfundsintheU.S.areregisteredwith transparency, marketing,andfundgovernance.Publicly setting minimumstandardsarounddiversification, Investment inTransferableSecurities(UCITS)Directive funds arecompliantwiththeUndertakingsforCollective standards ofregulation.WithintheEU,mostinvestment be effectivelymitigated. investment funds.CaseStudy4detailshowtheseriskscan the risksfromsecuritieslending,thesearenotuniqueto the mosteffectivemitiganthere. The fullstudiesareannexed tothispaperbutare Of course,regulatorsmustbe vigilant andcontinueto As such,InvestmentFundsseemunlikelytopose Interlinkages betweeninvestmentfundsandtherest Further, investmentfundsarealreadysubjecttohigh Equally, whiletheFSBwasrighttodrawattention Case Study 1. Money Market Funds Paper markets. This reduction can cause disruptions in the United States to these markets, creating a sudden liquidity shortage for financial institutions dependent on the rolling The issue of MMFs has featured centrally in the discussion over of short-term debt. This disruption can, in turn, on shadow banking” The International Organization of lead to further liquidity stresses in those institutions Securities Commissions (IOSCO) has recently launched a or associated entities such as conduits or Structured consultation on possible systemic risk from MMFs, their Investment Vehicles, leading to further stress role in the financial crisis, and possible policy options for throughout the chain of credit intermediation. mitigating risks. The IIF therefore felt that it would be useful to examine MMFs. Given differences in characteristics of MMFs have come to play a central role in the 25 MMFs and regulation between jurisdictions, the case study financial system. In the lead-up to the financial | focused on MMFs in the U.S. rather than as a whole. crisis, institutional cash managers and other investors relied on MMFs to place easily redeemable funds, and MMFs in the U.S. are open-ended mutual funds borrowers relied on them as a source of short-term that invest in high-quality short-term debt—such as liquidity. This reliance, when combined with a market U.S. Treasury securities, commercial paper, certificates shock, that may cause systemic risk. of deposit, and repo. They aim to maintain a stable net asset value (NAV) of $1 per share and are redeemable Even before the crisis, there was substantial on demand. disclosure to investors and reporting to regulators. MMF prospectuses explain how funds are established, their MMFs are bought by a wide variety of investors investment strategies, and risks and rewards attributable and gained widespread popularity because of their to investors and make it clear that MMFs are not bank ease of use and conservative approach, including deposits and are not guaranteed by the Federal Deposit institute of international finance institute of international safety, liquidity, and simplicity. In normal economic Insurance Corporation or any other government agency. circumstances, they offer a safe non-bank deposit alternative with slightly higher yields for those looking In the light of the crisis, rule changes now require to invest funds on a short-term and relatively liquid MMF managers to increase the level and clarity of basis. disclosure to investors and their warnings of the potential risks to enable investors and regulators In theory, all the credit risk is passed on to investors. to assess the associated risks. In addition, MMFs However, in practice, the reputational risk from falling themselves have made redoubled their efforts to ensure below the $1 NAV – known as “breaking the buck” - that investors are aware of potential risks and know created an incentive for sponsors of MMFs to intervene that they are not dealing with bank deposits. to support them even when located in legally separate structures and absent any formal requirement to do so. While there is a legitimate question as to whether potential risks have been sufficiently mitigated or It has been suggested that MMFs have the potential whether further regulatory measures are needed, given to contribute to disruptions to the financial system and the extent of the recent regulatory changes, it may be the wider economy, citing losses triggered during the more sensible to see first how they perform. At the very financial crisis. Given their limited capital cushions, least, the evidence from the way in which MMFs have MMFs can be vulnerable to large external shocks such so far navigated the European sovereign debt crisis as a credit downgrade of the fund, a rapid increase suggests that there is no imminent danger and at most in interest rates, or the default of a large debtor. This that the reforms have been effective. vulnerability was shown in September 2008 when Lehman Brothers declared bankruptcy, dramatically The financial crisis has also demonstrated the close affecting the market values of the commercial paper links that exist between MMFs and other parts of held by the MMFs. the financial system. This issue may require further consideration, with the goal of mitigating potential An actual or prospective breaking of the buck can systemic risk. lead to a loss of investor confidence in other MMFs, resulting in large-scale redemptions. Faced with this possibility, other MMFs may be forced to sell assets at reduced prices to meet the volume of redemptions. Redemptions can reduce funding to MMFs, resulting in liquidity crunches leading to further market stress. They are also likely to reduce funding to the repo, Asset-Backed Commercial Paper, and Commercial 26 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY credit risktransfer isrobust;(iii)intheunderwriting it—and consequently theextenttowhich the implied transformation; (ii)inthebank supportattachedto securitization andwhetheror nottheyeffectmaturity that therearesignificantvariations (i)intheformof However, theanalysisincasestudymakes itclear the interconnectionswith widerfinancialsystem. securitization structuresamplifiedthecrisisdueto of certainassetclasses,andinmarkets, result ofbadexperienceswiththesecuritization lower costthanotherwise. financing canbemadeavailabletohomebuyersat mobilized thatwouldotherwisebequiteilliquid,and (including onacross-borderbasis).Assetscanbe flows betweensaversandinvestorsmoreefficient well–operated RMBSmake intermediationoffinancial investment products.Fortheeconomymorewidely, than wouldbepossiblewithaconventionalarrayof to matchtheirpreferencesintheseareasprecisely rate, currency, andmaturity exposures—allowingthem degree ofliquidity—diversificationcredit,interest the abilitytotailorrisk/returntradeoffsanddesired smaller amountofcapital.Forinvestors,RMBSoffer originally offeredakey meansoffundingusingamuch term RMBSwithaveragelivesof1-5years. took placealmostexclusively throughtheissuanceof appetites. InthecaseofEuropeanRMBS,funding their ownbalancesheetsorsoldtofundswithhighrisk subordinated trancheswereeitherretainedbybankson of investorsinthehigher-ratedsecurities.The a trickle-downrepaymentstructuretothebenefit different creditcharacteristicsandtypicallyprovide securities—or tranchesoftheRMBSstructure—have from thesamepoolofmortgages.Thesemultiple residential mortgages.Morethanonesecurityiscreated come fromtheborrowersofresidentialdebt. RMBS receiveinterestandprincipalpaymentsthat mortgage loansthroughsecuritization.Holdersofan represents aclaimonthecashflowsfromresidential on whethersystemicriskwillbecreated. financial institutions.Thesedifferenceswillhaveanimpact can, andhas, differedwidelyacrossjurisdictions, sectors, and thus illustratesthattheaimandpracticeofsecuritization securitization inaspecificgeographicalarea.Thecasestudy that itwouldbeusefultoexamineataspecifictypeof Rather thancovering securitizationingeneral,theIIFfelt Mortgage Case Securitization acquiredapoorreputationas For banksandothermortgagelenders,RMBS The RMBScomprisesalargenumberofpooled RMBS areatypeofasset-backed securitythat Study -Backed 2. European Securities Residential

future date.Thesubsequent repurchaseisknownasa the purchaserforanagreed-upon priceonadesignated securities withacommitment tobuythembackfrom therefore feltthatitwasessential toexaminetheactivity. feature inthefinancialcrisiswas a“runonrepo”. TheIIF above. LordTurner inparticularhasarguedthatamajor in theFSBconsultationonsecuritieslendingandreponoted central placeinthe“shadow banking”debate.Repos feature A appears likely tocontinueforseveralyears. growth, especiallyinEurope,wherebankdeleveraging ability ofthesecuritizationmarkets tosupportcredit to continueimpactassessmentofthereformson new risksanddevelopments.Policy makers alsoneed these measurestotake effect,whilebeingattentiveto on thetradingbook. diligence requirementsinCRDIIandIII;rules haircuts applicabletoasset-backed securities;due Directive (CRDII);increasesinEuropeanCentralBank under Article122aoftheE.UCapitalRequirements notably theintroductionofriskretentionrequirements designed toreducetherisksfrommarket, most initiative. by developingthePrimeCollateralisedSecuritisation to restoreinvestorconfidenceinsecuritizationmarkets the EuropeanSecuritisationForumhavebeenworking European FinancialServicesRoundtableandAFM/ same timerevitalizingthesecuritizationmarket. The industry andregulatorstoaddressthesewhileatthe crisis therefore,therehasbeenafocusbyboththe were revealedthatneededtobeaddressed.Sincethe systemic. interconnectedness withthewidersystemwerenot activity, its combinationwithotheractivities,andthe suggests that,forEuropeanRMBStherisksfrom market amountedtoonly0.07% ofallissues.This is notablethatdefaultratesintheEuropeanRMBS underwriters androbustunderwritingstandards.It tool, withappropriateengagementbyEuropean securitization actedprimarilyasalegitimatefunding Development (OECD)hasacknowledged,inEurope, significant impactonthelevelofrisk. of thedisclosureandtransparency. Allofthesehavea standards oftheunderlyingloans;and(iv)inextent Case s withMMFs, repois—rightlyorwrongly—occupyinga A repurchaseagreement It wouldbeprudentforpolicymakers toallow In addition,manyregulatorychangeshavebeen Nevertheless, evenforEuropeanRMBS,weaknesses As theOrganisationforEconomicCooperationand Study 3: Repo , orarepoisthesaleof markets reverse repo. The agreement represents a collateralized Case Study 4. Securities Lending loan whereby the securities purchased by the buyer Securities lending is also occupying a central place in the constitute collateral to protect them against the seller debate. The FSB workstream on securities lending and repo failing to meet its repayment obligation. recently issued an Interim Report on their work, looking at The current policy discussion should not lose market practice and arguing that there were several financial sight of the fact that the activity is central to the stability issues. effective functioning of financial markets and the Securities lending involves a transfer of securities wider economy. Repo markets are vital to meeting the (e.g., shares or bonds) to a third party (the borrower), financing needs of a range of financial institutions, who will provide the lender with collateral in the form 27 including banks, broker-dealers, insurance firms, and | of shares, bonds, or cash. The borrower pays the lender asset management firms. For investors such as MMFs, a fee each month for the loan and is contractually hedge funds, insurance companies, and pension funds, obliged to return the securities on demand within the repos provide an opportunity to invest cash for a standard market settlement period. The borrower will customized period of time on a secured basis. In the also pass over to the lender any dividends/interest United States, the Federal Reserve, through the Federal payments and corporate actions that may arise. Open Market Committee, transact in repos to either add to or withdraw from reserves to stabilize interest rates. Securities lending is a well-established investment technique generating important incremental revenues Nevertheless, the crisis showed that there are risks for long-term institutional investors, driven by investor connected to the repo market. The use of collateral, demand to hold safe, liquid assets, and in this regard while highly desirable, complicates these risks. The is an important contributor to financial stability. issue, though, is how to manage these risks and the Securities lending improves the reliability of the trade finance institute of international special features of the repo market. settlement process as institutions’ ability to borrow Further, regulators need to be much more precise securities helps to reduce settlement failures. This can about the nature and scale of those risks. The evidence enhance market liquidity indirectly as it contributes to does not justify the idea that there was a “run on repo” investor confidence when trading. during the crisis and in fact suggests that the effects of Securities lending is already a regulated activity changes in haircuts and margins were much smaller and in many respects. It is fully collateralized, marked to that the role of repo in the crisis as a whole has been market daily, does not use leverage, is largely conducted overstated. between prudentially-regulated (banks and broker- The problem both with analyzing the repo market dealers) or soon-to-be prudentially-regulated entities and with ensuring that risks are mitigated is that there (hedge funds), and in these respects does not trigger is not enough centrally collected and consistent data. systemic risk concerns. This needs to be the primary focus of regulators. In Nevertheless, as with repo, the financial crisis addressing this, as Section 3 above argues, it is essential showed risks and weaknesses in the functioning of that regulators think carefully about what data would the securities lending market, particularly as regards be useful and do not collect additional data for the sake disclosure and transparency, and particularly from of it and on a basis which itself may affect behavior in the interconnectedness of the system. In 2008, losses unanticipated ways. for some securities lending participants led to more There is more that could be done on transparency widespread counterparty concerns in the securities and disclosure, albeit on an appropriately measured lending market. This prompted some participants to basis which contributes to a genuine improvement in reduce their activity in the market, some withdrawing the ability of market participants to make judgments entirely, which contributed to the significant fall in about risk and return. securities lending activity by late 2008. This situation Even where specific risks have been identified and has contributed to impaired market liquidity for certain quantified, regulators need to adopt solutions that types of securities and exacerbated funding issues really do address those risks and do not create serious for banks and non-financial companies. While in the unintended consequences. light of the failure of Lehman Brothers, most beneficial owners were able to liquidate their collateral and replace their lost securities, a few beneficial owners struggled to liquidate their collateral and made losses. Hedge funds that had borrowed securities via Lehman Brothers found it difficult to reclaim the collateral that 28 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY alternative productsandare constantlyevolving. a regulatorysqueeze,trustcompanies havedeveloped securities issuances.Facedwitheconomicpressures and underwriting oractingastrustees forasset-backed mainstream financialintermediaries suchasbond out additionalactivitiesnormallyassociatedwithmore structured, wheretheyinvest,andwhethercarry shorter termliabilitiesthanassets. Trust companiesareleveragedandhavetypically in specificareassuchasinfrastructureorrealestate. wide rangeofinvestments,trustcompaniesinvestthem administrative ceiling.Ratherthaninvestthemina deposits, asofficialdepositratesaresubjecttoan higher returnsandinvestmentalternativestobank rich companiesandHighNetWorth Individuals seeking regulators tomonitorandadapt. grow inresponsetoregulatorychangesandtheneedfor 5 demonstratesthewayinwhichactivitiesmayevolveand important lessonsforthewiderpolicydebate.CaseStudy Study 5andSofolesinMexicoCase6.Bothhave in emergingmarkets:Trust companies inChinaCase considerable benefitinexaminingtwotypesofactivity occur. Withthisinmind,theIIFfeltthattherewouldbe assess andmitigateriskswhereverwheneverthey financial activitiesmust,however, bedesignedtoidentify, in emergingmarkets.Anyglobalapproachonnon-bank developed marketsandhaveignoredthepotentialrisks almost exclusivelyfocusedonactivitiesorentitiesin International discussionson“shadow banking”havebeen should considertargetedandeffectiveresponses. should notoverstatetheextentofproblemand data repository. Aswithrepo,however, regulators and thismightusefullybeaccomplishedviaatrade of securitieslendingtransactionsisakey initialstep, level ofrisk. programs beforethefinancialcrisisalsoincreased liquidity risksinvolvedintheirsecuritieslending beneficial ownerstoappreciatethecounterpartyand of transparencyinriskexposuresandafailureby being adoptedandpotentialuncertainty. Alack leading toinconsistentpricingmethodologies available pricedataonsecuritieslending,potentially they hadpledgedtoLehmanBrothers. Companies Case From 1979to2000, trustcompaniesgrewmassively Trust companiesvaryconsiderablyinhowtheyare Trust companiesinChinaraisefundsfromcash- Greater disclosureandtransparencytotheregulators Further, thereiscurrentlyinsufficientpublicly– Study 5. Chinese

Trust

with short-term financing. alternatives. However, theyalsoprovidehomebuilders government supportprograms orbroaderfinancing informal sector-whoareunable tobenefitfrom to thoseoflower-middleincome –primarilyinthe Their mainactivityisproviding mortgagelending institutions specializedinmortgageintermediation. Mexican Sofolesarepredominantlysmallfinancial in thisassessmenthavechanged. development andregularlyreviewwhetheranyfactors • • • to posesystemicriskforthefollowingreasons: encompass aforward-lookingapproach. need foranypolicyresponseto“shadowbanking” and agentsconstantlyadapttoregulationthusthe demonstrates isthewayinwhichfinancialactivities which pointregulatorsadjustagain.Whatthisprocess only forthetrustcompaniestoadaptandmutate,at activities ortighteningparticularaspectsofregulation, characterized byregulatorsbearingdownonparticular recent years. considerably, althoughithasbeguntogrowagainin and 2011, thesizeoftrustcompanysectordeclined and offurtherregulationsintroducedbetween2001 business scopeoftrustcompanies.Asaresultthis Trust LawinOctober2001 significantlyreducedthe certification applications.Theestablishmentofthe companies toceasebusinessesandresubmit regulator ofthetrustindustry, orderedalltrust trusts. because ofpoorcreditassessmentandstructurethe notable bankruptciesoccurredduringthisperiod invest inkey areasofeconomicdevelopment.Some 1,000. Governmententitiesusedtrustcompaniesto in thefinancialsector. Bytheendof1992,therewere while regulatoryconstraintwasplacedonotherplayers Case However, regulatorsshouldmonitortheir to stepinbygrantingloanstheissuers. the lossbecauseshareholdershavestrongincentives trust companies’owncapitalisinsufficienttocover Limited spill-overeffectifborrowersdefaultand regulations; and Recent conduct-of-businessandprudential (compared tobanklendingofUS$6.8trillion); management US$764billionattheendof2011 Its relativelyinsignificantsize:totalassetsunder At themoment,Chinatrustsectordoesnotseem The periodfrom1998untilnowhasbeen In 2000,thePeoples’ BankofChina,thethen- Study 6. Sofoles in Mexico Sofoles do not take deposits and until 2008 relied While initial standards of disclosure and on the issuance of mortgage-backed securities (MBS) transparency were weak, the market and the to finance the loans. Mexican authorities supported the government have introduced far stronger standards, development of this market in the 2000s, recognizing comparable to those required of banks. The crisis has the difficulties of the regulated mortgage market. also led to tighter requirements in terms of reserves, Prior to the financial crisis, Sofoles were unregulated collateral and capital held by issuers. and unsupervised, mainly because they did not receive The Sofoles case illustrates the types of problems that deposits directly. They benefited from a stop-loss non-bank financial activities may create in emerging guarantee provided by the federal government on markets. Namely, that without the proper incentives, 29 their issuances. Credit rating agencies used this as a regulation, and transparency, even small institutions | sufficient criterion to give their MBS a AAA rating. could generate major losses for the financial system and These applied looser lending standards (higher loan-to- society. Regulation efforts have been important and are value ratios and lower income requirements than those heading in the right direction, especially because they of banks) for subprime borrowers and applied lower have resulted from consultations with other market standards in the design and structure of their MBS. participants. Sofoles themselves are no longer important Credit risk was transferred by Sofoles to investors market participants, but those that have survived are through securitization. However, investors were being more closely supervised and subject to higher unaware of the possible outcomes associated with the disclosure standards and regulation. Sofoles’ lending practices or the quality of the collateral in the MBS issuance. General findings from the Studies

Because Sofoles were focused on lower-middle While the scope and detail of these studies could be finance institute of international income households with inadequate risk assessment, enhanced considerably and while they are far from a partly because of the implicit subsidy element and comprehensive list, they do demonstrate the benefits thus had weak incentives for sound origination and of a systematic approach as set out in the template underwriting, their MBS had extremely high non– proposed in Section 3, and of the approach that the performing rates. IIF proposes in this paper of focusing primarily on the During the financial crisis, Sofoles were hit hard, underlying activity. Some general findings can be taken leading to a significant increase in defaults. By the end from the case studies: of 2011, the three biggest Sofoles, which provided over I. They demonstrate the considerable variety of 80% of issuances made by these types of institutions, non-bank financial activities. Case Study 5, saw non-performing levels in the 30%-45% range. for instance, underlines both the number of However, when the global financial crisis hit, the different activities that can be undertaken development of Sofoles was still at an early phase, so by a single entity in that country and the the impact was more limited than it might have been. fact that even under a broad label such as Had the Sofoles market been bigger, their impact on the trust companies is a huge variety of entity Mexican financial system could have been significant. and activity. Case Study 5 also shows the way in which financial market innovation is If such losses were to happen now, however, losses constantly leading to new forms of activity from Sofoles would have only a small impact on the and entity and is always evolving. The studies private sector, because the government guarantee underline the point made in Sections 2 and covers up to 35% of total issuance, and the Mexican 3 that a focus on “shadow banking” or some federal government is the biggest investor. comparable term is likely to be unworkable in As the main players in the MBS market at the practice. Instead, it is much better to focus on time of the financial crisis, the collapse of Sofoles was the individual activities and assess whether, in arguably a factor in the freezing of issuing activity for the context of the wider financial system, they other players, in particular banks. It may also have had present systemic risk. a role in coloring perceptions of the Mexican financial II. they underline that non-bank financial sector as a whole. activities usually emerge for sensible and Sofoles’ most recent MBS issuance was in mid-2008. practical reasons, most notably the desire to Since 2009, their only source of finance has been a provide investors with new and more effective credit line from the federal government to provide them investment opportunities and borrowers with with liquidity to restructure short-term liabilities. greater access to funding, and to exploit market 30 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY IV. III. prudential requirements.Inallcases,thereare required andshouldbeconsideredaheadof or improvementstodisclosurecanoftenbe thinking thatconduct-of-businessregulation Section 3above,therearegoodgroundsfor with theanalysisofriskmitigationtoolsin or upgradedinrecentyears.However, inline and inallcasesbothhavebeenintroduced is nowregulationandsupervisioninplace, acted tomitigatetherisks.Inallcases,there of acrisis,theindustryandregulatorshave before thatriskmanifesteditselforinthelight Nevertheless, inmostofthecases,either manifest itself. Sofoles, thepotentialwasthere,butitdidnot but inothercases,suchasEuropeanRMBSand companies thishasalreadymanifesteditself, risk. InsomecasessuchasMMFsandtrust mitigation, thereisapotentialforsystemic Some casesshowthatwithoutproperrisk regulation. —that activitiesmayemergeasaresponseto in CaseStudy5onhineseTrustompanies inefficiencies. Theyalsoshow—forinstance V.

thecasesdemonstrate,though,thatpolicy risks. its riskandensuringeffectivedisclosureof a significantandincreasingroleinmanaging disclosure standards,withtheindustryplaying makers andindustryshouldremainalert. in allcases,theriskshavebeenreduced,policy from thesizeofmarket asawhole.While the situationandassessingrisks,including makers andindustryneedtokeepmonitoring Conclusion: “Shadow Banking”: A Joint Responsibility

Non-bank credit intermediation has a potentially I. Firms have a responsibility to manage their valuable role to play that can benefit investors, risks effectively. As the IIF’s July 2008 paper 31 borrowers, banks, and the wider economy and that Final Report of the IIF Committee on Market Best | complements the traditional banking system. Far from Practices: Principles of Conduct and Best Practice being direct rivals for the same business, regulated Recommendations25 argued, firms must have banks both welcome the role that such activities can effective risk management in place to monitor play and indeed rely on them to provide services. and control exposures to the non-bank Subject to proper safeguards, these activities should be system. Since then, the IIF has worked with its strongly encouraged. members to ensure that such risk management Nevertheless, as the financial crisis has highlighted, is strengthened and that the necessary unless properly managed, such activities both resources are devoted to the issue. Two June individually and collectively can pose significant 2011 reports: Implementing Robust Risk Appetite systemic risk to the financial system and wider Frameworks to Strengthen Financial Institutions, economy. It is essential that such risk is detected, and Risk IT and Operations: Strengthening finance institute of international 26 monitored, assessed, and mitigated on a continuous and Capabilities provide updates on this. The IIF adaptive basis. and its members will continue to work hard on this. Policy makers should take a forward-looking approach focusing on individual non-bank activities II. Firms have a responsibility to monitor risks irrespective of whether they could be classified as from financial activities and alert regulators, “shadow banking” by collecting sufficient data; supervisors, and macroprudential authorities to carrying out an intelligent macroprudential assessment any concerns at an early stage. Following its of whether the activities could create systemic risk, July 2008 paper, the IIF created a high-level either of themselves or as part of an entity or wider Market Monitoring Group to detect early on system; and where necessary, using tools to mitigate the emergence of vulnerable spots. The group any risks. Such an approach must be adopted and is chaired by former Governor of the Banque coordinated globally, equally effective in emerging de France Jacques de Larosière and former markets as it is in developed ones. The template in Governor of the Bank of Canada David Dodge. Section 3 is a potential way to do this. It is keen to work with the Senior Supervisors Group (SSG) and other bodies to discuss any The central question, though, is how to carry out this new risks at an early stage. risk mitigation to both preserve the benefits brought by these activities and to not simply displace risk to III. Once potential risks have been identified, firms regulated banks or other parts of the financial system. have a responsibility to provide related data and information to regulators and supervisors to help them assess the magnitude and nature of The responsibility of industry those risks. This responsibility is irrespective of Effective policy and risk mitigation is a responsibility whether or not the institution is prudentially- not just of regulators and supervisors but also of the regulated, but must go hand–in–hand with the financial services industry. The industry recognizes that responsibility of the regulator and supervisor it has a key and indispensable role to help mitigate risks to handle that information sensitively and throughout the financial system. without an automatic assumption that there will be a move to further regulation.

