Shadow banking conduct has been practiced for years, since 1970, through money market funds. However, the concept of shadow banking was not originated until the pre-recessionary period in 2007, and thereafter popularised during the recession period because it underlined the bank-like functions performed by entities outside the regular banking system. The International shadow banking system is complex, with a multitude of non-regulated financial institutions that can be linked to the traditional banking system; Thus its precise size is difficult to determine. However, according to the FSB in its Global Shadow Banking Report of 2012, this system composed of nonbank agents has largely expanded from $26 trillion in 2002 to $62 trillion in 2007. Despite International Shadow Banking had declined during the crisis in 2008; thereafter, it returned to its rapid growth reaching the market size of $67 trillion in 2011.
Consequently, International Shadow Banking invited the attention of financial experts and researchers towards the emergence of non-banking entities playing a banking role. As a result, the Financial Stability Board (FSB) has formally identified their existence and role by defining the term shadow banking system. Shadow Banking involves non banking entities as intermediaries in the financial system but external to the banking system. They do not only perform banking activities, but also perform certain other activities which are not part of the banking system. (Pozsar et al, 2012). See appendix for figure on Shadow Banking securitization process.
No objection has been raised upon the point that there are certain financial entities, which are not banks, still playing an active role in credit risk transfer, providing financial leverage, maturing and Liquidity transformation. When studying shadow banking, it is also necessary to know that its activities might involve different levels of risks; some examples of the type of activities include repo transaction, securities lending and securitization played by non bank entities, as well as, asset-backed commercial paper (ABCP) conduits, structured investment vehicles (SIVs), credit hedge funds, money market mutual funds, securities lenders, and limited-purpose finance companies (LPFCs) (Pozsar et al, 2012).
II. - A set of policy recommendations addressing shadow banking issues at the international level.
After defining Shadow Banking, it is also important to set a framework in which shadow banking issues can be addressed even at the international level. Thus, FSB has recognized the existence of non-banking entities and their activities in financial sector, it has rightly identified the need to regulate presence and role of these entities. The major goal behind this regulation is to legalise and provide regulatory control on the activities of such entities. It goes without saying that there is certain risk associated with the performance of the activities complete in the shadow banking system, so the FSB needs to also protect the market by mitigating any potential systematic risk (FSB, 2012).
It is in the real interest of entire market system that financial activities are regulated under one umbrella that provides guidelines to financial sector of the economy. As a result, the FSB recommended two-stage approach for monitoring and responding to the newly regulated entities The first step is to identify all the entities and activities performed by them. It is crucial to design a continuous surveillance plan to cover entire shadow banking related activities, which is capable to adjust and develop as the system evolves. Attention should be paid to gather and maintain accurate data related to entities, activities and related risks. The second step is to focus attention on the activities that are purely external to banking domain and have higher impact based on contagion and systematic risk, which may involve maturity, credit and liquidity transformation risk as well as high leverage and regulatory arbitrage. (Sinha, 2013).
In lieu of regulating shadow banking, collective efforts by the Basel Committee on Banking Supervision (BCBS), the FSB, and the International Organization of Securities Commissions (IOSCO) were started. As a first measure, they identified five key areas which were prone to high financial risk. Then, these areas were analysed in detail and recommendations were designed (FSB, 2012). Mentioned below are the key identified areas.
Financial instruments traded in secured contracts like securities and repos, which are prone to high risk, especially in times of "runs", and take cyclical business volume trends (FSB, 2012).
Securitization and its associated risk that might involved creating excessively leverage financial systems (IOSCO and BCBS)
Systematic risk created by entities of shadow banking (FSB sub group)
Money market funds which pose serious threats to market because of their unpredictable behaviour (IOSCO)
Spill-over effect emerging between traditional banking sector and entities of shadow banking system (BCBS)
Having mentioned the above identifiable key areas and their issues, there are some relevant guiding principles that should be considered when implementing any recommendations that provides foundation for policy framework in the shadow banking. Below are the guiding principles.
Assessment and Review: As any sets of regulations for shadow banking are implemented, the regulators will be assigned the responsibility to assess how the implemented measures behaved, what are the drawbacks and how to remove them (FSB, 2012).
Effectiveness: The regulator should ensure that the new set of policy recommendation and system are effective both in terms of market performance and jurisdictions. As operations will be carried out across the borders at the international level, consistency must be maintained. Furthermore, differences between jurisdictions and financial structures should also be considered.
Forward-looking and adaptability: Considering that there is possibility of emergence of other risk factors, any policy recommendations for shadow