25 institute of International Finance (IIF) Report, Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations (July 2008). 26 institute of International Finance (IIF) Report, Implementing Robust Risk Appetite Frameworks to Strengthen Financial Institutions, and Risk IT and Operations: Strengthening Capabilities (June 2011). 32 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY V. IV.

consequences. arbitrage oranyotherundesirableunintended designed properlyanddonotleadtoregulatory engage withregulatorstoensurethattheyare be thesolution,financialinstitutionsshould work. Whereregulatorytoolsaredeemedto volunteering theseandensuringthatthey and institutionsshouldbepro-activein may bethemostproportionatesolution, or strengthenedinternalriskmanagement regulatory toolssuchasimproveddisclosure mitigation tools.AsnotedinSection3,non- regulators onthedesignanduseofrisk Firms havearesponsibilitytoworkwith disclosure ofrisksinETFs. SSG andtheindustryonmanagement of thiswasthediscussionin2011 betweenthe non-bank financialactivities.Agoodexample regulators ontheirassessmentoftherisksfrom Firms havearesponsibilitytoengagewith to dothis. studies willbeseenasastrongsignofitscommitment hope thatthispaper, theproposedtemplateandcase on whichcooperationisessential. one forpolicymakers, regulators,andindustryone potential risksshouldthereforebeseenasacommon effectively monitoring,analyzing,andcontainingthe efficiencies associatedwithnon-bankactivitieswhile The objectiveofmaximizingthepotentialbenefitsand industry cangetonlysofarinmitigatinganyrisks. they recognizethat,ontheirown,regulatorsandthe responsibilities andsupportsuchengagementbecause The IIFanditsShadowBankingA The IIFanditsmembersunderstandtheir dvisory Group ANNEX. CASE STUDIES

Case Study 1. Money Market Funds Figure 1.1 provides a simple representation of the linkages between MMFs and the wider market. 33 in the United States | MMFs use little to no leverage, and as noted above, Questions 1 and 2. Nature and generic invest directly in high-quality debt—in most cases with characteristics of the activity a maturity of less than 13 months. Nevertheless, given the ability to redeem on demand, there is still some MMFs in the United States are open-ended mutual maturity transformation risk, albeit to a lesser degree funds that invest in high-quality short-term debt such than for long-term loans. as U.S. Treasury securities, commercial paper (CP), In theory, all the credit risk associated with certificates of deposit, and repo. MMFs aim to maintain investments is passed on to investors28. However a stable net asset value (NAV) of $1 per share and are in practice, the aim of a constant NAV and the redeemable on demand.27 reputational risk from falling below the $1 NAV— MMFs are originated and run by dedicated fund known as “breaking the buck”—created an incentive for managers. They typically exist as legally separate sponsors of MMFs to intervene to support them even finance institute of international entities within asset management companies; securities when located in legally separate structures and absent companies; and in many cases, banking groups. any formal requirement to do so. MMFs are bought by a wide variety of investors: It should be noted that MMFs are able to maintain a retail, corporate, government, and institutional, and stable NAV because the difference between the market are required by Rule 2a-7 of the Investment Company prices of the high-quality, highly liquid assets they Act—see Question 7—to invest in short-term debt that hold, and the value using amortized cost of these assets meets requirements relative to credit quality, liquidity, is small—not because of a guarantee to repay shares diversification and maturity. at a fixed price or as the result of an accounting trick. MMFs gained widespread popularity because In addition, MMFs are required to track the “shadow of their ease of use and conservative approach, price” of shares using the market values of underlying including safety, liquidity, and simplicity. In normal securities to ensure that the deviation between the economic circumstances, they offer a safe non-bank “shadow price” and the amortized cost value is less than deposit alternative with slightly higher yields for US$0.005/share. If the deviation is larger than this, the those looking to invest funds on a short-term and fund’s board of directors will decide how to respond relatively liquid basis. In addition to aiming at a (a fund “breaks the buck” when its NAV is below 99.5 stable NAV, MMFs provide same-day liquidity with cents/share or above 100.5 cents/share). no redemption penalties. Assets are fully segregated. Through their purchases of debt from banks and They allow investors to diversify risk both away from other intermediaries, MMFs can also be a source of the banking system and any one issuer and provide leverage and maturity transformation to other market a service to investors by assessing, screening, and participants. To give two examples: monitoring the credit quality of a diversified portfolio • The purchase of repo provides the receiving party of individual issuers. Without such a service, many with cash that it can reinvest and investors— especially retail investors—would effectively be limited to insured bank deposits or U.S. government • The purchase of ABCP enables the short-term instruments. MMFs also provide a valuable—and at funding of long-term assets. times essential—source of liquidity to the government bond, CP, asset-backed commercial paper (ABCP), and repo markets.

27 Funds that meet the risk-limiting provisions of SEC Rule 2a-7—see Question 8—are allowed to value their securities at amortized cost rather 28 the use of collateral can create counterparty credit risk given the than at market value. This allows the fund to fix a share price at $1, which difference in the maturity of the collateral or the ease of its liquidation gives the investor advantages of simple tax reporting and accounting. and given the ability of the MMF investor to redeem on demand. 34 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY USD Trillions depend onthe levelofregulationandtransparency (see are risksinherent inMMFs.Theextentofthese will financial crisis.Aswithmostproducts, there the widereconomy, citinglossestriggeredduringthe contribute todisruptions the financialsystemand It hasbeensuggestedthatMM Fs havethepotentialto Risks posedbytheactivity Question 4. (Chart 1.1). 2008 of$3.8trillion,butfellto$2.6trillioninQ32011 Outstanding sharesofU.SMMFsreachedapeakinQ4 Source: U.Flowofunds,ederalReserve Outstanding Chart 1.1:U.S.MoneyMarketMutualFundShares Question 3. Figure 1.1TheBasicFunctioningofanMMFintheUnitedStates 1.0 1.5 2.0 2.5 3.0 3.5 4.0 Broker/Dealer Hedge Fund 00’ 01’02’03’04’05’06’07’08’09’10’11’ Scale oftheactivity Corporation Bank Broker/Dealer Government Government Broker/Dealer Corporation Bank Custodian Bank Floating–Rate Certificate of Term Deposit Government ABCP Repo Deposit Bond CP Note leading tofurther stressthroughoutthechain ofcredit as conduitsorstructuredinvestment vehicles(SIVs), stresses inthoseinstitutions orassociatedentitiessuch term debt.Thiscan,inturn,leadtofurther liquidity institutions dependentonthe rollingoverofshort- creating asuddenliquidityshortage forfinancial markets. Thiscancausedisruptionstothesemarkets, likely toreducefundingtherepo,ABCP, and CP crunches leadingtofurthermarket stress.Theyarealso can reducefundingtothemarket, resultinginliquidity prices tomeetthevolumeofredemptions.Redemptions other MMFsmaybeforcedtosellassetsatreduced including large-scaleredemptions.Facedwiththis, lead toalossofinvestorconfidenceinotherMMFs, broke thebuck. this level,wasunabletoabsorbthelossandtherefore 1% ofitsassetsinCPissuedbyLehmanand,evenat bankruptcy. TheReservePrimary Fund heldjustover in September2008whenLehmanBrothersdeclared will betransmittedtothefunditself.Thiswasshown losses governstheextenttowhichthisvulnerability the fundsponsorchoosestoinsulateinvestorsfrom or thedefaultofalargedebtor. Whetherthefundor as acreditdowngrade,rapidincreaseininterestrates, MMFs canbevulnerabletolargeexternalshockssuch Questions 6and7). An actualorprospectivebreakingofthebuckcan Given theirlimitedcapitalcushions,investorsin MMF Institutional Investor Insurance company A Pension fund Government sset manager Individual intermediation. in spite of the increased redemption requests. Funds In response to the financial crisis, the U.S. avoided creating the threat of runs precisely because Securities and Exchange Commission (SEC) introduced they had more than sufficient cash on hand to meet amendments to its rules, placing stricter requirements redemption requests. on the industry (see Sections 6 and 7). Question 7. Disclosure and Transparency Question 5. Risks posed by entities MMFs are subject to extensive disclosure and reporting undertaking the activity requirements. Prospectuses explain how funds are established, their investment strategies, risks and 35

Banks that are sponsors of MMFs may carry the | rewards attributable to investors, and also make clear reputational risk of breaking the buck, which could that MMFs are not bank deposits and are therefore have important consequences as highlighted during the not guaranteed by the Federal Deposit Insurance financial crisis in 2008. Although the Reserve Primary Corporation or any other government agency. However, Fund—which was not a bank-sponsored fund—was the the crisis revealed that despite these disclosures, many only MMF to break the buck in this period, concerns investors either did not consider or under-estimated regarding other MMFs led some sponsors to support the potential risks of a loss of value, with unforeseen their funds in order to prevent similar outcomes. As consequences. noted recently in a speech by Federal Reserve Bank of Boston President Eric Rosengren, this amounted to 47 Since the financial crisis, changes to Rule 2a-7 funds.29 John D. Hawke, Jr., former U.S. Comptroller of approved in January 2010 require MMF managers to the Currency, points out that this means that 95% of increase the level and clarity of their disclosure to

MMFs received no sponsor support and that the Reserve investors and their warnings of the potential risks finance institute of international Primary Fund was the only MMF to be redeemed at less involved to enable better and more informed investment than 100 cents on the dollar.30 Still and in light of this decisions. Indeed, MMFs are now also required to experience, concerns have been raised that sponsors disclose portfolio holdings on the fund’s Website at may feel obligated to bail out MMFs, but there is also least monthly and maintain that disclosure for at least countervailing pressure from regulators and securities 6 months. They are also required to report to the SEC analyst not to provide such support, which may make information on the fund’s risk characteristics, yield, sponsor support less probable in the future. portfolio holdings, and mark-to-market (“shadow”) NAV. This information is made public after 60 days. Question 6. Risks posed by linkages with the In addition, MMFs themselves have made rest of the financial system considerable efforts to ensure that investors are aware of potential risks and know that they are not dealing MMFs play a central and critical role in the financial with bank deposits. system. In the lead-up to the financial crisis, institutional cash managers and other investors relied on MMFs to place easily redeemable funds, and Question 8. Regulation and other risk borrowers came increasingly to rely on them as a mitigation source of short-term liquidity. It is this reliance when MMFs are regulated in the United States by Rule combined with a market shock that may cause systemic 2a-7 of the Investment Company Act of1940. The risk. For example, during the European debt crisis, amendments noted in Question 6 came into force in European banks’ dependence on U.S. lenders through May 2010. prime MMFs, which invested nearly half of their total31 The current rule contains the following main assets in European bank placements, was affected as provisions: MMFs sought to decrease their exposure. It must be noted, however, that due in part to the amended SEC • On liquidity, MMFs are required to maintain a rules – see below - the industry has so far navigated daily portfolio liquidity of 10%, a weekly portfolio the Greek debt crisis and the U.S. budget issues in 2011 liquidity of 30%, with illiquid securities limited to 5% of the portfolio at the time of purchase; 29 Eric Rosengren, Money Market Mutual Funds and Financial Stability, Remarks at the Federal Reserve Bank of Atlanta’s 2012 Financial Markets Conference. • On maturity, individual securities can have a 30 John D. Hawke, Jr., Comments of Federated Investors, Inc. on Financial maximum maturity of 397 days, with the weighted Stability Oversight Council Rulemaking Proposal “Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies” 12 C.F.R. average maturity (WAM) not exceeding 60 days, and Part 130 (December 2011). the weighted average life (WAL) or spread WAM not 31 Prime MMFs principally invest in non-government securities, whereas Treasury MMFs exclusively invest in government securities. 36 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY Despite theevents ofthefinancialcrisis,over thepast potential systemicrisk. require furtherconsideration, withthegoaltomitigate of thefinancialsystem.Thisisanissuethatmay close linksthatexistbetween MMFsandotherparts most thatthereformshavebeeneffective. crisis suggeststhatthereisnoimminentdangerandat successfully navigatedtheEuropeansovereigndebt least, theevidencefromwayinwhichMMFshave sensible toseefirsthowtheyperform.Atthevery of therecentregulatorychanges,itmaybemore regulatory measuresareneeded,giventheextent have beensufficientlymitigatedorwhetherfurther While thereisaquestionastowhetherpotentialrisks and reducedcreditriskmaturitymismatch. have beenintroducedthatincreasedtransparency regulated beforethecrisis,furtherregulatorymeasures to externalshocks. notwithstanding theirbenefits,MMFscanbevulnerable The financialcrisishasdemonstratedthat, Conclusion perform ratherthanrushingintoanewwaveofreform. wait toseehowthemeasuresalreadyimplemented The industrystronglybelievesthatregulatorsshould further options,butsofar, nothinghas beenproposed. • • • • Nevertheless, thisshouldbeseen inperspective. The financialcrisishasalsodemonstratedthe As aresult,whileMMFwerealreadyextensively There aresignsthatregulatorsconsidering and reportingrequirements. As notedabove,therearealsostringentdisclosure securities fromafundthroughanaffiliate;and under unusualcircumstances,andbeabletobuy procedures inplace,beabletosuspendredemptions less than$1pershare,have“KnowYour Client” to processredemptionselectronicallyataNA in placetocarryoutregularstresstests,beable MMFs arerequiredtohavepoliciesandprocedures counterparty; required toevaluatethecreditworthinessofrepo items orgovernmentsecurities,withtheadviser only forlook-throughpurposesifcomprisedofcash Fully collateralizedrepoagreementscanbeused 0.5% perissuerwithamaturityofupto45days; concentration limitof3%portfolio,limitedto portfolio assetsandamaximumsecond-tierissuer first-tier issuerconcentrationlimitof5% On creditanddiversification,thereisamaximum exceeding 120days; V of 32 JohnD.Hawke, Jr., ibid. institutions. dollar comparedtothefailureof3,000depository which anMMFpaidoutlessthan100 centsonthe 40 yearsintheU.S.,therehavebeenjust2cases 32

Case Study 2. European Residential rather rare in European RMBS relative to the size of the Mortgage-Backed Securities market. These highly rated tranches were sold to various investors. Question 1. Nature of the activity A typical securitization funding of mortgages can take several forms: Residential mortgage-backed securities (RMBS) are a type of asset-backed security that represents a claim on the • It is typically funded through the issuance of term cash flows from residential mortgage loans through RMBS bonds with average lives of 1-5 years; securitization. Holders of an RMBS receive interest • It may though be funded through the issuance of and principal payments that come ultimately from the short-term asset-backed commercial paper (ABCP) 37 | borrowers of the residential debt, through structures of maturities of 7 days or longer (as noted below, such as SIVs. The RMBS comprises a large number of this creates significant maturity mismatch); and pooled residential mortgages. • Another option is the creation of asset-backed European RMBS are debt instruments secured by security collateralized debt obligations (ABS CDOs), residential mortgages. More than one security is created pooling and restructuring a number of term RMBS. from the same pool of mortgages. These multiple In the case of European RMBS, however, the vast securities—or tranches of the RMBS structure—have majority of the funding took place through term RMBS. different credit characteristics and typically provide a trickle–down repayment structure to the benefit of In the majority of securitizations, the bank sells the investors in the higher-rated securities. pool of underlying loans to a special purpose entity (SPE). Credit ratings agencies have treated these as For banks and other mortgage lenders, RMBS bankruptcy–remote and legally separate from the bank, finance institute of international originally—pre–2007—offered a key means of funding based on external counsel opinion. The SPE in turn for the institution in a capital–efficient manner (from carries out the securitization, using the proceeds to pay a Basel I perspective). If all tranches are sold, they also the bank the purchase price of the mortgages. The bank facilitated the transfer and potential dispersal of credit may offer credit and liquidity enhancements in addition and duration risk. This transfer allowed risk to be taken to the underlying collateral, including contingent by investors with the desire and means to do so rather liquidity support commitments (typical in ABCP deals) than being concentrated on the balance sheets of banks. or puts on given credit events, as a way to reassure This transfer and the dispersal of risk that was supposed potential investors. to result from it should have enhanced the resilience of the financial system. However, banks have historically retained and/or bought back a portion of securitizations issued and For investors, RMBS offers the ability to tailor risk/ will now be subject to “skin in the game” retention return tradeoffs and their desired degree of liquidity requirements in the major markets (see Question 7). —diversification of credit, interest rate, currency, and maturity exposures—allowing them to match their preferences in these areas more precisely than Question 2. Generic characteristics of the if they were confined to conventional investment activity opportunities. Prior to the crisis, European issuance of RMBS was For the economy more widely, well operated RMBS to an important degree driven by funding needs, in make intermediation of financial flows between savers addition to the pressure from capital requirements. and investors more efficient (including on a cross- Securitization facilitated the build–up of leverage to the border basis). Assets that otherwise be quite illiquid can extent that banks were able to lend more with the fund be mobilized, and financing can be made available to from other banks that bought the securitized mortgage home buyers at lower cost than otherwise. debt. Nevertheless, this did not create systemic risk in Europe. For RMBS as for other forms of securitization, banks divide the securitized debt into tranches representing As the New York Federal Reserve has recognized different levels of claim on the underlying assets. The “not all forms of securitization facilitate maturity, subordinated tranches were either retained by the credit, and liquidity transformation. ABS performs bank on their own balance sheet or sold to investors maturity, credit as well as liquidity transformation, with higher risk appetites. In certain circumstances, however, term ABS and ABS CDO primarily purchased tranches were further bundled into perform credit and liquidity transformation, but collateralized debt obligations (CDOs), although this was due to their maturity-matched nature, no maturity 38 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY 2010). Banking, FederalReserveBankof New York Staff Report No.458(July 33 ZoltanPozsar, T transformation.” securities afterissuance.Othertransactions,suchas mortgage pooldetailsandon theperformanceof provided detailedupfrontand ongoinginformationon the risks.Forexample,many RMBS originatorshave does notguaranteethatallthe stakeholders understand things tovariousstakeholders. Detailedinformation Data andstructuretransparencycanmeandifferent vehicles (SIVs),ormanagedCDOsaremoreopaque. others, suchasABCPconduits,structuredinvestment mortgage-backed securitiesareverytransparent,while against theriskofdefault. crisis, monolineinsurancecompaniesagreeingtoinsure or providingcreditliquiditysupport,or, beforethe large lossestoinvestors,anybanksretainingRMBS a massivedefaultintheunderlyingloanscancause classes thantheinvestorshadexpected.Inaddition, losses weresometimesmuchgreaterinsomeasset stock market andnomoresystemic.However, these to investorsarenodifferentinnaturefromfallsthe if securitizationworksasitissupposedto,thelosses control theirexposuretotheselossesintheory, hence of differentlevelsriskinessallowsinvestorsto defaults ontheunderlyingloans.Theuseoftranches expose investorstotheriskoflossesifthereisare enhancement. bank andthenatureofanysuchcreditand/orliquidity credit and/orliquidityenhancementprovidedbythe crucially dependentonwhetheritisaccompaniedby Furthermore, theextentofrisktransferisalso bank retainssomeoftheRMBSonitsbalancesheet. risk transferisalsodependentonwhetherornotthe transformation islimited.Inmostcases,theextentof to theECBorBankofEnglandliquidityfacility, credit England creditoperations. products ascollateralforEurosystemorBankof have alsobeenabletouseexistingeligiblesecuritized to besoldintothemarkets. OriginatorsinEurope (“retained securitizations”).Manytransactionscontinue Central Bank(ECB)ratherthansoldinthemarkets collateral forliquiditygenerationviatheEuropean securitizations (typicallyRMBS)solelytobeusedas ABCP orthroughtheuseoftermS. whether theissuerofRMBSfinancesitthrough transformation takes placewilldependprincipallyon As thefinancialcrisisshowed,certainasset-or RMBS, like otherformsofsecuritization,does Where RMBSarecreatedforthepurposeofpledging Since 2007, Europeanbankshavecreatedsome It followsthatwhetherornotmaturity obias A 33

drian, A dam Ashcraft,&HayleyBoesky, Shadow 200 400 600 800 zero disclosureofindividualloans.” which mayhavemanysuchcollectionsofassetsand transparent thanacorrespondingbankbalancesheet, simple toevaluate,thisportfolioisconsiderablymore thousands ofindividualassetsandisbynomeans noted, “Whiletheunderlying...portfoliomaycontain risks. AsGaryB. Gorton andAndrewMetrickhave RMBS pools,toenableinvestorsbetterevaluatetheir enhance thetransparencyofunderlyingassetsin Various proposalshavebeenmadeinthemarket to presentations, andpoolreports(seeQuestion7below). information memoranda,ratingagencyreports,investor provided throughsuchconventionalsourcesas additional informationandimprovingthedisclosure standards canbemitigatedtosomedegreethrough classes. European mortgagesaswellcertainU.Sasset mortgages performedverywell,particularlywith of crisis.Manysecuritizationspoolsresidential increases thepricevolatilityofinstrumentsintimes problem. Realorperceivedlackofunderstanding mortgages ortheriskofpotentialadverseselection evaluate theadequacyofunderwritingoriginal the crisis. level oftransparencyhaschangedsignificantlysince Nevertheless, astheanswertoQuestion7shows, between thevariousstructuresincludedinCDO the underlyingcollateralbutalsooninteraction standpoint, tounderstandsufficientdetailsonnotonly that manyinvestorswereunable,fromapractical Europe, inhindsightincludedsuchlevelsofcomplexity CDOs, whichwerenotusedtoasignificantextentin System 34 GaryB. Gorton&AndrewMetrick, Regulating theShadow Banking 2010, EURbillion Figure 2.1.Europeansecuritizationissuance2002- Question 3. 0 Nevertheless, thesedifferencesintransparency Historically, ithasbeendifficultforinvestorsto 2002 (September2010). 2003 2004 Scale oftheactivity 2005 2006 2007 2008 34

2009 2010 Retained Placed . 800 Retained

Placed RMBS 600

CMBS

400 ABS

CDO

200 39 |

0 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: AFME (Association of Financial Markets in Europe).

Unlike the government sponsored enterprises (GSEs) ABCP market and disruption to short-term funding in the U.S., Europe does not have a quasi-government markets. At the level of the individual investor, it will guarantee system, and thus the growth of RMBS in also depend on the tranche held and thus the level of Europe was more gradual (although the GSEs did not certainty of continued payments. directly impact the growth of non-agency RMBS). However, in Europe as an OECD study has suggested, European securitization issuance peaked at 625 billion euros in 2008, most of which was RMBS (Figure 2.1). It was never really a credit story for the European However, this figure is misleading, because the banks securitization market but one of investors taking mark- institute of international finance institute of international retained the vast majority of the securities as a means to-market losses as securitization markets became illiquid to access central bank liquidity schemes. After the and prices fell. A survey conducted by Bishopsfield Capital crisis, the European market for placement with third– Partners in June 2010 revealed that 73% of investors believed party investors of securitized assets (excluding covered that losses were attributed to market re-pricing rather than bonds) has remained subdued. actual credit impairments. … in Europe this under-pricing mainly reflected liquidity risks while credit risk was often properly priced.”35 Question 4. Risks posed by the activity What this suggests is that, in Europe, the risk Even if RMBS is carried out with adequate transparency may have been more from the connections between to investors, and the risks are diversified across the securitization and the rest of the financial system rather financial market rather than being concentrated in than from the quality of the underlying activity (see banks, in the event of an economic shock leading to Question 6). falling house prices and larger than expected levels of defaults on mortgages, there is still a risk to insurers, investors, and banks holding RMBS. Question 5. Risks posed by entities undertaking the activity The primary risk of RMBS is, as with any other credit product, that the borrower—in this case the There can be a risk that the bank originating the residential borrower—fails to pay interest and principal mortgage may have little incentive to carry out proper on the loan, which will be translated into mark–to– underwriting if it knows (or believes) that the risk will market and actual losses. A major concern with RMBS be entirely transferred to the investor. However, given regarding systemic risk is if a lack of transparency that in the European RMBS market banks retained more of the quality of the underlying loans leads to an of the RMBS on their balance sheets and thus had more erroneous appreciation of the nature of this primary “skin in the game,” as the OECD noted, “underwriting risk and, therefore, to underpricing of the risk (in other standards were seen to be significantly more robust in words, leaving the investors exposed to greater risks Europe.” European banks both had incentives to and than they expected). Although the extent to which indeed evaluated the risks properly, as the low default this could lead to investors losing confidence depends rate (0.07% mid-2007 to Q4 2010) shows. on the severity of its impact, the sudden awareness of There can be an additional risk depending on the greater-than-expected risks could lose investors’ whether the RMBS is subject to implicit or explicit confidence in the RMBS market as a whole and lead to sell-off of RMBS or refusal to buy or roll-over ABCP. In the latter case, this could lead to a freezing of the 35 Hans J. Blommestein, Ahmet Keskinler, & Carrick Lucas, Outlook for the Securitization Market (2011). 40 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY led todifficulties. default rate on the underlying assets, have generally not also providedbybanks,butintheevent,duetolow the EuropeanRMBSmarket, suchenhancementswere introduce explicitbackstopsfortheABCPmarket. In markets functioning,theFederalReservewasforcedto such adegreeintheU.Sthatordertokeep ABCP compelled toprovidesupport.Thishappened decline, thebankmaybeforcedorfeelcommercially risk thatintheeventoflargedefaultsormarket price RMBS isenhanced,evenifonlyimplicitly, thereisa there isnomeaningfuladditionalrisk.However, ifthe a veryhighseniority, isexplicitandproperlypriced, there isnosuchenhancementorthehas bank andtheactualnatureofthatenhancement.If includes providing implicitorexplicitguaranteesagainst losses. liquidity totheSPE tosupportitscash flowwhilecreditenhancement 36 Liquidityenhancement includesprovidingtemporaryshort-term crisis, canextendtobanks’ potential insolvency, which leads tosignificantimpacts on banks,asseeninthe the banksonstructures. Anysuchexposure,which maturity mismatchriskexplicitly orimplicitlytaken by can causesignificantexposuresarisingfromthe to fundtheirmortgagesthroughconduits,thisreliance associated withtheirnames. to repurchaseRMBSfromfailingSIVsthatwereclosely as wasseeninthecrisis,bymarket forcingbanks contingent commitmentsbackingABCPstructuresor, for short-termfunding,imperilingbankseitherthrough transformation, itcouldcauseafreezingofthemarket of ABCPorSIVs,whichcreatessignificantmaturity the crisis.Whereittakes placethroughtheissuance the imperfectrisktransferthatbecameapparentduring amplified bytheinterconnectednessofsystemand invest inRMBS.Moreover, thisnaturalreactioncan be the numberofdefaultscanleadtoinvestors’ceasing mismatches. near–fatal forleveragedentitieswithacutematurity funding. Thiscontractioninliquidityprovedfatalor banks becameunabletorelyonthismechanismfor investors. TheRMBSmarket became lessliquidand markets werestillaffectedbythewithdrawalof European RMBSandABremainedhigh, system asawhole.Eventhoughthecreditqualityof misunderstood isinitsconnectionwiththefinancial other formsofsecuritizationthatmighthavebeen As notedinQuestion4,oneriskfromRMBSand rest ofthefinancialsystem Risksposedbylinkageswith the Question 6. liquidity orcreditenhancements If banksbecomereliantontheABCPorSIVmarket A largeeconomicshockleadingtoanincreasein 36 bytheoriginating solutions torestore investorconfidencein securitization Europe, orAFM)hasalsobeenworkingon market-led now partoftheAssociationfor Financial Markets in standards forRMBSusedrepoatcentralbanks. England onnewrequiredloan-by-loan reporting actively worked withboththeECBandBankof information. InEurope,forexample,theindustry of details,includinginsomecasesloan–by–loan strides towardgreatertransparencyintheprovision and supervisors,failedtovaryingdegrees. trust, includingauditors,securitieslawyers,regulators, flawed. Inaddition,othergatekeepers ofthepublic certain complexstructuredfinanceproductswere in assessingtherisksofU.Ssub-primelendingand put increditratingagencieswhoseownmethodologies investors andintermediaries,whiletoomuchfaithwas evaluation wasnotalwaysundertaken byprofessional decisions. Investorstypicallyreliedonfoursources: available toinvestorsmake informedinvestment earlier, evenbeforethecrisis,therewereseveralsources T Question 7. transformation risks. include ABCP, whichcanpotentiallycreatematurity risk, ascomparedtothoseRMBSstructuresthat by termsecuritizationtranches,whichposenosystemic important todistinguishbetweenRMBSbacked solely mitigated theirriskofinsolvency. Therefore,itis necessarily preventbanksfromdeleveragingbuthas drying upofexternalmarket funding.Thiscouldnot funding mortgagesandotherassetsdespitethe by pledgesofRMBShasenabledbankstocontinue and theBankofEnglandtoprovidefundingsecured can inturncreatesystemicrisk. o dealwiththetransparencyproblemsindicated IV. III. II. I. In Europe,theuropeanSecuritisation Forum (ESF Nevertheless, sincethecrisis,industryhasmade In thelead-uptocrisis,however, properrisk However, inthecrisiswillingnessofECB

compliance withprogramrequirements. and broadlydescribingcurrentassets Pool reports,typicallydistributedmonthly enhancement andliquidityfacilities; of theprogramincludingdetailsoncredit Investor presentations agencies; Rating agencyreports notes, andsellingrestrictions; descriptions, termsandconditions,formof Information memoranda Disclosure andTransparency , usuallyfromatleasttwo , outliningthestructure , includingissuer , markets. Several initiatives include (i) support for additionally require credit rating agencies to disclose standardization of securitization products; (ii) improved the sensitivity of the assigned credit rating to changes issuer disclosure and investor due diligence practices; in key credit risk–modeling parameters. and (iii) reduction of information asymmetries and In January 2011, the ECB raised the haircut improvement of alignment of incentives among applicable to ABS from 12% to 16%. In addition, to be originators, investors, and other market participants eligible for repo from March 2011 on, ABS have needed and (iv) improvement of access to market information to carry two AAA ratings at issuance and a single A on European securitization market activity through its rating over the life of the security. quarterly and monthly data reports on issuance activity by country and product sector, balances outstanding, Both CRD II and CRD III impose ongoing due 41 | ratings changes, and secondary market spread diligence requirements on banks when they invest changes.37 in securitized products and require both originator and investor to disclose information. Specific rules One example of AFME/ESF’s work in recent months for securitized products held in the trading book also is an initiative to create a “quality label” designed to stipulate higher capital charges, although these will complement credit ratings. The label would be awarded not be implemented until the end of 2011 (CRD III). to simply structured securitizations whose sizes are Significant regulatory changes are also underway in over a certain threshold and are backed by a certain the U.S. due to the Dodd-Frank Act and other SEC quality of assets for which prices are easily available. rulemaking. This initiative, on which AFME/ESF has been working with the European Financial Services Roundtable, In addition, insurers will have to comply with is supported by the ECB—which itself has been Solvency II capital charges, establishing the framework developing proposed new standards for disclosure and for risk-based capital assessment. finance institute of international transparency—as well as other European policy makers. The European industry, under the scrutiny of In April 2010 the ECB itself announced it would competent European authorities and institutions, is move ahead with its proposed new eligibility also finalizing the development of industry-wide requirements that refer to loan–level data reporting. standards and of a conduct–of–business regulation. The work will now be taken up by a series of technical Such a development would set out best practices committees to flesh out the plans, which include regular to build investment guidelines and regulations to reports on the performance and status of the underlying encourage issuance and investment, with the ultimate loans. goal of supporting the real economy. AFME/ESF and the European Financial Services Round Table, working together, have been leading the process to deliver such Question 8. Regulation and other risk a scheme in the form of Prime Collateralised Securities mitigation (PCS). This market-led initiative defines best market Since the crisis there have been several regulatory practices and creates the incentives to enforce best changes designed to reduce the risks from the market. practices through a label granted and maintained by an independent third party. The PCS label is intended to Under Article 122a of the EU’s Capital Requirements be available later this year for European securitization Directive (CRD II), risk retention requirements have been transactions that meet industry best practices in terms introduced, requiring issuers to retain a material net of quality, simplicity, standardization, and transparency. economic interest of not less than 5% on an ongoing basis. The Article also requires originators and bank investors in securitization to undertake heightened due Conclusion diligence, risk management, and disclosure practices on This case study illustrates that the aim and practice an ongoing basis or face penalties. of securitization can and has differed widely across There have been regulatory efforts targeting jurisdictions, sectors and financial institutions. There improvement in transparency and disclosure are significant variations (i) in the form of securitization requirements, internal governance structures, whether or not it involves maturity transformation; supervisory oversight, and registration requirements (ii) in the degree of bank support attached to it—and for the credit rating agencies. Moreover, in Europe a consequently in the extent of the credit risk transfer; special identifier must now be applied to the ratings of (iii) in the underwriting standards of the underlying structured finance products, while regulators in Europe loans; and (iv) in the extent of the disclosure and transparency. All of these will have an impact on 37 See www.afme.eu for this report. whether systemic risk will be created. 42 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY collateralised securities,shouldstrengthenthisrevival. Further industryreformssuchastheworkonprime best, asluggishrevivalofthesecuritizationmarket. of regulatoryreformsappearstocontributeto,at of securitization,andthelackfullimplementation continuing creditworthinessofthemoreclassictypes not alreadyimplemented. course offinalizationintheU.SandEU,toextent international standardssetbytheG20,arenowin types, andextensiveregulatorychange,mandatedby to accepttransactionsofthemoreaggressivepre-crisis Reform hascomeaboutbythemarket’s unwillingness such structuresallledtoappropriatecallsforreform. based solelyonratings;andshort–termfinancingof high ratingstocomplexstructures;investmentdecisions asset values;willingnessofratingagenciestoassign reliance onthecontinuedappreciationofunderlying subprime mortgages.Poor underwriting including securitization ofcertainassetclasses,primarilyU.S in Europe,asaresultofdevastatinglyexperiencewith benefits investors,borrowers,andthewidereconomy. securitization canbecarriedoutsafelyinawaythat risk retention,disclosure,andothersafeguardsinplace, What thissuggestsisthat,withproperriskmitigation, RMBS market amountedtoonly0.07% ofall issues. of theeconomiccrisis,defaultratesinEuropean Europe. Itisnotablethat,notwithstandingtheseverity of whichwashistoricallyafeaturesecurizationsin underwriters androbustunderwritingstandards–much borrowers, providedthereisappropriateengagementby efficient meansofintermediationbetweeninvestorsand securitization isalegitimatefundingtoolaswellan The problemnowisthefailuretorecognize Securitization acquiredabadreputation,especially As theOECDhasacknowledged,inEurope, several years. where bankdeleveragingappearslikely tocontinuefor responsible growthofthemarket, especiallyinEurope, credit fortheeconomyandtoconsiderwaysfoster the abilityofsecuritizationmarkets togenerate need tocontinueimpactassessmentofthereformson attentive tonewrisksanddevelopments.Theyalso for thesepost-crisisreformstotake effectwhilebeing CRD IIIandIV, policymakers mustgiveachance mandated bytheG20andcarriedoutinEuropethrough Given theconsiderablerecentregulatoryreforms— Case Study 3. Repo Markets bank or clearing organization acts as an intermediary between the buyer and seller and maintains control of Question 1. Nature of the activity the securities that are subject to the agreement. It also processes payments from the seller to the buyer. The A repurchase agreement, or a repo, is the sale of tri-party agent is responsible for the administration securities with a commitment to buy them back from of the transaction, including collateral allocation, the purchaser for an agreed upon price on a designated marking to market, and substitution of collateral. future date. Economically, the agreement represents a Tri-party arrangements help to improve the efficiency collateralized loan whereby the securities purchased by of the collateral management process but do not, in the buyer constitute collateral to protect them against themselves, reduce credit risk for the buyer or seller. 43 the seller failing to meet its repayment obligation. A | wide range of fixed income and equity collateral may As the FSB has pointed out, “Repo allows banks as be used to secure a repo. These are generally liquid in well as non–banks—such as securities broker–dealers, nature so they can be easily liquidated by the buyer in pension funds, and (to a greater extent before the 38 the event of a default by the seller or can be obtained crisis) conduits and investment vehicles.” by the seller in the open market in the event of a Nevertheless, what this suggests is that the maturity default by the buyer. transformation may come from the use of repo rather Examples of collateral types may be a Treasury than inherently from the activity itself. It would be security or sovereign bond; money market instrument; perfectly possible to have repo with very little maturity federal agency security; mortgage-backed security; transformation. or stocks, preferred shares, convertible bonds, or

American Depository Receipts. Legal title to the Question 3. Scale of the activity finance institute of international security passes from the seller to the buyer on the In its report on securities lending and repos, the initial purchase date, with the seller then repurchasing FSB has estimated that the total volume of outstanding the security from the buyer at the end of the loan term, repos and reverse repos were US$ 2.1–2.6 trillion and title transferring back to the seller at that time. in the United States, US$8.3 trillion in Europe, and Repo markets are vital to the financing needs of US$2.5 trillion in Japan. The European and Japanese a range of financial institutions, including banks, figures are overestimates because they do not take broker-dealers, insurance firms, and asset management account of double counting (i.e., a repo and a reverse firms. For investors such as MMFs, hedge funds, repo constitute only one transaction).39 However, the insurance companies, and pension funds, repos provide European number does not cover all repo users. an opportunity to invest cash for a customized period More granular data on the repo market is provided of time on a secured basis. In the United States, the by the Federal Reserve for (tri-party) repo in the U.S. Federal Reserve, through the Federal Open Market and by the International Capital Market Association Committee, transacts in repos to either add to or (ICMA) for repo in Europe. Data on the composition of withdraw from reserves to stabilize interest rates. collateral for these respective markets are provided in Tables 3.1 and 3.2. Question 2. Generic characteristics of the The size of the U.S. Tri-party repo market was $1.7 activity trillion as of March 2012. Repo maturities may be overnight, term, or open. An The total value of the outstanding repos, among overnight repo refers to a one–day maturity, whereas a market participants according to the ICMA in term repo has a specified end–date that may range in December 2011, was 6.204 trillion euros, of which duration from 2 days to multiple years. An open repo 32% is subject to central clearing and tri-party repo at does not have a specified end–date and is therefore 11.4%. ongoing until either party decides to terminate the Nevertheless, as Question 7 notes, despite the wide agreement, at which point it becomes a one–day range of statistics available, market data sources are maturity. disparate and often inconsistent. A repo may occur in the form of specified delivery, tri-party, or hold-in-custody. Specified delivery, also known as delivery versus payment, requires the delivery 38 Financial Stability Board, Securities Lending and Repos: Market Overview of a specific bond at the onset and maturity of the and Financial Stability Issues, Interim Report of the FSB Workstream on Securities Lending and Repos (April 2012). contractual period. In a tri-party repo, a custodian 39 Financial Stability Board, Securities Lending and Repos: Market Overview and Financial Stability Issues (27 April, 2012). 44 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY the buyerisrequired totransfermargin thesellerif, to market oftheparties respectiveobligations,sothat obligation). Itisalsomitigatedbythedaily marking apply thatrepurchaseprice against itsownrepayment securities inthemarket shouldthebuyer default(and which shouldenabletheseller topurchaseequivalent closeout provisionsoftherelevantrepoagreement, date. Thisriskismitigatedbytheeventofdefaultand the termofrepo)uponrelevanttermination additional margintransferredtothebuyerduring to redeliverequivalentpurchasedsecurities(andany failure todeliversecuritiesback,wherethebuyerfails risks tothesellerandbuyer. from repo.Theseriskscanbethoughtofinterms The useofcollateralisdesignedtomitigatetherisks Risksposedbytheactivity Question 4. Source: FederalReserve municipality debt,andwholeloans. * Otherincludescollateralizeddebtobligations,internationalsecurities, ASSET GROUP Composition ofTri-PartyRepoCollateral 2012 Table 3.1Tri-PartyRepoStatistics,asofMarch Total Other* US Treasuriesexcludingstrips US Treasuriesstrips Money market Equities grade Corporate non–investment Corporate investmentgrade grade) (investment &non–investment obligations privatelabel Collateralized mortgage securities Agency mortgageback Agency debentures&strips obligations Agency collateralizedmortgage grade) (Investment &non–investment Asset-backed securities For theseller, asignificantriskisfrombuyer (BILLIONS) VALUE COLLATERAL $1,758.98 $21.53 $535.42 $43.27 $25.58 $79.24 $23.79 $54.23 $37.46 $657.27 $119.23 $130.05 $31.92 TOTAL OF SHARE 1.2% 30.4% 2.5% 1.5% 4.5% 1.4% 3.1% 2.1% 37.4% 6.8% 7.4% 1.8% securities onthe agreedrepurchasedate(economically, that thesellerwillnotfulfill itsobligationtopurchase term liquidity. associated withaconcentrated investorbaseandshort- profile istaken tomanagethereinvestment risk counterparty diversificationandastaggeredmaturity agreed securitiesportfolios.A institutions transactinreposforlongertermagainst on notice.T transaction isnotrenewedorifthebuyerterminates that thefundingmaybecomeunavailableif or openrepotransactionsaresubjecttotherisk relying onfundingthroughovernight,short-term, during thetermoftrade. for example,thevalueofpurchasedsecuritiesincreases Source: ICMASurveyoftheEuropeanRepoMarkets(December2011). Analyzed ByTypeOfCollateral Table 3.2Tri-PartyRepoCollateralInEurope Other Equities Convertible bonds linked notes,etc. obligations, credit collateralized loan debt obligations, Collateralized backed securities Other asset- securities mortgage-backed Commercial securities mortgage-backed Residential Covered bonds Corporate bonds agencies Supranational agencies / Sub-national Public agencies Securities Government A key risktothebuyer issellerdefault:Therisk There is,though,afurtherliquidityrisk.Sellers o mitigatethis“rolloverrisk,”financial 2011 DECEMBER 0.8% 12.8% 0.2% 0.5% 1.0% 0.2% 1.4% 9.7% 18.3% 2.8% 7.2% 45.2% dditionally, afocuson 2011 JUNE 0.9% 19.2% 0.1% 0.7% 0.6% 0.3% 0.3% 9.1% 23.3% 2.2% 5.6% 37.8% 2010 DECEMBER 1.1% 19.0% 0.0% 0.6% 0.8% 0.2% 0.4% 6.5% 25.5% 1.8% 3.4% 40.6% to repay the borrowed money) is a fundamental risk of haircuts build in potential future exposure over a repo transactions. holding period and so change much more. This risk is mitigated by the ability of the buyer to sell collateral following a default event and apply Question 6. Risks posed by linkages with the the proceeds of the sale to the seller’s outstanding rest of the financial system repayment obligations. Typically, a “haircut” is applied The real potential risk though from repo does not come on a repo transaction, so that the buyer will be sold from the activity itself or from its combination with purchased securities with a market value slightly other activities but instead from its interconnectedness greater than the purchase price, and this haircut is with the rest of the financial system and the way that it 45 maintained through the term of the transaction. Also, | is used. the buyer may apply concentration criteria in respect of purchased securities and margin, so that, for example, There is a significant degree of interconnectedness only a certain proportion of securities in any one with the rest of the financial system, given the breadth market, or issued by a single issuer, can constitute part of institutions that engage in repo across multiple of the aggregate purchased securities. This mitigates jurisdictions and product types. Repo is a global the related risk of liquidity delays and collateral market instrument with global investors who wish to gain price fluctuations post-default. exposure to various products. The repo market provides an alternative source of financing to unsecured credit, Note, however, that haircuts are not used for the bank deposits, and central bank funding. As the FSB majority of interdealer refinancing activities against notes in its report, “liquid securities financing markets government bonds (OECD), an activity largely replacing are therefore critical to the functioning of underlying the unsecured interbank funding used pre–Basel 2. An cash, bond, securitization and derivatives markets.” finance institute of international example of this shift can be found in the ECB 2011 Annual Report, while 80% of interbank funding is now The interconnectedness of this market was observed on a secured basis, the trend for unsecured funding is during the financial crisis as liquidity was constrained still decreasing. for many financial institutions that relied on short-term repo as a main source of funding. Repo market liquidity Nevertheless, as Question 6 below examines, there is is a key source of financing for financial institutions. a risk that adjustments to collateral requirements and However, to avoid disruptions to liquidity, it is haircuts, designed to mitigate risk, may actually create advisable to enhance the durability of secured financing pro–cyclical effects. by ensuring that the maturities of repo transactions are diverse and not exclusively very short term. Question 5. Risks from entities undertaking The FSB has argued that the risks from this the activity interconnectedness were aggravated by a lack of In its recent report, the FSB argued that insufficient transparency both in the market and among firms. rigor in collateral valuation and management practices The ICMA European Repo Council acknowledges caused major disruption in financial markets: this issue, but noted that “the problem is that market data When the prices of mortgage-backed-securities (MBS) sources are disparate and often inconsistent.” fell during the early stage of the financial crisis, a number of In addition, the FSB suggested that, prior to financial institutions did not mark-to-market their holdings crisis, many prime brokers did not provide sufficient of MBS or based decisions on prices generated by overly- disclosure on re-hypothecation activities, which creates optimistic models, and later suffered significant losses when counterparty risk and cash collateral reinvestment risk, they eventually had to do so. Arguably, the decline in the to their hedge fund clients. prices of MBS would have caused less of a major disruption in financial markets should such price changes have been As the ICMA European Repo Council report reflected in financial institutions’ balance sheets earlier and admitted, more gradually through continuous marking-to-market. 40 The problem is that some accounting regimes do not This is a very fair point. Market practice is not as indicate clearly which assets on the seller’s balance sheet good in this area as it should be. It may be addressable are out on repo. All that may be shown is a footnote giving a through small but effective measures like improving netted repo total. However, the accounting treatment of repo marking and margining. Such margining is preferable under IFRS is much clearer. to haircuts; margins reflect daily price changes, whereas

40 Financial Stability Board, ibid. 46 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY (2010). 41 GaryGorton,&AndrewMetrick, Securitized Banking and theRunonRepo haircuts werethemaincauseofcrisis and AndrewMetrick,whoarguedthatchangesin sheet transparency. an issuespecifictorepo.Rather, itisaboutgeneralbalance transparency wouldbethatusefulinpractice.Butthisisnot sheets andotherreturns, itseemsdoubtfulwhethergreater events versustheperiodicityofpublicationbalance could rapidlydrainaway. Unfortunately, giventhespeedof their collateraleligibilitycriteriaandhigh-quality gets intodifficulties, andinacrisis, lenderswilltighten grounds forconcern.…However, whenacounterpartyvisibly receive cash,whichisarisk-freeasset,therearenoreal repo investmentbyU.Smoneymarket mutualfunds is delegatedtothird-partycustodians). Astudyon not bilateral,buttriparty(where collateralmanagement sector debt(agencies).Further, mosttransactionsare in theU.Srepomarket isTreasuriesand/orpublic bilateral U.Srepo,whereasthevastbulkofcollateral collateralized loanobligations(CLOs)andonlyfor such ascollateralizeddebtobligations(CDOs)and only forcollateralintheformofstructuredsecurities data usedbyGaryB. GortonandAndrewMetrickwere crisis andtheextentofrisksthatitpresents.The markets hugelyoverstatestheimpactthatithad onthe liquidity crisisandthesubsequentcapitalcrisis. an “after thefact”effect,ratherthanprimarydriverof SFTs [structuredfinancetransactions]couldbearguedto down exposures. Theincreaseinhaircutsandmargins creditworthiness concernsledbankstoactivelymanage played inthecrisisasawhole.Liquidityconstraintsand one shouldnotoverstate therolethatmarginsandhaircuts procyclical characteristics. IIF acknowledgedthatmarginsandcollateralhadsome requirements andhaircutsinprocyclicality(‘CGFS36’),the on theGlobalFinancialSystem,Theroleofmargin Derivatives AssociationtothepaperbyCommittee the availabilityofreliablepricesforcollateralvaluation. markets damageunderlyingcashmarketliquidity, reducing a viciouscircleascontractioninthesecuritiesfinancing entire classesofcollateralfromtheirtransactions, creating procyclicality: has arguedthatthefargreaterproblemisoneof Building onworkbyU.SacademicsGaryB. Gorton In normalmarketconditions, giventhatthesellerwill Nevertheless, asthatreportpointedout, Indeed, theanalysisofprocyclicalityrepo this procyclicalityshouldbeseeninperspective,and However, itpointedoutthat, In itsjointresponsewithnternationalSwapsand Sudden shifts, ...cancausemarketparticipantstoexclude 41 , theFSB sector tothewholemarket. unreasonable toextrapolatefromaspecializedmarket markets primarilyuseliquidcollateral.Itistherefore issue. Illiquidcollateralisaspecialcase,whereasrepo hold themintradingportfolios. institutions thathaveusedthosesecuritiesascollateralor of thecollateralassets, withcontagiontootherfinancial would putdownward pressureonthealreadystressedprice collateral firesales: in aggregateovertheperiod. CGFS alsoreportsthathaircutsdidnotincreasemuch points ofthe28%deleveragingrepomarket. The changes inhaircutsexplainlessthan3percentage repo market fromthesemi-annualsurveysofICMA, 2009 bytheCGFS,weighteddataonEuropean T last pointwasconfirmedbytheFederalReserveBoard’s non-government collateralroseonlymodestly. This haircuts onTreasuriesandagencies, study alsofoundthattherewasnoincreaseinthe just 14%-19%wereagainststructuredsecurities.The investments wereinrepos,mainlytriparty, ofwhich, and securitieslendersindicatedthat15%-20%oftheir 42 Seewww.icma-group.org of trendsandchanges. points ontheoverallsizeofmarket, aswellanalysis participants publicly, whichprovideseveralkey data the resultsofitsbi-annualsurveyrepomarket generally madeavailable.InEurope,ICMApublishes as counterparty, term,andproductspecificsarenot a quarterlybasis.However, moregranulardetailssuch product levelinformationontheirbalancesheets report thevolumeofthisactivityaswellgeneral disclose thedetailsofsuchtransactions. financial institutionsthatengageinrepotopublicly There arecurrentlynoofficialrequirementsfor Question 7. basis. Therewouldalso bemeritinmorecomplete and greatly inthemonitoringof therepomarket onaglobal European SystemicRiskBoard( ERSB). Thiswouldassist including theFSB,Federal Reserve, andthe the variousbodiesthatmonitor systemicriskglobally, More datacouldbeprovided toregulators,particularly to illuminatethescaleandnatureofrepomarket. askforce onTripartyRepoMarket Infrastructure. However, onceagain,thisseemstoexaggeratethe Ifmarketsarealreadyunderstress, furtherselling The FSBhasalsoarguedthattherearerisksfrom For Europe,usingasurveyofhaircutsin2007 and In theUnitedStates,regulatedfinancialinstitutions There isclearlyscopefortheprovisionofmoredata Disclosure andTransparency 42 consistent public reporting on the aggregate volumes • The use of central clearing mechanisms is outstanding in repo markets. This would serve to increasingly prevalent in the repo markets, increase general understanding of the important role particularly between dealers. Central clearing that repo plays in financial markets. reduces counterparty credit risk by interposing a Nevertheless, as with procyclicality, this should not CCP between the repo counterparties, such that be overstated. While there were particular concerns each counterparty’s obligations switch to the CCP with Lehman Brothers’ Repo 105 and MF Global’s Repo rather than the other counterparty. In this way, the to Maturity, both cases were unusual transactions that counterparties are no longer exposed to each other’s exploited loopholes in the U.S. accounting regime credit risk, but rather to that of the CCP, which (in principle) should be negligible. While central 47 allowing repo to be removed from the balance sheet of | the seller. The accounting treatment under IFRS is much clearing certainly brings key systemic benefits to clearer and would have prevented these problems. the market, not all transactions will be suitable for clearing, as has been recognized in the debate on derivatives clearing in the U.S. and Europe. Certain Question 8. Regulation and other risk types of collateral may not be sufficiently liquid mitigation to be suitable for clearing, because they lack the Participants in repo markets are, generally, regulated pricing data to permit accurate valuation. Regulators entities and therefore are subject to prudential should not force increased use of central clearing for regulatory standards, notably including capital, transactions that are not suitable for it. liquidity, and counterparty management requirements. • There is likely to be a degree of scope for increased Several potential areas of regulatory intervention have transparency, both in terms of data submission been suggested in the debate on the repo market, which to regulators (described earlier) and between the finance institute of international are discussed below. counterparties to the repo transaction themselves. A • The motivation behind a global minimum haircut greater understanding among market participants of on repo assets is understandable (i.e., to avoid a key determinants such as the frequency of valuation, procyclical rise in haircut levels during stressed the nature of the underlying collateral, and market conditions). However, certain implications margining practices is likely to improve confidence would flow from this approach, which need to be in the repo market and thereby its soundness. carefully considered. A minimum haircut would not be sensitive to the creditworthiness of the Conclusion counterparty, meaning that each participant would The current policy discussion on the use of repo should potentially be treated in the same manner as the not lose sight of the fact that the activity is not only least creditworthy counterparty. Hence, there is a beneficial to financial markets and the wider economy; danger of imposing inappropriately high haircuts it is also vital to its functioning. on sound counterparties. Moreover, where one repo counterparty (i.e., the one accepting the collateral) Nevertheless, the crisis showed that there are risks defaults, the other counterparty (i.e., the one that connected to the repo market. The use of collateral, has provided securities as collateral) would suffer while highly desirable, complicates these risks. The a loss at least equal to the haircut imposed. Hence, issue, though, is how to manage these risks and the an inappropriate haircut would artificially increase special features of the repo market. losses, potentially aggravating stressed market Further, regulators need to be much more precise conditions. about the nature and scale of those risks. The evidence • The increased use of tri-party repo mechanisms does not justify the idea that there was a run on repo certainly has benefits in terms of better operational during the crisis and in fact suggests that the effects of efficiency around the management of collateral. changes in haircuts and margins were much smaller and Because it manages a range of collateral centrally, that the role of repo in the crisis as a whole has been the triparty repo administrator (a custodian bank or overstated. clearing house) can provide a range of services (e.g., The big problem both with analyzing the repo collateral management and valuation) in a more market and with ensuring that risks are mitigated is that cost–effective way than can be achieved bilaterally. there is not enough centrally collected and consistent Nevertheless, it is important not to confuse tri–party data. In addressing this, as Section 3 argues, it is with central clearing, because credit risk is not essential that regulators think carefully about what materially reduced through tri–party mechanisms. data would be useful and do not collect excessive data, 48 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY skepticism aboutitsviability. consequences. IIFwillrespondonhaircutsbuthassome those risksanddonotcreateseriousunintended about comingupwithsolutionsthatreallyaddress quantified, thereneedstobealotofconsideration framework issound. Loopholes needtobeclosed,butthebasicaccounting should notoverstatetheextentofproblemhere. transparency anddisclosure.Onceagain,regulators asking forsimpledata. change market behavior, soregulatorswouldbebetter which maycloudanalysis.Datacollectionwillalso Even wherespecificriskshavebeenidentifiedand There isalsomorethatcouldbedoneon Case Study 4. Securities Lending

Question 1. Nature of the activity

Figure 4.1. Participants in securities lending

Lenders Borrowers Borrowers or principal End-users Beneficialowners Agent Lenders intermediaries 49 | Pension Hedge Funds Securities on funds loan Banks Custodians Market Insurance Collateral Proprietary Companies Third-party makers traders specialists Lending fees Prime brokers Investment Investment Funds funds

Bank of England

Securities lending involves a transfer of securities (e.g., The securities–lending market has four key players. shares or bonds) to a third party (the borrower), who Institutional asset managers are the source of supply for finance institute of international will give the lender collateral in the form of shares, securities lending and the custodian agents who act on bonds, or cash. The borrower pays the lender a fee their behalf. The demand for the loans comes mostly each month for the loan and is contractually obliged from hedge funds, who sell short. They rely on their to return the securities on demand within the standard prime brokers (generally global investment banks) to market settlement period (e.g., 3 days for U.K. equities). source the loans from the custodian agents. The borrower will also pass over to the lender any Lenders are typically large scale investors, such dividends, interest payments, and corporate actions that as pension funds, insurance companies, collective may arise. investment schemes and sovereign wealth funds (see In essence, the lender will retain the key rights it Figure 4.1). These investors would normally employ an would have had if it had not lent the securities, except agent (e.g., a custodian) to arrange, manage and report it will need to make special arrangements if it wants to on the lending activity. vote on the shares. Borrowers are typically large financial institutions, There are two key differences between a securities such as investment banks, market makers, and broker loan and a repo: dealers. Hedge funds are among the largest borrowers I. The purpose of the transaction. Securities loans of securities, but they will borrow through investment are usually motivated by an institution’s banks or broker dealers rather than directly from the demand to borrow a security for purposes such investors. as short-selling or trade settlement. Repo is Institutions borrow securities for a variety of sometimes used to borrow or lend securities, reasons, including but generally the motivation is to borrow or I. To facilitate the buying and selling of securities. lend cash. This activity is commonly known as “market- II. Transaction structure. In a repo transaction making.” Market–makers stand ready to buy there is an outright sale of the securities and sell securities on a regular and continuous accompanied by a specific price and date basis. In order to meet customer demand to buy at which the securities will be bought back. securities, they hold an inventory of securities Securities loans are often open-ended, which and also borrow securities. makes them more flexible for lenders and II. To facilitate trade settlement. Settlement failure borrowers and there is no transfer of beneficial occurs when a seller fails to deliver a security, ownership. such as an equity, to a buyer on an agreed 50 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY offer thebeneficial ownerprotectionagainst losseson securities lending programs.Agentlenderssometimes as acustodianorthird-party specialist,tomanagetheir revenue. activities canrepresentasignificant proportionoftheir such asexchange-traded funds,their securitieslending owners’ totalreturns,butforsomebeneficialowners, billion in2010. lending peaked at$14.3billionin2008,falling to$6.5 assets. as payingacustodiantosafeguardandadministerthe associated withmaintainingaportfolioofassets,such asset portfolios.Thisincomecanhelpoffsetexpenses out securitiestogenerateadditionalincomeontheir as pensionfundsandinsurancecompanies.Theylend beneficial owners, whicharetypicallyinvestorssuch IV. III. Beneficial ownersusuallyuse anagentlender, such This representsasmallproportionofbeneficial A Lenders ofsecuritiesarecommonlyreferredtoas ccording toDataExplorers,revenuefromsecurities difference. price, inordertomake aprofitfromtheprice with aviewtobuyingitbacklateratlower investor borrowsandthensellstheequity, is overvaluedandexpectsitspricetofall.The example, aninvestormaythinkthatequity which isusedinseveraltradingstrategies.For securities tosellthem—so–calledshort-selling, For tradingstrategies.Aninstitutionmayborrow transactions. or ascollateralforswapandderivative then beusedtoraisecashintherepomarket upgrade trades.Theborrowedsecuritiescan transactions areoftenreferredtoascollateral backed securities(ABS),ascollateral.These securities, suchascorporatebondsorasset- pledge relativelylowerqualityandlessliquid as governmentbonds,againstwhichthey high-quality andliquidsecurities,such Institutions, usuallybanks,mayborrow To accesshigh-qualityandliquidcollateral. lender inordertoterminatethesecuritiesloan. seller, thiscanbedeliveredtothesecurities Once theequityisreceivedfromoriginal equity inordertocompletethetransaction. deliver theequity, itcanborrowanequivalent and penaltiesthatcanarisefromfailingto agreed toselliton.Inorderavoidthecosts that iswaitingtoreceivetheequityhasalready between parties.Insomecases,theinstitution settlement instructionsbeingexchanged date. Thismayhappenduetoincorrect

• • Benefits ofsecuritieslending: manage theirownsecuritieslendingprograms. their lendingactivity. Somelargebeneficialowners markets forrepooflow-quality securities. quality securities aretypicallymorerobust than these fundingsources.Also,repomarkets forhigh- access, thelowerimpact fromashocktooneof The widertherangeoffunding sourcesabankcan for abank,allowingthemto diversifytheirfunding. Second, thisrepresentsanadditional fundingsource of funding,thebankcanobtaincheaperfunding. the securitieslendingfeeislessthanothertypes the combinedcostofrepointerestrateand from thesetypesoftransactions.First,provided There aretwopotentialfundingadvantagestobanks used toaccessfundingintherepomarket. securities, suchasgovernmentbonds,thatcanbe securities forhigherqualityandmoreliquid upgrade tradesthatallowthemtoswapthese accept. Instead,bankscanundertake collateral may haverestrictionsonthetypeofcollateralthey difficult asprovidersoffunding,suchMMFs, But forsomesecurities,suchasABS,thismaybe by pledgingthemascollateralintherepomarket. securities. Theysometimesfundthesesecurities makers forclientswhowanttobuyandsell to make areturnandbecausetheyactasmarket Funding forbanks.Banksholdsecuritiesinorder confidence whentrading. it contributestoefficientsettlementandinvestor This canenhancemarket liquidityindirectlyas borrow securitieshelpstoreducesettlementfailures. trade settlementprocessasinstitutions’abilityto Securities lendingimprovesthereliabilityof customer demandforsecurities. able toborrowsecuritieshelpsmarket makers meet basis, whichcanenhancemarket liquidity. Being buy andsellsecuritiesonaregularcontinuous trade settlement.Market makers standreadyto to supportactivitiessuchasmarket-making and increasing thetotalsupplyofsecuritiesavailable in amarket, securitieslendinghastheeffectof By creatingaccesstosecuritiesalreadyoutstanding securities. and capitalalsohelpsinvestorstobuysell and non-financialcompaniesinraisingfunding volatility, whichcanfacilitatefinancialinstitutions enables betterpricediscoveryandcanreduce trading andincreasingmarket efficiency. This market liquidity, potentiallyreducingthecostof Market liquidity.Securitieslendingcanimprove The key steps in a securities lending transaction are: collateral. Institutional lenders have an inventory and I. the loan is initiated and terms are agreed do not typically lend if the inventory is not there. between the lender and the borrower. The agent lender usually negotiates the terms on Question 3. Scale of the activity behalf of the beneficial owner. Terms may This market is global, with over $800 billion worth include the duration of the loan, borrowing of equities on loan spread across over 3 million fees, eligible collateral and collateral margins. transactions. Institutional asset managers, with over II. the lender delivers the securities to the 20,000 portfolios, make over $6.5 trillion worth of borrower and the borrower delivers the global equities available to borrow. 51 | collateral to the lender. At over US$300 billion a year, the U.S. equity III. During the life of the loan, the collateral lending market dwarfs that of other markets and required from the borrower may vary as the represents almost half of the global securities–lending values of the collateral and of the securities industry. US$ trillions lent change. 18 IV. When the loan is terminated, securities are 16 returned to the lender and the collateral is Securities available returned to the borrower. for loan 14

12 Question 2. Generic characteristics of the 10

activity finance institute of international Securities lending activity does not use leverage. 8 There is a margin requirement, depending on type Securities 6 of securities borrower. In the U.S., the margin is 2%; on loan 4 outside the U.S. it is 5%. Credit lines are extended for all lending/borrowing 2 activity, subject to the usual counterparty credit risk 0 assessments by the lenders. 2005 06 07 08 09 10 11 When acting as a borrower of securities, a broker- Sources: Data Explorers and Bank calculations dealer would pledge collateral (cash or securities) to (a) Data are based on market value of securities. the lender. Where cash is pledged, it will be reinvested. (b) Chart uses daily data that are converted to a ten-day moving Since the crisis, beneficial owners have put in place average. (c) Securities available for loan are all securities that beneficial more stringent agreements with agent lenders on their owners have specified they are willing to lend subject to specific parameters for cash reinvestment (ie, to limit maturity transaction terms. and liquidity risk). If lending is undertaken on behalf (d) Lehman Brothers announced bankruptcy on 15 September 2008. of a pension fund, there are guidelines regarding use of collateral in order to protect the pension fund from loss Question 4. Risks posed by the activity caused by collateral re-hypothecation. Where securities are pledged as collateral, this usually done by a third Non-delivery of securities would characterize a party in tri–party situations, the custodian bank would securities lending failure. There are monitoring and oversee the risk of collateral re-hypothecation. remediation procedures in most countries, but these vary. Different countries have varying rules regarding In the U.S., cash typically gets reinvested. If their tolerance for securities lending failures. Spain has a lending institution is involved, they could re– an automatic buy–in. The U.S. has Regulation SHO, Rule hypothecate but generally do not. If they are pledging 204 controlling a set time period for delivery, absent securities to another broker-dealer, they will re– which there is a mandatory buy–in, and mandating a hypothecate. For margin debit in the context of prime penalty list to help control and disclose failures. brokerage activities, there is re–hypothecation. It is rare for a lending institution to fail on a Securities lending transactions are generally against securities loan; it is more common when the loan is payment; non–U.S. transactions would be pre-paid and recalled that there is a failure. A client could have collateralized in advance of the stock borrow. If a stock instructed transfer of securities from one broker to borrow failed to settle, the lender would still have the another and could have used the securities. These 52 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY reinvestment of customercashbyagentlendings. These the financialmarkets. many ofthepotentiallosses, withminimalimpacton operational, creditandrisk management mitigated 2009 whichtestedthesecurities lendingmarket. Sound counterparty defaults,aswelltheeventsof1998and and underlyingparties).Therehavebeenmany regularly restrictacceptingborrowsfrom(e.g.,agents review ascheduleofwhotheyarelendingtoand credit riskisafactor. Lenders’creditdepartments As formostsecurities–tradingactivities,counterparty activity Question 5.Risksfromentitiesundertakingthe The answertoQuestion6examinesthis. others anditsconnectionswiththefinancialsystem. securities lendingthoughmaycomefromitsuseby to assessandunderstandtherisks.Therealriskfrom methodologies, andafailureofmarket participants risks frominadequatetransparency, inconsistentpricing • • • • • answer toQuestion6looksatthisinmoredetail. does notmeanthatanygivenpartyisatmorerisk.The effects ifthesamesecurityisre-lentonward,butthis counterparty failingtoanother. Therecanbeknockon enhanced post-LehmanBrothers. the globe,becausemediationprocedureshavebeen they wereafewyearsago,duetoregulationacross failures havereducedtoafractionallevelofwhat Other significant lossesin2008derivedfrom As theanswertoQuestion7suggests,therecanbe claim foradividendorotherentitlement? o recalled late? o risk matters,suchas Operational risk:Thiscoversday-to-dayoperational collateral isreceived. being lentaredeliveredtotheborrowerbefore Intraday settlementrisk loss onthere-investmentofcashcollateral. Cash collateralrisk: are lent. falls belowthereplacementcostofsecuritiesthat Collateral risk: unable toreturnthesecurities). the loan(e.g.,borrowerbecomesinsolventandis Borrower risk:Thethattheborrowerdefaultson Types ofriskforsecuritieslendingactivityinclude There isusuallyachain,soitnotone What happensifthelenderoritsagentfailsto What happensifsharesthataresold Theriskthatthevalueofcollateral Theriskthatthelendersuffersa : Theriskthatthesecurities purposes. collateral postedbyitsclients ascollateralforother by LehmanBrothers,apracticethat involvesusing This waspartlyduetore-hypothecation ofcollateral to LehmanBrothersinorder borrow securities. difficult toreclaimthecollateral thattheyhadpledged borrowed securitiesviaLehmanBrothersfoundit collateral andmadelosses.Hedgefundsthathad a fewbeneficialownersstruggledtoliquidatetheir their collateralandreplacelostsecurities.But failed, mostbeneficialownerswereabletoliquidate of clients,suchashedgefunds.WhenLehmanBrothers lending market andoftenborrowedsecuritieson behalf for example,wasalargeborrowerinthesecurities counterparties andtheircustomers.LehmanBrothers, institutions aretransmittedacrossnetworks,impacting can causecontagionwhenproblemsatoneorfew to thesystemortheircounterparties. individual playersuponliquidatingposednorealthreat banks andnon-financialcompanies.However, lossesat types ofsecuritiesandexacerbatedfundingissuesfor contributed toimpairedmarket liquidityforcertain in securitieslendingactivitybylate2008.Thissituation some entirely, whichcontributed tothesignificantfall some participantstoreducetheiractivityinthemarket, concerns inthesecurities lending market. Thisprompted participants ledtomorewidespreadcounterparty making activity. Lossesforsomesecuritieslending inventories ofsecurities—ledtoareductioninmarket- as market makers toreducetheirbalancesheetsand loan—alongside capitalpressuresonbanksacting financial institutions. additional interconnectionsbetweenvarioustypesof within thefinancialsystem.Securitieslendingcreates counterparty exposuresincreaseinterconnections of thefinancialsystem Risks fromlinkageswiththerest Question 6. measures suchasimprovingmarkingandmargining. be, itmaybeaddressablethroughsmallbuteffective market practiceinthisareaisnotasgooditcould financial markets. However, exactlyaswithrepo,while and managementpracticescausedmajordisruptionin argued thatinsufficientrigorincollateralvaluation securities lending. liability managementfailures,onlyslightlyrelatedto losses stemmedfrombasicdiversificationandasset During episodesofstress,interconnectedness In 2008,thereductioninsecuritiesavailablefor Financial transactionsthatresultinchainsof As withrepoinCaseStudy3above,theFSBhas In addition, in its report on securities lending No equity securities lending lines were terminated and repo43, the FSB has recently expressed concerns and haircuts held up at normal levels. As such some about the use of collateral. In particular, it has argued argue the securities lending product did not add to the that securities lending and other forms of securities disruption. financing As with repo, the FSB has also argued that re- may allow financial institutions (including some non- hypothecation and collateral velocity, or the length banks) to obtain leverage in a way that is sensitive to the of collateral re-use chains, can be procyclical. value of the collateral as well as their own creditworthiness. Nevertheless, it noted that the length of “re-pledging As a result, these markets can influence the leverage chains” has shortened significantly since the crisis 53 and level of risk-taking within the financial system in a and that many lenders will accept only high-quality | procyclical and potentially destabilising way. government bonds as collateral or cash collateral that Sudden shifts [in collateral values] however have they will reinvest at short maturities in high–quality tended to follow unexpected common shocks to a large government bond repo, Treasury bills and/or in MMFs. section of the collateral pool, such as the deterioration in For their part, most Prime Brokers either post most the U.S. housing market affecting ABS markets, and doubts of their collateral directly with funding counterparts about the creditworthiness of some European government that safe keep the assets or they house them in tri– issuers affecting government bond. These can cause market party. Re-pledging such assets is not a feasible practice participants to exclude entire classes of collateral from their in the equity securities lending market. In that sense the transactions, creating a vicious circle. … Changes in the securities lending chain is very short. The major dealers market value of lent securities (e.g. equities) feed directly do not lend to each other. Where real money funds or into changes in the value of cash collateral required against securities lending counterparties take the assets versus institute of international finance institute of international securities lending and then reinvested in the money market. cash or stock loans – the asset remains with that fund. This creates a procyclical link between securities market valuations and the availability of funding in the money Question 7. Disclosure and transparency markets. There are currently no ongoing requirements to file As noted in Case Study 3, in its joint response with securities lending transaction records with regulators. ISDA to the paper by the Committee on the Global Regulators regularly request securities borrow/loan Financial System The Role Of Margin Requirements And records, particularly in the event of several fails in the Haircuts In Procyclicality (‘CGFS 36’), while noting that market place. There are private data service providers some element of procyclicality in normal economic that track securities lending–related data and provide circumstances is inevitable and indeed desirable in access to such data to subscribers for a fee. the financial system, the IIF and ISDA acknowledged that margins and collateral had some procyclical Transactions are usually conducted bilaterally rather characteristics. than through a centralized exchange, which leads to limited transparency on the fees paid for borrowing However, as with repo, securities. However, the majority of market participants this procyclicality should be seen in perspective, and use data from companies that collect and distribute data one should not overstate the role that margins and haircuts on the securities lending market. Their data includes played in the crisis as a whole. Liquidity constraints and information on fees and volumes of certain types of creditworthiness concerns led banks to actively manage securities. down exposures. The increase in haircuts and margins in Some have raised concerns that a lack of easily SFTs could be argued to be an “after the fact” effect, rather available data on pricing can lead to inconsistent than the primary driver of liquidity crisis and the subsequent pricing methodologies being adopted and can lead to capital crisis. uncertainty. In turn, that can potentially lower volumes, During the crisis losses in the securities lending particularly during periods of high volatility. Others, market as a result of the failure of two major dealers including the Risk Management Association in the U.S., were minimal and in fact many counterparties were refute the general point about a lack of transparency. drawn to the stock loan market for re-investment as Indeed, detailed securities lending information is more it was considered a safe haven. Equity collateral was readily available to the market than is the case with mostly liquid and a clear price was readily available. repos. It is not clear that more information would have helped in the Lehman Brothers case. 43 FSB, Securities Lending and Repos: Market Overview and Financial Stability Issues, Interim Report of the FSB Workstream on Securities Lending and Another concern is that securities lending may also Repos (April 2012). 54 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY subject tothe provisions oftheFSA Handbook,and borrowers orlenderswould, asauthorizedpersons,be to theFSA in securitiesborrowingand lending maybesubject an exclusion wereapplicable. Individualsinvolved be authorizedandsupervised underthatactunless A the FinancialServicesandMarkets A generally becarryingonaregulatedactivityintermsof or lendingbusinessintheUnitedKingdomwould under thepassportarrangements. borrowing andlendingactivitiesinothermemberstates authorized inoneMemberStatemayconductstock– Directive (MiFID2004/39/EC).Firmsincorporatedand requirements oftheMarkets inFinancialInstruments subject toEUregulationunderthegeneralregulatory Securities borrowingandlendingactivitiesare Securities lendersareregulatedfinancialinstitutions. mitigation Regulationandother risk Question 8. funding pre-emptively. being repaid,potentiallyleadingthemtowithdrawtheir depositors andcreditorsmaybemoreuncertainabout claim toifthebankfails.So,inastressedsituation, of abankasitmeanstheyhavefewerassetstolay market participants. is encumberedinthiswaymaybeunknowntoother them. Theproportionofabank’sbalancesheetthat are encumbered collateral. Thismeansthataportionoftheirassets to asignificantamountofassetsbeingpledgedas borrowers ofsecurities,securitieslendingcanlead participants toassesstheriskoftheseinstitutions. exposures. Thismightmake itmoredifficultfor publish dataonthesizeoftheirsecuritieslending due tosecuritieslending.Manyinstitutionsdonot difficult tounderstandtheriskexposureofinstitutions funds andbanks’counterparties,mayalsofindit information. but fromalackofexpertiseinanalyzingtheavailable although mayresultnotfromalackofinformation transactions. Thisissueismoregenerallyaccepted the riskstowhichtheyareexposedasaresultofthese their clientsandcounterparties,donotfullyunderstand involved, aswellothermarket participants,suchas create opacityinriskexposureswhentheinstitutions ctivities) Order2001 andthereforewouldhaveto Any personwhoconductssecuritiesborrowing Encumbrance canbeanissueforunsecuredcreditors In thecaseofbanks,forexample,thatarelarge Market participants,suchasinvestorsininvestment ’s approved–personsregime. Thesecurities — anotherpartyhaslegalclaimover ct 2000(Regulated lending asnoted inSection984of Dodd-Frank. securities lendingforinvestment fiduciaries. directly impactthesupplyside bysettingconditionson the EmployeeRetirementIncome Security A such astheInvestmentCompany A effect onthedemandsideofmarket. rules underRegulationSHO indirect regulations,includingRule204andtheother on itssecuritiesborrowingandlendingactivities; minimum netcapitalitisrequiredtomaintainbased relate tohowaU.Sbroker-dealer mustadjustthe Exchange A that mustbeprovided,settingaminimumof100%); of acceptablecollateralandtheamount securities borrowsfromcustomers,includingthetypes how aU.Sbroker-dealer documentsandcollateralizes the SecuritiesExchange A securities lendingtransactions.);Rule15c3-3under under whichaU.Sbroker-dealer mayengagein Federal ReserveSystem(specifiestheconditions are RegulationToftheBoardGovernors regulations thatdirectlyrelatetosecuritieslending regulated andhasbeenformanyyears.Amongthe product types. use ofcentralcreditcounterpartiesacrossavariety remain potentialimpactsonindemnificationandthe exempt fromseveralofBaselIII’snewrules,butthere practitioners chairedbytheBankofEngland. Lending andRepoCommittee,agroupofmarket Disclosure Codeofonduct,drawnupbytheSecurities this activity. Thereisalsoa Securities LendingAgent Guidance 2009governsmarket participant’sconductfor section MAR5oftheFSA Handbook regulatory regimeintheUnitedKingdomsetout Multilateral TradingFacilities,whichhaveadedicated lending market, mayberegulatedastheoperatorsof by someparticipantsinthesecuritiesborrowingand concerned inmeetingtheFSA and otherprovisionsrelevanttotheconductoffirm account. TheFSA Handbookcontainsrules,guidance, a beneficialowner’sconsenttostocklendingonits The ConductofBusinessSourcebookmayrequire related CodeofMarket ConductissuedbytheFSA. A abuse provisionsoftheFinancialServicesandMarkets they wouldalsohavetoregardthemarket ct 2000,theMarket AbuseRegulations,andthe In theU.S., SEC hasauthority oversecurities On theborrowingside,there are alsoregulations, The securitieslendingmarket intheU.Sishighly Securities lendingtransactionsarespecifically The BankofEngland’sSecuritiesLendingCode Providers ofelectronictradingplatforms,used ct Rule15c3-1,whichhasprovisionsthat ct of1934(requirementsfor , primarilyhavingadirect ’s HighLevelStandards. ct of1940and ct, which However, a year after the signing of the Act, the SEC to play a key role in reducing Europe’s reliance on has given no clear indication of how it intends to adapt traditional relationship–based bank lending and the regulation of securities lending or what data must increasing the use of capital markets–based financing. be provided to ensure supervision. Ultimately, the SEC Nevertheless, as with repo, the financial crisis is expected to provide new reporting and transparency showed several risks and weaknesses in the functioning requirements for securities lending in U.S. markets. of the securities lending market, particularly in regard Securities lending activities are also generally to disclosure and transparency and particularly from governed by standard form industry contracts, notably the interconnectedness of the system. As is noted above, the Global Master Standard Lending Agreement. in 2008, losses for some securities lending participants 55 led to more widespread counterparty concerns in | Conclusion the securities lending market. This prompted some participants to reduce their activity in the market—some Securities lending is already a regulated activity in entirely—which contributed to the significant fall in many respects. Securities lending activity is short in securities lending activity by late 2008. This situation duration, fully collateralized, is marked to market daily, contributed to impaired market liquidity for certain does not use leverage, is for the most part very liquid, types of securities and exacerbated funding issues for is largely conducted between prudentially-regulated banks and non-financial companies. Although, most (banks and broker-dealers) or soon to be prudentially- beneficial owners were able to liquidate their collateral regulated entities (hedge funds); and in these respects, it and replace their lost securities following Lehman does not trigger systemic risk concerns. Brothers’ failure, a few beneficial owners struggled to Securities lending is a well-established investment liquidate their collateral and made losses. Hedge funds technique generating important incremental revenues that had borrowed securities via Lehman Brothers finance institute of international for long–term institutional investors. The activity is found it difficult to reclaim the collateral that they had driven by investor demand to hold safe, liquid assets, pledged to Lehman in order to borrow securities. and in this regard is an extremely important contributor A lack of transparency in risk exposures and to financial stability. Collateralized lending of securities a failure by beneficial owners to appreciate the has helped to enable financial globalization, as it counterparty and liquidity risks involved in their enables global counterparties to transact with each securities lending programmes before the financial other on the basis of secured collateral rather than crisis also increased the level of risk. A full review by a direct counterparty relationship. A globalized/ beneficial owners of counterparty creditworthiness globalizing economy has large liquidity needs, which combined with basic parameters of diversification, can be met only by a collateral-based financial system. concentration, liquidity and asset-liability management There is a delicate and dynamic relationship between could significantly reduce the probability of a money demand and the funding liquidity of assets in significant loss. economies where collateral is central. Greater disclosure and transparency to the regulators Securities lending improves the reliability of the of securities lending transactions is a key initial step, trade settlement process as institutions’ ability to and this might usefully be accomplished via a trade borrow securities helps to reduce settlement failures. data repository; however, as in the derivatives arena, This can enhance market liquidity indirectly as establishing multiple trade data repositories is to be it contributes to efficient settlement and investor avoided, if possible. As with repo, however, regulators confidence when trading. By supporting trading should not overstate the extent of the problem here and strategies such as covered short selling, securities should consider targeted and effective responses. lending further increases market liquidity. Liquid and safe collateral is the main form of money for large firms, asset managers, and financial institutions. Unsecured bank deposits can never play this role. The efficiency advantages of a collateral- based financial system include its adaptability and reduced need for costly relationship-based lending, which is also limited in times of stress by counterparty credit risk concerns. In these regards, securities lending should continue 56 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY charges andwillnot undertake anyloanrisk. borrowers, purpose, amount,termandrate.Thebankcollectshandling The entrustedfunds areadministeredbythebankaccording totarget (government departments,enterprises/public institutionsorindividuals). 45 Abankactsasanagentofentrustedfunds fromthe“Principal” and repackagesthemintoawealthmanagement product. or atrustcompanygrantsnewandlow-risk loansatthebehestofabank, 44 Abanktakes aselectionofhigh qualityloansfromitsloanportfolio, trust cooperationproducts products. Thesecanrangefromlowfee-payingbank- typically alargeinstitutionalinvestor, determinesthe lower feeandcommissionincome,astheclient, single investor. Ingeneral,single–unittrustsgenerate company. Asingle–unittrust refinancing riskoverleasesforanautofinance to tollroads,oritcanofferaserviceofmanaging be structuredaroundinvestingintheincomerights product oraservice.Fexample,thistypeoftrustcan monetary assets,anditcanbeeitheraninvestment capital trusts(single–andcombined–unittrusts). investor profileintopropertymanagementtrustsand typically shortertermliabilitiesthanassets. (see below).Trustcompaniesareleveragedandhave in specificareassuchasinfrastructureorrealestate wide rangeofinvestments,trustcompaniesinvestthem administrative ceiling.Ratherthaninvestthefundsina deposits, asofficialdepositratesaresubjecttoan higher returnsandinvestmentalternativestobank companies andHighNetWorth Individualsseeking China trustcompaniesraisefundsfromcash-rich characteristics oftheactivity Natureandgeneric Questions 1and2. • • • products thataresoldtomultipleinvestors. specific investmentcriteria.Combined–unittrustsare higher fee-payingproductsinwhichclientslayout Companies Case A propertymanagementtrustmanagesnon- Trust productscanbecategorizedbystructureand Security investmenttrusts infrastructure enterprises. unable tosecuresufficientfinancingfortheir by localgovernmentsbecausemanyofthemare focus onsecond-tierandthird-tiercityconstruction products) financepublicworksprojects.Themajority Infrastructure trusts(government-trustcooperation 30%. to ayear, andtheinterestraterangesfrom10% to 10% oftheirloans.Debtmaturityisafewmonths For mostdevelopers,trustloansmake uplessthan Real estatetrusts, financeinvestmentinrealestate. The rangeofinvestmentscanbequitewide: Study 5. Ch inese 44 investinproductssuchas andentrustedloans isaproductofferedto Trust

45 to • • • • • • more conventionalintermediariesincluding increasing arrayofactivitiesthathaveusuallyfallento products remainsrobust. activity haswanedwhen,infact,issuanceofothertrust incorrectly extrapolatedthistomeanthatalltrust regulation. However, manymarket participantshave a default. come underpressuretomake upforthelossincaseof the trustcompany(thatfacilitatedsecuritization) in reality, itisquitepossiblethatthebankaswell accordingly thebankdoesnottake creditrisk.However, obligation onthebankonceloanhasbeensold,and them throughatrustmechanism.Thereisnolegal retail depositorsorsmallinvestorsaftersecuritizing within ayear. Trustloansaresoldbybankstotheir which aregenerallyshort-termandtypicallymature whose underlyingassetsconsistsolelyofloans, type oftrustproductcreatedjointlywithbanksand Trust loansrefertocreditextendedthroughaspecific Trust Loans companies inexchange forafee. banks actasabroker betweeninvestorsandtrust investors directly. However, insomecases,commercial • • use ofbanksaspaying agentsallowsCBRCtotrackthissector. (paying) agentsin such transactions,andtake on nodirectcreditrisk.The lends themoneyto thedesignatedborrower. Banksactmerelyastransfer by entrustingthemoneytoabankor financecompany, whichthenon‐ not legallypermittedtoextendloans (e.g.,corporatetocorporate)doso 46 WhereasEntrustedloansrepresenttri–party inwhichentities Providing arbitragesecurity trusts(i.e.,arbitraging Providing RealEstateInvestment Trusts; A A A Underwriting bonds; Trust companieshavealsostartedtoengageinan Issuance oftheseproductshasfallenamidstricter Traditionally, trustcompaniesraisefundsfrom in stocksandbondslistedHongKong. QDII productwaslaunchedin2010, anditinvested currently 5truststhathaveQDIIlicense.Thefirst license areextremelyrigorous,andthere invest abroad.TheapplicationcriteriaforaQDII Qualified domesticinstitutionalinvestor hybrids. medium enterprises(SMEs)withdebt-equity Private equityinvestmenttrusts the primaryandsecondarymarkets. “Sunshine Funds”,andothersecuritieslistedonboth structured securities,privatelymanagedequityfunds cting ascustodians; cting asassetmanagers; cting astrusteesforABSissuances; 46

lendstosmalland (QDII)products price differences between similar financial Question 3. Scale of the activity instruments, such as short term bonds and MMFs Since its peak in late 1990s, the number of trust in different markets, exchange-traded funds; and companies has fallen from more than 1,000 to about 65, individual stocks, warrants and convertibles.) largely in the face of regulation following a meltdown Trust companies have also recently developed of the sector (see below). According to the China Trustee alternative products to raise new funds: Association, there were 65 registered trust companies at the end of 2011. Total assets under management (AUM) • Property project trusts: These trusts invest in equities were CNY4.81 trillion (US$764 billion), up 58% from of project companies set up by property developers. the end of 2010. Single–unit trusts accounted for 68% The trust pays a fixed yield to the investor until 57 of total assets. | the equities are bought back based on a repurchase agreement. Total capital trusts (single– and combined–unit trusts) were CNY4.6 trillion (US$737 billion) by the end • Interbank trust: Banks package discounted bills into of 2011 (whereas bank lending was US$6.8 trillion), trust products or attract trust funds as “negotiated compared to CNY2.9 trillion (US$459 billion) in 2010. deposits.” In terms of forms of funds application, loans accounted • Equity linked trust: Issuers receive funding by for 37%. In terms of the target sector, 22% went into pledging equity stakes or selling the capital gains of infrastructure and 15% into real estate. stocks to trust, with a guaranteed minimum yield. In terms of AUM by product composition, bank- • Trust of trust (TOT): A product invests in trust products trust cooperation products reached CNY1.65 trillion issued by other major trust companies (annual yield (US$265 billion, 35% of AUM), and government-trust of 7.5% compared to average trust yield of 10%). cooperation products accounted for 5.3% of AUM. finance institute of international Thus, trust companies are constantly evolving, In addition to the China Trustee Association, Use- offering new products and carrying out new activities Trust Studio and Wind Information Co. also collect to raise funds or increase profits. As the case study data. shows below, part of this is in response to regulatory changes.

Chart 5.1. Chart 5.2.

Trust Assets Under Management (AUM) Trust Assets by Type: 2011 trillion yuan trillion yuan 5 Total RMB 4.8

4 Single Fund Trust 3.3 Assembled Fund Trust 3 1.4 Property Management Trust 0.2 2

1

0 2005 2006 2007 2008 2009 2010 2011 Source: China Trustee Association Source: China Trustee Association 58 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY property developers faceddemandsforredemption from banks (accounting for8%oftotalbankcredit). If developers alreadyborrowon averylargescalefrom type single–andcombined–unit trustproducts.Property sector, makingcreditriskaprominentissuefor loan- macro-economic policiesto cooldowntheproperty 2010 Chineseregulatorshaveimplemented numerous that wouldincreaseNPLsatbanks.Forexample,since (NPLs) ofbanks. would notdirectlyaddtothenon-performingloans commercial banks.Defaultsbytrustloanborrowers trust loanshavelimiteddirectcreditexposurestothe borrow toinvestinwealthmanagementproducts, the bank’sownclients. trust loansbecamenon-performing,astheyaresoldto some reputationrisks(i.e.,accusationsofmis-selling)if - actingsolelyas“brokers,” bankswouldbearperhaps investors. banks andotherinformallendingsectors,aswellto take deposits). from overseas,toguaranteeminimumreturns,or companies (i.e.,werenotallowedtoborrow significantly reducedthebusinessscopeoftrust The establishmentoftherustLawinOctober2001 cease businessesandresubmitcertificationapplications. the trustindustrythen,orderedallcompaniesto billion. debt ofTICsreachedbetweenUS$12billionand$20 to Japanesecreditors.In2010, theIM F estimatedtotal US$370 millionworthofSamuraibondsthatwereowed of thetrusts.Forexample,HainanITICdefaultedon period becauseofpoorcreditassessmentandstructure the overseasanddomesticpartner. which trustcompanieswouldplaythedualroleofboth to governmententities’constructionsubsidiariesin common functionofthesetrustcompanieswaslending invest inkey areasofeconomicdevelopment.Themost Government entitiesusedthesetrustcompaniesto 1992, thenumberoftrustcompaniesreached1,000. other playersinthefinancialsector. Bytheendof massively whileregulatoryconstraintwasplacedon trust companieshasalreadycrystallized. In asense,thesystemicriskposedby“failure”of Risksposedbytheactivity Question 4. However, theremightbesomesecond-ordereffects Given thatwealthyindividualsgenerallydonot As banks’directinvolvementintrustlendingislow At themoment,therearesomeriskstocommercial In 2000,thePeoples’ BankofChina,theregulator Several notablebankruptciesoccurredduringthis From 1979to2000,trustcompaniesweregrowing impact bankbalance sheets,forexample, via theforced would deterioratequickly, andthefinancialrisksmay landing oftheeconomy, trustcompanybalancesheets of property/asset prices, (and/or) accompanied by a hard vis banking.However, iftherewereasharpcorrection now—based onthescaleoftrust companyactivityvisà interlinkages withtherestoffinancialsystemfor We donotseepotentialsystemicrisksfrom rest ofthefinancialsystem Risksfrominterlinkageswiththe Question 6. framework (seeQuestions7and8). risks aremitigatedbytheexistingprudentialregulatory liquidity shortagesintrustcompanies.However, these deposits isintroduced,whichpotentiallycreatessudden change inpolicyfavoringtheformalsectorattracting many funds(andbanks),especiallywhenasudden risks ofinsolvencyanda“run”onliabilitiesasare than assets.Inthissense,theyaresubjecttothesame leveraged andhavetypicallyshortertermliabilities As notedinQuestions1and2,trustcompaniesare the activity Risksfromentitiesundertaking Question 5. unlikely torepresentsystemicfinancialrisks. banks withaflighttoquality. the bankingsysteminformofdeposits,benefitting decline intheshort–term,withmoneyflowingbackto occurred, theamountoftrustlendingwouldlikely stress tothetrustcompanies.Ifthisredemption to awidespreadredemption,whichcouldcauseliquidity disclosure, isolatedcasesofdefaultcouldpossiblylead the trustshaveinvested,partlybecauseoflack of thefinancialconditionsprojectsinwhich (2011). formal lendingsystem.ThisriskishighlightedbyFitch domino effectinotherpartsofChina’sinformaland 22% oftotaloutstandingloans.Therecouldalsobea for SMEs,whereloansfrombanksaccountabout step inbygrantingloanstotheissuers.Thesameistrue in caseofdefault,shareholdershavestrongincentiveto are limitedandthattheCBRCmaysuspendlicense vehicles, insurers,andbanks).Giventhattrustlicenses state-owned enterprises,localgovernmentfinancing help fromtheirshareholders(whicharemostlylarge liquidity risk.However, trustcompaniescouldaskfor was insufficienttocovertheloss,thiscouldcause If theydefaultedandtrustcompanies’owncapital investors, theirrepaymentabilitywouldbeaffected. In theimmediatefuturethough,theseareall Given thatindividualinvestorshavelittleknowledge sale of assets diminishing asset prices. While there is an companies needed to be compliant with new impact, this is an simultaneous effect that everybody regulations and risk management guidelines within else suffers from the same root cause, and we do not 3 years in order to be certified. As a result, 10 trust see this as posing material systemic risk considering the companies underwent restructuring and have been scale of the activity. successfully relicensed. At a non-systemic level, if in the light of an --The Measures for the Administrative of Trust economic shock, trust companies stopped providing Companies set guidelines to restructure the trust liquidity to SMEs, SMEs might borrow from other sector as an investment vehicle for institutional informal lending channels that charge a much higher investors. 59 interest rate, reducing their access to credit and --The Measures for the Administration of Collective | exacerbating any economic downturn. Funds Trust Schemes of Trust Companies define qualified investors, set restrictions on the Questions 7 and 8. Disclosure, transparency, promotion of trust products, and create and regulation requirements for the custodians of trust assets. --The Trust Company Governance Guidelines require Prudential regulation trust companies to establish corporate governance In September 2010, the CBRC published the Measure structures in line with banks (i.e., create a board for the Administration of Net Capital of Trust Companies. that includes independent directors, internal audit Trust companies need to report on, and apply certain and risk management committees). As a result, the risk weightings to AUM in their 2011 financial corporate governance of trust companies improved statements. This regulation ensures that each trust fund significantly. finance institute of international is sufficiently supported by capital and discourages --The Measures for the Administration of Trust channel-type products (i.e., bank-trust cooperation Companies’ Overseas Financial Management Business products) that lack direct input or risk oversight from permitted trust companies to apply for QDII the trust company. Specifically, trust companies are licenses. The application criteria are particularly subject to a form of prudential regulation, where a rigorous; trust companies are required to have calculation of net capital (net assets minus prescribed no less than CNY1 billion in registered capital. deductions) cannot exceed a calculation of risk capital (a The companies must have generated a profit type of standardized approach to risk weighted assets). and received good ratings by the CBRC over the previous 2 years. The CBRC also has high Conduct-of-business regulations standards for corporate governance and risk management processes. Over the past decade trust companies have constantly evolved, the CBRC has issued a series of circumstantial • In 2008, the CBRC issued the Guidance for Trust regulations, [chasing trust company activities, rather Companies to Operate Trust Private Equity Investment than being based on general principles]. Business, detailing the key operational guidelines for management of PE investment trust products. • In 2001, the issuance of Trust Law established the legal basis for the trust companies. In 2002, the • In August 2009, the CBRC released Risk Alert on PBOC released the Provisional Rules on Entrusted Funds Trust Company Equity Trading Accounts to prohibit Management of Trust and Investment Companies. These trust companies from opening new share–trading were aimed at improving regulatory oversight and accounts without first closing another existing establishing a penalising mechanism for companies account. operating outside of the law. As a result, trust • Between 2009 and 2010, the trust sector once again companies’ business scope was sharply reduced. grew dramatically. The CBRC was concerned about However, the companies quickly rebounded. the sustainability of the risk management processes • In 2003, the CBRC took over oversight and launched and aimed at transforming trust companies into investigations into the trust sectors and discovered well-managed third–party wealth management three scandals in 2004. The CBRC thus required trust institutions. It published guidelines regarding companies issue annual financial statements, and the higher risk trust investments in private equity, number of players dropped dramatically by 2005. security, infrastructure, real estate, and bank-trust cooperation products. • In 2007, the CBRC instituted a series of new regulations to restructure the trust sector. Trust 60 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY • • • • • • Between BanksandTrust : Further RegulatingtheW In January2011, theCBRCissuedNoticeon publicly available.) 6 beingtheworstscore).(Thisinformationisnot Regulators givescoresonascaleof1to6(with capabilities, andprofitabilityoftrustcompanies. controls, regulatorycompliance,assetmanagement that focusoncorporategovernancestructures,risk The ratingsaredevelopedbasedonevaluations Ratings andClassifiedRegulationofTrust Companies. The CBRCalsoissuedtheGuidanceonSupervisory risk mitigationmeasures,includingthefollowing: Estate Trust. Asaresult,trustcompaniesbegantouse CBRC swiftlyissuedRiskAlertsonTrust CompanyReal of realestatetrustproducts.InDecember2010, the However, thisnoticedidnotslowdownthegrowth only upto65%ofthetotalprojectcost. “Four Pass” testandcanseektrustfinancingfor related risks.Realestatedevelopersmustmeetthe attention tomanagementofrealestateproject– Trusts, whichrequiredtrustcompaniestopaygreater Companies toStrengthentheSupervisionofRealEstate In February2010, theCBRCissuedNoticetoTrust government guarantees. supported byimplicit(especiallymunicipal) Guarantees Forbidding PublicFundRaisingwithLocalGovernment In November2009,theCBRCpublishedGuidance the AUMwithoutCBRCapproval). trust’s AUMbalance(loanscannotexceed 30%of can make byweighingoutstandingloansagainstthe also limitedthenumberofloansatrustcompany individual investorsperproduct.Theseregulations investors, thusexempting themfromthecapof50 in excess of,CNY3mn(US$476,190)asinstitutional characterized investorswithinvestmentsequalto,or In 2009,theCBRCannouncedanewrevisionthat ------principle, the bank trustcooperationloan balances its provincialofficesbefore January 31, 2011. In had tobesubmittedtheC BRC headquartersor sheets bytheendof2011. Detailedtransferplans wealth managementcooperation intotheirbalance off-balance-sheet assetsconcerning banktrust First, thecommercialbanksmusttransfer Using specialisedstructurestoreducerisk. guarantees; and A Pledging theequityofunlistedcompanies; Increasing collateralizationabovethe100% mark; dding creditenhancements,suchas toaddressconcernsaboutthosefunds ealth ManagementCooperation Conclusion 3. 2. 1. Further Reading factors inthisassessmenthavechanged. their developmentandregularlyreviewwhetherany models. Italsosuggeststhatregulatorsshouldmonitor can beandhownimblytheychangetheirbusiness illustrates howsystemicallyimportanttheiractivities • • • systemic riskforthefollowingreasons: out oftrustindustryintounregulatedareas. be consideredwhetherthishasjustpushedthemoney revival, comparedtothelate1990s.However, itshould industry hasshrunksignificantlyevenafteritsrecent • However, thecaseofChinatrustcompanies to stepinbygrantingloanstheissuers. the lossbecauseshareholdershavestrongincentives trust companies’owncapitalisinsufficienttocover Limited spill-overeffectifborrowersdefaultand sufficient capital;and among othersandprudentialregulationsthatrequire governance, riskmanagementandcompliance significantly andimprovedtheircorporate narrowed trustcompanies’businessscope Recent conduct-of–businessregulationsthat lending ofUS$6.8trillion); US$764 billionattheendof2011 (comparedtobank Its relativelymoderatesizeofatotalAUM At themoment,Chinatrustsectordoesnotpose After alltheseregulations,thescaleoftrust for China’sSMEstosecurefunding. commercial paper, whichhadbecomeapopularway wide banonthesaleoftrustproductsthatinvestin In mid-January2012, theCBRCimposedanation- - - China’s Trust Sector:ANewChapter , KPMG,2008. Mainland ChinaTrust Survey www.cbrc.gov.cn/index.html). China BankingRegulatoryommission(http:// - - the totalbalanceofbanktrustloans. of thenon-performingbanktrustloansor2.5% if thetrustcompensationreservesfallbelow150% Third, trustcompaniesshouldnotdrawdividends risk-based capital. remaining off-balance-sheetbanktrustloansas Second, trustcompaniesshoulddraw10.5% ofthe should bereducedbyatleast25%quarterly. , KPMG,2011. 4. Chinese Banks: Growth of Leverage Still Outpacing GDP Growth, Fitch Ratings (July 2011).

5. Trust Market: Innovation, Innovation And Innovation, Bank of America Merrill Lynch (February 2012).

6. China Trustee Association (http://www.trustee.org. cn). 61 | institute of international finance institute of international 62 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY agencies usedthisasasufficientcriteriontogivetheir entities FannieMaeandreddieMac.)Creditrating private sectorversionofU.Sgovernmentsponsored on theirissuances.(Inthisregard,theyareakintoa guarantee (SLG)providedbythefederalgovernment deposits directly. Theybenefitedfromastoploss and unsupervised,mainlybecausetheydidnotreceive issuance—and credit-ratingagencies. acting aslenderoflastresortandbackingtheirdebt private investors;theMexicanfederalgovernment— (homebuyers andhomebuilders),institutional the difficultiesofregulatedmortgagemarket. development ofthismarket inthe2000s,recognizing to financetheloans.Mexicanauthoritiessupported on theissuanceofmortgage–backed securities(MBS) with short-termfinancing. alternatives. However, theyalsoprovidehomebuilders government supportprogramsorbroaderfinancing the informalsector-whoareunabletobenefitfrom to lower-middleincomehouseholds–primarilyin Their mainactivityisprovidingmortgagelending institutions specializedinmortgageintermediation. Mexican “Sofoles”arepredominantlysmallfinancial characteristics oftheactivity Natureandgeneric Questions 1and2. Case Prior tothefinancialcrisis,Sofoleswereunregulated Those involvedwithSofolesareborrowers Sofoles donottake depositsanduntil2008,relied Study Clients 6: Sofoles $ Institutions Financial loans in Mexico portfolio Mortgage $ Trustee

Mortgages Bond Trust

Capital result oftheirrelativeopacity. quality ofthecollateralinMBSissuance,partlyasa outcomes associatedwiththeirlendingpracticesorthe However, investorswereunawareofthepossible to retainpartofthecollateralontheirbalancesheets. through securitization,becausetheywerenotrequired months. increased in2008from60%toover70% inamatterof interest expenses,asashareoftheirgrosstotalincome, basis pointsoverthesameperiod.Notsurprisingly, the of thatshort–termfundingincreasedbyupto400 60 daysinearly2009.Evenmore,theinterestrates from approximately 130daysinmid–2008toaround short–term liabilitieshalvedduringthefinancialcrisis, required short–termfinancing.Theiraveragetermof also wereactiveinhomebuildingfinancing,which Securitization helpedfinancemortgageloans,butthey condition duringthefinancialcrisesof2008and2009. and liabilitieswascrucialtotheSofoles’distressed term assets,thematuritymismatchbetweenloans and structureoftheirMBS. borrowers andappliedlowerstandardsinthedesign income requirementsthanthoseofbanks)forsubprime standards (higherloan-to-valueratiosandlower MBS aAAArating.Theseentitiesappliedlooserlending guarantees Financial Credit riskwastransferredbySofolestoinvestors Because Sofolesusedshort–termfundingforlonger Manager Bond MBS $ Stock market Investors rating agencies Credit Question 3. Scale of the activity

Figure 6.1. MBS issuances Figure 6.2. MBS issuance: 2003-2011 (Bn Pesos 2011 prices) (Bn Pesos, cumulative amount, 2011 prices and % share)

25

44.2 55.8 21% 20 26% 63

32.7 | 15 15% 80.5 38% 10

5

Source: BBVA Research with Infonavit, Fovissste, and SHF 0 data 2003 2004 2005 2006 2007 2008 2009 2010 2011

Fovissste Infonavit Banks Sofoles institute of international finance institute of international

Government Agencies Private Entities

Source: BBVA Research with Infonavit, Fovissste, and SHF data The roll-out of MBS in Mexico began with Sofoles Question 4. Risks posed by the activity issuances in 2003. From then until 2008, these Because Sofoles were focused on lower-middle institutions issued a total of 35 MBS for an amount income households with inadequate risk assessment, of 44 billion pesos (at constant prices, equivalent to partly because of the implicit subsidy element and 47 around 4 US$ billion ). This represented nearly 75% thus the weak incentives for sound origination and of their total portfolio of 59 billion (5.4 US$ billion). underwriting, their MBS had extremely high non– In sharp contrast, issuances by banks amounted to 33 performing rates. For example, their latest issuances, in billion (3 US$ billion), roughly 9% of their 360 billion 2007 and 2008, started to show non–performing rates (32.7 US$ billion) portfolio. of up to 10%, as early as 3 months after the issuance. The importance of Sofoles can also be measured by During the financial crisis, Sofoles were hit hard, comparison with public sector housing institutes that which increased delinquency rates of the underlying are the most important mortgage generators in the loans. Although Sofoles had Stop Loss Guarantees, they country. The amount issued by Sofoles represented over covered only a part of the loss. By the end of 2011, a third of issuances from public institutions between the three biggest Sofoles, which provided over 80% of 2004 and 2011. Taken together, they total 126 billion issuances made by these types of institutions, saw non- pesos (11.5 US$ billion). performing levels in the 30%-45% range, much higher The Comisión Nacional Bancaria y de Valores than those of banks, which had better origination and (CNBV), the government agency responsible for underwriting (see Figure 6.3). financial institutions’ regulation and supervision in However, when the global financial crisis hit, the Mexico, is currently collecting data from the Sofoles. development of Sofoles was still at an early phase, so Before the crisis, the CNBV did not collect adequate the impact was more limited than it might have been. data to assess the risks, but since then they have been Had the Sofoles market been bigger, their MBS issuances improving data collection in terms of both lending and would probably have been higher. Had they defaulted, MBS issuance (see Question 7). the impact on the Mexican financial system - and the perception of risk in the system - could have been significant.

47 Using the average Forex rate over the period 2003-2008. 64 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY default arerathersmall. there potentiallossestoeithersocietyorinvestorsfroma range of20–25billionpesos.Inabsolutetermstherefore, roughly speaking,potentiallossescanbeestimatedinthe nearly 50%recoveryrateintheeventofforeclosures.So, to nearly44billionpesos.Someestimatespointa total stockofMBSissuedbySofolescurrentlyamounts (domestic andforeign),commercialbanks.The is inthehandsofinsurancecompanies,privateinvestors 80% ofthetotaloutstandingtitles.Theremaining20% and thesecondlargestinvestor, pensionfunds,have support hasmadeSofolesnon-systemic.)Thegovernment the moralhazardcreatedbyimplicitgovernment is thebiggestinvestor. (Inthatsense,itcanbesaid up to35%oftotalissuance,andthefederalgovernment private sector, becausethegovernmentguaranteecovers from Sofoleswouldhaveonlyasmallimpactonthe resort. government ultimatelyforced toactaslenderoflast assumed bySofoleswastaken onbyothers, withthe There werealsomoralhazard problemsbecausetherisk been subjecttomorerigorous regulatoryrequirements. had amoreprofessional boardofdirectorsandhad Conditions wouldhavebeendifferentiftheinstitutions executive officers,whowereatthesametime the owners. in somecasestofraudchargesagainsttheirchief practices insomeofthemostimportantSofoles,leading Even beyondtheserisks,thereweremismanagement the activity Riskposedbyentitiesundertaking Question 5. 10 15 20 25 30 35 Source: BBV Sofoles % Non-performing MBSportfolio:Banksvs. 0 5 If suchdefaultsweretohappennow, however, losses Nov-0 Banks 3 Nov-0 A ResearchwithSHFdata 4 Nov-0 5 Sofoles Nov-0 6 Nov-0 7 Nov-0 8 Nov-0 9 Nov-1 0 Nov-1 1 Mexican financialsystemcould havebeensignificant. and havebecomesystemicallyrisky. Theimpactonthe with theiropaqueandlow–qualitystructuringpractices “intervened,” Sofoleswouldlikely havekept ongrowing wider financialareas.However, ifthecrisishadnot of Sofoles,withanegativespill-overeffecton billion). is estimatedtobearound230billionpesos(18.3US$ instruments. Potential investmentjustfromthissource than 20%ofwhattheyareallowedtointhiskind example. Pension fundsarecurrentlycoveringonlyless own problemsintermsofportfoliodiversification,for the bondissuancemarket hascausedinvestorstheir liquidity torestructureshort–termliabilities. line fromthefederalgovernmenttoprovidethemwith 2009, theironlysourceoffinancehasbeenacredit the Mexicanfinancialsectorasawhole. effect onfundingofotheroriginatorsandperhapseven financial sectorasawholeandhashaddampening heightened investors’perceptionofriskintheMexican increasing thecostoffinancingforwholeindustry. can besaidthatSofoleswerepartiallyresponsiblefor has becomedominatedbypublicsectoragents.It banks was10%, in2009).Thus,themortgagemarket of Sofolesneverexceeded 5%,andthemaximumfor overcollateralization rateofaround25%(whilethat points, withaninflationadjustedbondvalueand that ofbanksandSofolesbymorethan150basis on average,publicinstitutions’MBSyieldsexceed are theonlyonescurrentlyissuingMBS.Forexample, the privatesector, andsincemid–2009publicinstitutes required higheryieldsandcollateralization. suddenly tightenedconditionsofunderlyingassets, down. InvestorsbecamewaryofMBSasawholeand of Sofolestofundinginfinancialmarkets wasshut players, inparticularbanks.Duringthecrisis,access a factorinthefreezingofissuingactivityforother the financialcrisis,collapseofSofoleswasarguably As themainplayersinMBSmarket atthetimeof rest ofthefinancialsystem Risk posedbylinkageswiththe Question 6. learned fromthe Sofolesexperience.Thegovernment were weak,the market and thegovernmenthave While initialstandardsofdisclosure andtransparency Question 7. Thus, thecrisiseffectivelyshutdownactivity In addition,theabsenceofmoreparticipantsin Sofoles’ lastMBSissuancewasinmid–2008.ince Moreover, theturmoilcausedbySofoleshas As aresult,MBSbySofolesbecameunprofitableto Disclosure andtransparency has now placed much greater emphasis on improving Conclusion transparency by requiring mortgage lenders to present Sofoles were part of well-intentioned policies aimed at detailed and standardized information on the credit improving financial inclusion. However, their design terms and conditions, as well as reporting on a monthly and implementation were deficient, including lax basis to the regulatory authorities on their portfolio regulation, poor incentives for sound underwriting, and performance, which includes expected losses. Sofoles are insufficient transparency, which in some cases allowed now reporting their lending activities using the same for mismanagement practices. All these, compounded formats as banks do, and on their past MBS issuances, by the stigmatization of securitization in global they are required to present their collection and financial markets after the crisis, led to widespread payment distribution reports regularly. Because the level 65 solvency and liquidity problems in the sector, whose | of detail on these reports vary according to the terms liabilities (and potential losses) were absorbed by public 48 of each contract , an additional standardized report sector entities. will be requested (as of late 2012 or early 2013) with detailed information on their loan portfolio. The Sofoles case illustrates the types of problems that non-bank financial activities may create in emerging For MBS issuances, a “price calculator” is now markets. Namely, that without the proper incentives, compulsory for all institutions that have or plan to regulation, and transparency, even small institutions issue MBS. Regulations ensuring standardized and fully could generate major losses for the financial system comparable information on the structuring process are and society. Regulation efforts have been important in the course of being implemented, probably effective and are heading in the right direction, especially as from 2013. As a result of the crisis, there are thus better they have resulted from consultations with other tools for the federal government to assess the risks market participants. Sofoles themselves are no longer associated with this activity. important market participants but those that survived finance institute of international are being more closely supervised. However, the real Question 8. Regulation and other risk measure of success should be full normalization of the mitigation MBS issuance market, something that is still to be seen. Furthermore, regulators will need to monitor the effects The crisis has also led to tighter requirements in terms of the new disclosure standards and regulation. of reserves, collateral, and capital held by issuers. Measures were also adopted to clarify the functions of different intermediaries involved in the securitization process, as well as the regulation applicable to each of them. For a start, Sofoles are required to have capital requirements at the same level as that of commercial banks. Also, when delinquency rates for Sofoles exceed 10%, they are required to cover 60% of their loan portfolio with reserves, as a condition to maintain access to public funding sources from Sociedad Hipotecaria Federal. They are also required to comply with stock market disclosure and reporting standards. A specific regulation for the Sofoles, already approved and becoming effective in 2013, requires them to either convert themselves into a bank (or merge with one) or, as long as they seek funding in the financial market, to meet the same disclosure requirements (both in terms of detail and regulating authorities) as those of commercial banks.

48 At the moment, the collection and payment distribution reports vary considerably because they vary according to the terms set in the contract. 66 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY iif board of directors KB FinancialGroup Chairman &CEO Yoon-dae Euh Institute ofInternationalFinance Managing Director Charles H.Dallara(exofficio)* National BankofKuwait Group ChiefExecutiveOfficer Ibrahim S.Dabdoub The GoldmanSachsGroup,Inc. President &ChiefOperatingOfficer Gary D.Cohn Commerzbank A Chairman oftheBoardManagingDirectors Martin Blessing Banco deCréditodelPerú Chief ExecutiveOfficer Walter Bayly Arab fricanInternationalBank Vice Chairman&ManagingDirector Hassan ElSayedAbdalla Vice ChairmanoftheBoard Itaú UnibancoHoldingS/A Itaú UnibancoS/Aand Roberto E.Setubal* Vice Chairman President &CEO Chairman oftheBoardDirectors G Walter B.Kielholz* Vice Chairman Swiss ReLtd.

Chairman oftheManagementBoard& the GroupExecutiveCommittee Douglas Flint(Chairman Josef Ackermann* HSBC Holdingsplc Deutsche BankA Vice Chairman Group Chairman Designate) Chairman Industrial andCommercial BankofChina Chairman ofthe Board&President Jiang Jianqing ING Group Chairman oftheExecutiveBoard Jan Hommen BNY Mellon Chairman &CEO Gerald Hassell DBS GroupHoldings&BankLtd Chief ExecutiveOfficer&Director Piyush Gupta Morgan Stanley Chairman &CEO James P.Gorman BBVA Chairman &CEO Francisco González* UniCredit Group Chief ExecutiveOfficer Federico Ghizzoni * G (Vice ChairmanDesignate) Marcus Wallenberg* Chairman oftheBoard Treasurer SEB Chief ExecutiveOfficer Vice Chairman Rick Waugh* President & Scotiabank

Chanda Kochhar Peter Sands * iif board of directors Managing Director & CEO Group Chief Executive ICICI Bank Ltd. Standard Chartered PLC

Nobuo Kuroyanagi * Yasuhiro Sato Chairman Group CEO & Chairman of the Board The Bank of Tokyo-Mitsubishi UFJ, Ltd. Mizuho Financial Group

Jacko Maree Martin Senn Group Chief Executive Group Chief Executive Officer 67 Standard Bank Group Ltd Zurich Financial Services |

Masayuki Oku Michael Smith Chairman of the Board Chief Executive Officer Sumitomo Mitsui Financial Group Australia and New Zealand Banking Group Ltd

Frédéric Oudéa James E. (Jes) Staley Chairman & CEO Chief Executive Officer, Société Générale Investment Banking J.P. Morgan Chase & Co. Vikram Pandit * Chief Executive Officer Andreas Treichl institute of international finance institute of international Citigroup Inc. Chairman of the Management Board & Chief Executive Erste Group Bank AG Baudouin Prot * Chairman of the Board Axel Weber BNP Paribas Group Chairman-Designate UBS AG Urs Rohner Chairman of the Board of Directors Peter Wallison, Board Secretary Credit Suisse AG Arthur F. Burns Fellow in Financial Policy Studies Suzan Sabanci Dincer American Enterprise Institute Chairman & Executive Board Member Akbank T.A.S.

* ANC Member 68 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY iif special committee on effective regulation BlackRock Solutions Managing Director Dr. ThomasGarside BBVA Regulation &PublicPolicy Senior Economist Ms. MariaVictoriaSantillanaMiranda Bayern LB Chief ExecutiveOfficer Mr. GerdHäusler Barclays PLC Legal Group GeneralCounsel Mr. MarkHarding Barclays Director, RegulatoryAffairs Mr. RichardQuinn Bank ofMontreal SVP, CapitalManagement&Optimization Mr. MarkE.White Bank ofAmericaMerrillLynch European ChiefOperatingOfficer Mr. RobEverett Banco Santander Communications, GroupMarketing&ResearchDivision Senior VicePresident,HeadofResearch&PublicPolicy Ms. AlejandraKindelánOteyza Allen &OveryLLP Partner, BankingRegulatory Mr. BobPenn ABS GroupLimited Group FinancialDirector Mr. DavidHodnett Mr. PeterAlexanderSands Standard Chartered,PLC Group ChiefExecutive Chairman Clifford Chance Partner Mr. SimonGleeson Cleary GottliebSteen&Hamilton LLP Senior Counsel Mr. EdwardGreene Citigroup Inc Legal General Counsel&CorporateSecretary Mr. MichaelHelfer CIBC Member oftheBoard Mr. NicholasLePan InfraHedge, Ltd Director Ms. JillM.Considine BNY Mellon Compliance EVP, ChiefCompliance&EthicsOfficer Mr. MarkMusi BNY Mellon Vice Chairman&ChiefRiskOfficer Mr. BrianG.Rogan BNP Paribas Chairman Mr. BaudouinProt BNP Paribas Head ofGroupPrudentialAffairs Mr. ChristianLajoie BMO FinancialGroup Vice-Chairman The HonorableKevinG.Lynch Dr. Korbinian Ibel Mr. Kaj-Martin Georgsen iif special committee on effective regulation Divisional Board Member Head of Political Affairs & CEO Communication GRM Risk Controlling & Capital Management DNB Commerzbank AG Mr. Roar Hoff Dr. Stefan Schmittmann Executive Vice President, Head of Group Risk Analysis Member of the Board of Managing Directors Group Risk Commerzbank AG DnB NOR ASA

Mr. Robert Jesudason Dr. Florian A. Strassberger 69 Group Head of Strategy Global Head | Group Strategic Development Financial Institutions Commonwealth Bank of Australia DZ Bank

Mr. Olivier Motte Mr. Wolfgang Kirsch Director of Public Affairs Chief Executive Officer, Chairman of the Board General Management DZ BANK AG Credit Agricole CIB Dr. Manfred Wimmer Mr. Jérôme Brunel Chief Financial Officer, Chief Performance Officer & Member Head of Public Affairs of Management Board Crédit Agricole SA. Erste Group Bank AG institute of international finance institute of international

Dr. René P. Buholzer Mr. Barry Stander Managing Director, Global Head Public Policy Head of Banks Act Compliance Public Policy Regulatory Risk Management Credit Suisse AG FirstRand

Mr. Urs Rohner Mr. Faryar Shirzad Chairman Managing Director, Global Head Credit Suisse Group AG Office of Government Affairs Goldman Sachs Mr. Robert Wagner Chief Analyst Mr. Santiago Fernandez de Lis Group Finance, Regulation Chief Economist Danske Bank Group Financial System & Regulation Group BBVA Mr. Paul L. Lee Partner Ms. Lara de Mesa Debevoise & Plimpton LLP Head of Public Policy Research Department Ms. Deborah Bailey Grupo Santander Managing Director Deloitte Mr. Nasser Al-Shaali Chief Executive Officer Mr. David Strachan Gulf Craft Partner Centre for Regulatory Strategy Mr. James L. Chew Deloitte LLP Global Head, Regulatory Policy & Development Financial Sector Policy Unit Mr. Bjørn Erik Næss HSBC Holdings Plc Group Executive Vice President/Chief Financial Officer Group Finance & Risk Management DNB 70 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY McKinsey &Company Director Mr. PhilippHärle Mark LawrenceGroup Managing Director Dr. MarkLawrence Manulife Financial Financial Regulations Senior VicePresident Mr. PeterBethlenfalvy Lloyds BankingGroup Group PublicAffairs Director ofRegulatoryDevelopments Mr. JonathanGray La Caixa Research Department Chief Economist Mr. JordiGual KPMG Financial RiskManagement Principal Mr. SimonL.Topping Kleinwort BensonA Managing Director Mr. FernandoBarnuevoSebastiandeErice KBC Group ValueRisk&CapitalManagement Risk Advisor Dr. BartDelmartino JPMorgan ChaseInternational Chairman Dr. JacobA.Frenkel Itaú UnibancoS/A the BoardofItaúUnibancoHoldingS/A President &CEOofItaúUnibancoS/AViceChairman Mr. RobertoEgydioSetubal Intesa SanpaoloSpa Chief FinancialOfficer Mr. CarloMessina ING Bank Vice-chairman Mr. KoosTimmermans dvisers A G Nomura EuropeHoldings Vice Chairman Mr. DavidBenson Nomura Corporate Communications Director, PublicAffairs Mr. SamuelHinton-Smith Nedbank Limited Balance SheetManagement Group ManagingExecutive Mr. TrevorPowellAdams National BankofKuwaitS.A. Group RiskManagement General Manager&GroupChiefRiskOfficer Mr. ParksonCheong National BankofKuwait Group ChiefExecutiveOfficer Mr. IbrahimS.Dabdoub Morgan Stanley Institutional Securities Chief FinancialOfficer Mr. DavidRusso Morgan Stanley Managing Director Ms. SusanRevell Moody’s InvestorsService Global RegulatoryAffairs Managing Director Ms. FarisaZarin Mizuho FinancialGroup,Inc. Chief StrategyOfficer Managing Director&ExecutiveOfficer Mr. MasaakiKono Mitsubishi UFJFinancialGroup,Inc. Managing Director Mr. AkihikoKagawa Mitsubishi UFJFinancialGroup,Inc Corporate PlanningDivision Manager, OfficeofBaselIII&InternationalRegulation Mr. ToshinaoEndou Mr. Ari Kaperi Mr. Nobuaki Kurumatani Group Chief Risk Officer Managing Director Group Risk Management Sumitomo Mitsui Banking Corporation Nordea Bank AB Mr. Philippe Brahin Mr. John P. Drzik Head of Governmental Affairs President & Chief Executive Officer Regulatory Affairs Oliver Wyman Swiss Re Ltd.

Mr. Erik Palmen Mr. Donald F. Donahue 71 Chief Risk Officer President & Chief Executive Officer | OP-Pohjola Group The Depository Trust & Clearing Corporation

Mr. William S. Demchak Mr. Takashi Oyama President Counsellor on Global Strategy to President & the Board of PNC Financial Services Group Directors The Norinchukin Bank Mr. Richard H. Neiman Vice Chairman Mr. Kevin Nixon Global Financial Services Regulatory Practice Executive Director, Head of Regulatory Reform PricewaterhouseCoopers LLP The Westpac Group institute of international finance institute of international Mr. Eugene A. Ludwig Mr. Brandon Becker Founder & Chief Executive Officer Executive Vice President & Chief Legal Officer Promontory Financial Group, LLC Advocacy & Oversight Group TIAA-CREF Mr. Morten Friis Chief Risk Officer Dr. Steve Hottiger Royal Bank of Canada Managing Director & Head Group Governmental Affairs Mr. Russell Gibson UBS AG Director, Group Regulatory Affairs Royal Bank of Scotland Group Mr. Sergio Lugaresi Senior Vice President Head of Regulatory Affairs Mr. Robert H. Pitfield Public Affairs Group Head, Chief Risk Officer UniCredit Group Global Risk Management Scotiabank Mr. Richard Yorke EVP & Group Head, International Group Mr. Nils-Fredrik Nyblaeus Wells Fargo & Company Senior Advisor to the Chief Executive Officer SEB Mr. Gregory P. Wilson President Mr. Pierre Mina Wilson Consulting Head of Group Regulation Coordination DGLE/CRG Dr. Madelyn Antoncic Société Générale Vice President & Treasurer World Bank Mr. H. Rodgin Cohen Senior Chairman Mr. Francis Bouchard Sullivan & Cromwell LLP Group Head of Government & Industry Affairs Government & Industry Affairs Zurich Insurance Group 72 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY iif shadow banking advisory group CIBC Member oftheBoard Mr. NicholasLePan China MinshengBankingCorp., LTD Risk ManagementDepartment Deputy GeneralManager Mr. BoZhang BNP Paribas Group Group RiskManagement Group PrudentialAffairs Mr. ThomasDemiansd’Archimbaud BNP Paribas Head ofGroupPrudentialAffairs Mr. ChristianLajoie BBVA BBVA Research Chief Economist-RegulationandPublicPolicy Ms. MariaAbascalRojo Barclays PLC Legal Group GeneralCounsel Mr. MarkHarding Bank ofCommunicationsLimited Executive VicePresident Mr. DickyYip Bank ofChina Risk ManagementDepartment Head Mr. WangXiaowei Arab Bankplc Risk ManagementDivision EVP andChiefRiskOfficer Mr. GeorgesF.El-Hage Cleary GottliebSteen&HamiltonLLP Mr. EdwardGreene Senior Counsel Chairman Group BBVA Financial SystemandRegulation Chief Economist Mr. SantiagoFernandezdeLis Goldman, Sachs&Co. Government AffairsEMEA Executive Director Mr. AngusCanvin Goldman Sachs Office ofGovernmentAffairs Managing Director,GlobalHead Mr. FaryarShirzad Ernst &Young LLP Office oftheChairman Advisor, RegulatoryAffairs Mr. DonaldT.Vangel Deutsche Bank Director, SecuritiesMarketsPolicy Mr. LeeFoulger Deutsche BankA Government &RegulatoryAffairs Global HeadofGovernment&RegulatoryAffairs Mr. AndrewProcter Credit Suisse Head ofPublicPolicyEMEA Managing Director Ms. LisaRabbe Commerzban Market andOperationalRiskControl Managing Director Mr. WilliSchwarz k G Ms. Alicia Sanchis Ms. Susan Revell iif shadow banking advisory group Public Policy Senior Manager Managing Director Public Policy and Research Morgan Stanley Grupo Santander Mr. David Benson Ms. LIU Ruixia Vice Chairman General Manager Nomura Europe Holdings Risk Management Industrial & Commercial Bank of China Mr. Michael Jefferson Public Affairs 73 Ms. Jill M. Considine Nomura | Director InfraHedge, Ltd Mr. David Knott Regulatory Developments Ms. Ana Carla Abrão Costa Group Regulatory Affairs Director RBS Group plc Director of Risk & Capital Management Itaú Unibanco S.A. Mr. Russell Gibson Director, Group Regulatory Affairs Ms. Debbie Toennies Royal Bank of Scotland Group Managing Director

Corporate and Regulatory Affairs Mr. Helmut Bauer finance institute of international JP Morgan Chase & Co. Managing Director SALA Mr. Adam M. Gilbert Managing Director Mr. Paul Harrald Head of Regulatory Policy Head Quantitative Analytics JPMorgan Chase Portfolio Risk Standard Chartered Bank Mr. Hugh Kelly Principal Dr. Sven Kasper Bank Regulatory Advisory Director EMEA KPMG LLP Regulatory, Industry & Government State Street Bank Mr. Alain Dubois Chairman of the Board Mr. Stefan M. Gavell Lyxor Asset Management Executive Vice President Head of Regulatory and Industry Affairs Mr. Naoaki Chisaka State Street Corporation Senior Vice President Group Planning Division Ms. Ameesha Chandnani Mizuho Financial Group, Inc. Officer State Street Corporation Mr. Nick Miller Associate Mr. Tetsuro Yoshino Government Relations Team Joint General Manager Morgan Stanley Corporate Planning Department Sumitomo Mitsui Banking Corporation Mr. Edward McAleer EMEA Head of Financing Mr. Philippe Brahin Morgan Stanley Head of Governmental Affairs Regulatory Affairs Swiss Re Ltd. 74 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY UBS A Head SupervisoryRelations Managing Director Dr. MattiaL.Rattaggi The W Executive Director,HeadofRegulatoryReform Mr. KevinNixon The NorinchukinBank Directors Counsellor onGlobalStrategytoPresidentandtheBoardof Mr. TakashiOyama G, FinancialServicesGroup estpac Group Zurich InsuranceGroup Government &IndustryAffairs Senior PolicyAdvisoronGlobalIssues Mr. AlessandroIuppa Unicredit Group Consultant -StrategicandRegulatoryAffairs Ms. MicolLevi UniCredit Group Public Affairs Senior Adviser,RegulatoryAffairs Mr. MarcoLaganà project team

For the Institute of International Finance: • Paul Wright, Former Senior Director • Crispin Waymouth, Policy Advisor, Regulatory Affairs • Mariko Kawabata, Policy Advisor, Regulatory Affairs

Production & Design: 75 | • Natalia Rocha, Senior Staff Assistant, Regulatory Affairs institute of international finance institute of international 76 “SHADOW BANKING”: A FORWARD-LOOKING FRAMEWORK FOR EFFECTIVE POLICY 3 | institute of international finance institute of international Institute of International Finance 1333 H Street, NW, Suite 800 East Washington DC 20005-4770 Tel: 202-857-3600 Fax: 202-775-1430 www.iif.com Edward Greene Chair, IIF Shadow Banking Advisory Group Senior Counsel, Cleary Gottlieb Steen & Hamilton

June 8, 2012

By e-mail to: [email protected]

Re: European Commission Green Paper on “Shadow Banking” (COM(2012) 102 final)

On behalf of the Shadow Banking Advisory Group of the Institute of International Finance (IIF), the global association of financial institutions, we appreciate the opportunity to comment on the European Commission Green Paper on “Shadow Banking” issued for comment in March 2012.

We acknowledge and very much welcome the efforts of the European Commission to engage with regulators, investors and financial institutions to understand and assess the benefits, potential risks, and where necessary risk mitigation measures in the non-bank financial sector. This is clear from the welcome decision to provide a lengthy period for comments and from the “Towards a better regulation of shadow banking” conference held by the Commission on April 27, 2012.

We particularly welcome the Commission’s efforts to promote international consistency and coordination through the G20 and Financial Stability Board, as well as the Commission’s determination to ensure that any EU approach is fully consistent and coordinated with that of the FSB. This will help to avoid any temptation to front-run any parts of the FSB’s work or other international discussions.

We agree with the need for sound policy in this area. Properly structured, and with risks properly managed, many non-bank financial activities that might separately, or in combination, amount to non-bank credit intermediation can provide significant benefits to investors, borrowers and the wider economy. As the financial crisis demonstrated, however, when the risks from these activities are not managed and mitigated effectively, they have the potential to create substantial and even systemic effects. We therefore value the engagement of the Commission and the FSB on these issues.

Indeed, the IIF strongly believes that effective policy and mitigation of risks from non-bank financial activities and their connections with the banking system is a joint responsibility of the official sector and the financial services industry. We are therefore responding in a spirit of constructive engagement and are keen to work with the European Commission and other policy makers towards sensible and well-targeted policy.

1 With this in mind, in November 2011, the IIF’s Special Committee on Effective Regulation agreed that the IIF should produce a paper to contribute both to the FSB’s work and to other policy discussions, such as the one in the Commission’s Green Paper. To assist this process, the IIF established a working group - the “Shadow Banking Advisory Group” under the chairmanship of Mr Edward Greene, Senior Counsel, Cleary Gottlieb Steen & Hamilton.

We are pleased to attach that paper “Shadow Banking: A Forward-Looking Framework for Effective Policy”, published on June 1, 2012 – henceforth “the IIF Paper”. The IIF Paper is a sign of our commitment to engaging constructively, and provides an extensive analysis of the issues connected to “shadow banking”. With that in mind, we quote directly from the paper where relevant below, and provide references to particular sections of the paper that provide more details or a more thorough explanation of our views.

This said, and in a spirit of cooperation, we have a number of general comments on the Commission Green Paper. A number of these reflect the constraints that the Commission faces in producing a Green Paper, which must, out of practical necessity, be rather challenging. These constraints are particularly demanding in an area as vast and as diversified as that broadly described as “shadow banking”. Nevertheless, we still believe that the comments should be made.

A key suggestion is that the Commission should look to develop a number of separate Green Papers or other policy documents on particular non-bank financial activities as and when monitoring identifies these activities as potentially creating systemic risk rather than attempt to produce an all-encompassing policy and regulation covering “shadow banking.” This would allow scope for the Commission to explain its arguments in greater detail and to explore the particular benefits, risks and possible risk mitigation of individual non-bank financial activities.

As we suggest in the IIF Paper, macroprudential authorities have a central role to play in ongoing monitoring of the financial system and individual activities affecting it. it. It is essential that the policy response not be confined only to those non-bank financial activities where well-known issues of potentially systemic impact have already been evidenced by the recent financial crisis. Instead, a forward-looking approach is needed to identify any new risks that may emerge in the future from dynamic and innovative financial markets, however they might manifest themselves. This forward-looking and preventative policy approach can deliver the most timely, most efficient, and least invasive risk mitigation.

In this vein, as the attached IIF paper explains in more detail, whilst we understand the attraction of the term “shadow banking”, trying to define it in a sufficiently detailed and precise way for the purposes of regulation or legislation is extremely challenging and ultimately, in our view, unworkable.

We believe that a more satisfactory approach that would achieve the aim of increasing financial stability would be to focus on individual non-bank financial activities and assess whether they have the potential to create systemic risk, whether this risk is being properly mitigated through existing regulation, transparency and disclosure, and if not, how the particular risks can be most effectively mitigated. This will most likely have to be done at

2 the level of the entity. If coupled with effective macroprudential oversight of system-wide risk the potential interconnectedness of financial activities and entities, this would achieve the Commission’s policy objectives and strengthen the EU economy. We hope that you will consider this approach.

In the attached IIF paper, we set out a template that macroprudential oversight bodies, regulators and supervisors might use to assess whether a particular activity can pose systemic risk. We hope that this will be useful to you.

As the IIF Paper argues, where risks are identified, policy makers should make full use of the risk mitigation tools available, including conduct of business regulation, and where clearly justified, appropriate and proportionate prudential regulation. Policy makers should use the least invasive tool that still achieves the objective of risk mitigation.

Further, whilst we understand and agree with the need to address the risks posed by individual non-bank financial activities, we would encourage the Commission first to take stock of the extent to which these have been addressed or are in the process of being addressed by measures already implemented or in the process of being implemented at the national and international level.

As the Green Paper quite rightly points out, the EU has adopted or is in process of adopting a considerable framework of financial reform legislation. We believe that the Commission should assess whether these changes are likely to be effective, and if necessary, give more time for these changes to take effect before assessing if there are remaining risks that further regulation would be well-placed to tackle.

Detailed response to Commission questions

Question (a): Do you agree with the proposed definition of “shadow banking”?

Question (b): Do you agree with the preliminary list of shadow banking entities and activities? Should more entities and/or activities be analysed? If so, which ones?

We agree with the FSB that “shadow banking” can be broadly described as “the system of credit intermediation that involves entities and activities outside the regular banking system”.

However, in our work in preparing the attached IIF Paper, we concluded that this only works as a broad description. It does not work as a specific definition of specific activities or entities. We also considered alternative terms that have been suggested such as “market-based financing” or “alternative sources of funding” but concluded that they all are likely to create arbitrary boundaries between ‘shadow banking’ and ‘non-shadow banking’ or equivalents.

In the same vein, as we say in our paper:

“attempting to come up with a definitive list of “shadow banking activities” is unworkable for a number of reasons:

3 i. Creating such a list would imply a “one-size-fits-all” approach to very different activities with diverse characteristics and risks such as monoline insurance, the use of hedge funds, and direct lending to retail borrowers by independent finance companies, and be overly general or blunt.

ii. While in combination with other activities, an activity might result in a system of non-bank financial intermediation involving maturity and liquidity transformation, credit risk transfer or the build-up of leverage, on its own it might have only some of these characteristics and might thus not present systemic risk.

iii. Whether an activity forms part of a financial intermediation process and creates systemic risk will depend to a large extent on the context within which it takes place. For instance, securities lending can serve both financial intermediation and other market purposes such as generating increased yield. It would be impractical to make a distinction between these uses.

iv. Equally, whether an activity forms part of a financial intermediation process and creates systemic risk will depend on the scale at which it is carried out, which will vary over time. Some activities may present little risk to the financial system if carried out at a low level, but be system-threatening if they grow much larger and if the market relies on them. A hardwired list would not be able to pick up these variations.

v. Given that the premise of the term “shadow banking” as noted is that some activities come close to mimicking one or more of the core functions of banks, any definition or list would need to involve a judgment on just how closely an activity would need to mimic a core function to be classified as “shadow banking”. For instance, does a hedge fund have sufficiently deposit-taking characteristics for it to be treated as a “shadow bank” even though, unlike a bank deposit, it might offer no guarantee of any investment being redeemed at or above par, and is not redeemable on demand? Where exactly would one draw the line between “shadow banking” and “non-shadow banking” and how would one avoid this line being completely arbitrary? Any line could create incentives for funds to adjust their characteristics so as to move themselves to one side of it.

There are similar difficulties with attempting to list “shadow banking entities” instead. Indeed using the term “shadow banking” creates an implicit assumption that entities carrying out these activities should be subject to prudential regulation similar to that for banks when this may be neither justified nor the most effective and proportionate option.”1

As we noted above, an alternative and arguably more effective approach that would be consistent with the Commission’s public policy aims would be to focus on non-bank financial activities with the potential to create systemic risk.

Question (c): Do you agree that shadow banking can contribute positively to the financial system? Are there other beneficial aspects from these activities that should be retained and promoted in the future?

1 IIF “’Shadow Banking’: A Forward-Looking Framework for Effective Policy” June 2012 pp. 12-13

4 Question (d): Do you agree with the description of channels through which shadow banking activities are creating new risks or transferring them to other parts of the financial system?

Question (e): Should other channels be considered through which shadow banking activities are creating new risks or transferring them to other parts of the financial system?

We strongly agree that non-bank financial activities (including financial intermediation) contribute positively to the financial system and to the real economy.

As we outline in Section 1 of the attached IIF paper in broad terms, the benefits from non-bank financial activities can include:

 “Efficiency, innovation and specialization. An extensive study by the New York Federal Reserve argued that: “there were also many examples of shadow banks that existed due to gains from specialization and comparative advantage over traditional banks. … These … could include non-bank finance companies, which are frequently more efficient than traditional banks through achieving economies of scale in the origination, servicing, structuring, trading and funding of loans to both bankable and non- bankable credits.”2 This can have additional benefits such as aiding financial inclusion.

 Diversification and mitigation of risk. These activities can enable investors to diversify and mitigate their risks as their deposits are not concentrated on a single bank balance sheet but are spread over a number of investments. They also can enable banks and borrowers to diversify their sources of funding and liquidity and therefore avoid relying on a single source.

 Greater flexibility and investment opportunities. These activities can give investors greater flexibility over the duration and risk profile of their investments and also broaden their investment opportunities, making available assets such as corporate treasury financing and mortgage loans which might otherwise not be available.

 Increased liquidity and funding. For borrowers and market participants, such activities can lead to a greater diversity and supply of funding and liquidity in the market.. This option allows firms to reduce reliance on traditional sources of funding, sometimes at lower cost.3

We therefore welcome the comment by Commissioner Barnier that “we will be careful not to call into question the alternative financing chains which complement bank lending and are of direct benefit to the real economy”.

In line with our suggested approach, we believe that it is important to look at the particular benefits and potential risks from each particular activity. As noted in the IIF paper “Regulators will also need to pay attention to whether there are additional risks from the combination of activities inside a particular entity. It will be necessary to examine linkages between activities and firms and the rest of the financial system, including the prudentially-regulated banking system, as these linkages may

2 Pozsar, Adrian, Ashcraft, Boesky “Shadow Banking”, Federal Reserve Bank of New York Staff Report no. 458, July 2010 3 IIF “’Shadow Banking’: A Forward-Looking Framework for Effective Policy” p. 5

5 have an important bearing on the risks.”4 “It is also essential that this analysis is integrated with a wider macroprudential analysis of risks to the economy and the interconnections between activities.”5

The template set out in Section 3 of the attached IIF paper would, we believe, be a useful way of carrying out such an assessment.

Further, we believe that policy makers should be forward-looking and adaptive, open to new sources or types of risk whenever and wherever they might occur. Policy makers should also note that the scale at which an activity takes place can be a factor in whether it presents systemic risk. An activity that is carried out at a relatively low level can pose no systemic risk, yet may pose risks if the size of the market grows. This underlines the point about moving away from an overly prescriptive approach. Policy makers, regulators and supervisors should focus on the current risk from current levels of activity, while reviewing on a regular basis to see if an increase in the levels of activity has changed that level of risk.

Question (f): Do you agree with the need for stricter monitoring and regulation of shadow banking entities and activities?

Question (g): Do you agree with the suggestions regarding identification and monitoring of the relevant entities and their activities? Do you think that the EU needs permanent processes for the collection and exchange of information on identification and supervisory practices between all EU supervisors, the Commission, the ECB and other central banks?

Question (h): Do you agree with the general principles for the supervision of shadow banking set out above?

We have set out our views on data collection and monitoring in more depth in Section 3 of the attached IIF Paper. We agree with the need for the effective monitoring of non-bank financial activities with the potential to create systemic risk, and in the proportionate use of regulation when this is the most effective tool to mitigate that risk. We agree with the FSB’s approach of beginning by casting the net wide for data gathering and surveillance before narrowing the focus to activities that could increase systemic risk or lead to regulatory arbitrage. Indeed, an even wider macroprudential approach should be taken of monitoring all developments in the financial system, irrespective of whether they amount to “shadow banking” or not.

In general terms, as we suggest in the IIF Paper, we favor greater commonality and coordination in the collection and exchange of information, subject to effective data protection safeguards. In doing so, however, regulators and supervisors should ensure that data is collected in the most efficient manner possible – avoiding the collection of the same data twice by different regulators and supervisors – and also communicated with confidentiality safeguards to other macroprudential authorities and national regulators as required. This approach should apply to all non-bank financial activities, not just those

4 IIF “’Shadow Banking’: A Forward-Looking Framework for Effective Policy” p.11 5 IIF “’Shadow Banking’: A Forward-Looking Framework for Effective Policy” p. 15

6 labeled as “shadow banking,” including financial market infrastructures such as central counterparties (CCPs).

We support the creation of a Legal Entity Identifier (LEI) as a significant contribution to efficient data collection, and encourage regular discussions between regulators, supervisors and the industry in the regulated banking sector and beyond.

If such monitoring and analysis of the risks from a specific activity do not reveal any potential systemic risks or other significant risks, policy makers should have the flexibility to decide that no regulation is necessary at that time. Nevertheless, they should continue to monitor the activity and assess on a regular basis whether there are any developments that would change this decision. Equally, if the monitoring and analysis show that there are risks but that these risks are being successfully mitigated by good risk governance and regulation, policy makers should have the flexibility to decide that no further regulation is needed at that point.

If, however, there are risks that have so far not been successfully mitigated, policy makers should reach a decision on the most proportionate and effective way of mitigating that risk. Regulation may not be the only option: in Section 3 of the IIF Paper, we have listed eight potential risk mitigation tools that policy makers could decide to use.

In regard to the general principles for the supervision of “shadow banking”, we agree with these principles and we believe that supervision has a crucial role to play in mitigating risks and ensuring strong risk management. However, we would point out that these principles might be applicable to all forms of financial activity, not just those that might be considered to amount to a system of non-bank financial intermediation.

Question (i): Do you agree with the general [FSB] principles for regulatory responses set out above?

We agree with the FSB Principles for regulatory responses but believe that they should apply to the design and implementation of risk mitigation tools for both the non- bank and regulated banking system as a whole rather than solely for regulation of “shadow banking”.

Further, in designing and implementing these tools, there needs to be close coordination between macroprudential authorities, microprudential and conduct-of-business regulators to avoid policy confusion, or the unnecessary layering of multiple levels of regulation.

In line with our views on Question (j) below, national policy makers should consult with the FSB and policy makers in other jurisdictions to ensure international consistency or at the very least, the absence of conflicts. Fragmented international regulation could jeopardize the effectiveness of the whole approach. We support the Commission in its efforts to avoid this fragmentation.

7 We also believe that policy should be designed so as to be consistent with the treatment of similar activities or entities, including those already subject to existing prudential regulation. This implies carefully considering the impact of potential measures, including whether they will lead to regulatory arbitrage or simply displace risk from one part of the financial system to another. Policy makers should also consider the cumulative impact of policy measures on the financial system and the wider economy, and policy should be balanced against the risk-control benefits by using a cost-benefit or impact analysis.

Above all, the key to effective policy is that it be proportionate. Policy makers should use the least invasive and distortionary tool available that still achieves the objective of risk mitigation.

Question (j): What measures could be envisaged to ensure international consistency in the treatment of shadow banking and avoid global regulatory arbitrage?

The IIF is supportive of efforts towards international consistency of financial regulation, and as noted above, we welcome the Commission’s commitment to working not only towards consistency and coordination both globally and at the level of the EU. This was a clear message from the Brussels Conference and the Commission is sending a positive message by asking this question in the Green Paper. We agree that regulatory arbitrage should be avoided.

In the IIF Paper, we argued that “the design of policy should be internationally consistent and coordinated in such a way that similar activities posing similar risks in different jurisdictions are addressed in a similar and consistent way.” 6

The IIF is developing a submission to international regulators on avoiding extraterritoriality. We believe that the possible solutions that it suggests would be equally sensible in ensuring international consistency in the treatment of non-bank financial activities and avoiding global regulatory arbitrage, specifically:

o A commitment to limit the use of hybrid and domestic solutions to issues where there are common problems across jurisdictions;

o A greater focus on effective global standards;

o Work towards mutual recognition.

In particular, we support a greater focus on effective global standards once a specific activity has been identified as posing specific risks. However, for such standards to be developed in a way that avoids either coming up with vague international principles for the sake of agreement or coming up with an overly prescriptive “one-size-fits-all” approach with unintended consequences, international standard setters and the regulators who participate in their discussions must be given the time and resources to get it right. What will count in

6 IIF “’Shadow Banking’: A Forward-Looking Framework for Effective Policy” p.11

8 the long-run is whether the international solution is the right one, not when it was adopted. In this regard, we support the commitment of the European Commission to avoid “front- running” the work of the FSB and to align its regulation with the FSB’s recommendations.

Question (k): What are your views on the current measures already taken at the EU level to deal with shadow banking issues?

The Commission Green Paper rightly points to the considerable body of regulation that has been adopted since the financial crisis. Given the weaknesses revealed by the financial crisis, it was appropriate to carry out both financial reform and for the industry itself to strengthen its own standards. The IIF has consistently supported the objectives of the financial reform even though we have had difficulties with some of the measures that have been proposed, and with the timeframes to adopt and implement them.

It is most important that regulators and supervisors ensure that regulation is implemented effectively and consistently, given a chance to work and that its effects should be studied carefully before regulators take decisions on whether to introduce new regulation or legislation.

Question (l): Do you agree with the analysis of the issues currently covered by the five key areas where the Commission is further investigating options?

We believe that the Commission and other policy makers should look to mitigate any risks from specific non-bank financial activities where they arise, as well as any macroprudential risks from the interconnectedness of the system as a whole.

However, possibly due to the constraints posed by the length of the Green Paper, we do not understand the rationale for the work in the areas that the Commission has set out. In pages 10-13 of the Green Paper, the Commission lists a considerable amount of possible work with little, if any, justification for why this work might need to be carried out or why it might represent the most effective means of mitigating risks.

We believe that a more effective approach would be for the Commission to make the case for action or particular measures in the areas that it has set out on an individual basis in separate Green Papers or other policy documents. In doing so, the Commission could set out the evidence that has led it to the conclusion that particular measures are necessary and why it feels that a given approach might represent the most proportionate and effective means of mitigating the particular risk or risks. In line with the suggested template in the IIF Paper, the Commission should take note of existing regulation and industry measures to mitigate risk or promote higher standards, such as the Prime Collateralised Securities initiative.

Where there are potential risks, we support the idea of ensuring that supervisors have access to all necessary information. Section 3 of the attached IIF Paper goes into this in more detail, but we agree that for the entire financial sector, microprudential and

9 macroprudential authorities should have access to high quality, relevant information and that the industry – in the regulated banking sector and beyond – is open in supplying related data. Indeed, it is in the industry’s own best interest to alert authorities to emerging risk.

Question (m): Are there additional issues that should be covered? If so, which ones?

Question (n): What modifications to the current EU regulatory framework, if any, would be necessary properly to address the risks and issues outlined above?

Question (o): What other measures, such as increased monitoring or non-binding measures should be considered?

Our answer here very much encapsulates our approach to the whole issue of “shadow banking” and to the Commission’s Green Paper.

We agree that any non-bank financial activities that could – individually or collectively – pose systemic risk or any other significant detriment should be identified and closely examined. Where such risks are identified and where insufficient risk mitigation is in place, policy makers should consider the use of relevant risk mitigation tools including where justified and proportionate, the use of regulation.

We also support the development and use of effective macroprudential oversight to monitor risks emerging in the system as a whole and the targeted and proportionate use of macroprudential policy tools.

We believe that the Commission and other authorities should use the results of this analysis and macroprudential oversight to guide them in deciding whether further measures are needed. We and our members would be happy to work with Commission on this analysis.

Conclusion

The IIF and the members of the Shadow Banking Advisory Group welcome the Commission’s engagement in this area and its consultation with stakeholders. We strongly support the Commission’s efforts to ensure international consistency and coordination.

We agree that the weaknesses that were revealed by the financial crisis must be tackled if this has not already occurred as a result of new regulatory and industry reforms. We also believe that a strong system of macroprudential oversight needs to be put in place, and that policy makers should be constantly adapting and anticipating new forms of risk. In doing so, it is also essential that the significant benefits from non-bank financial activities be preserved.

In line with this view, we believe that the most satisfactory approach would be to focus on individual non-bank financial activities and assess whether they have the potential

10 to create systemic risk, whether this risk is being properly mitigated through existing regulation, transparency and disclosure, and if not, how the particular risks can be most effectively mitigated, whilst noting that this will most likely have to be addressed at the level of the entity.

We look forward to engaging further with the Commission and are ready to answer any questions on the attached paper. If you have any questions, do not hesitate to contact Crispin Waymouth – [email protected]

Yours faithfully,

Mr. Edward Greene Chair, IIF Shadow Banking Advisory Group Senior Counsel, Cleary Gottlieb Steen & Hamilton

Attachment: IIF Paper: “’Shadow Banking’: A Forward-Looking Framework for Effective Policy”, June 2012

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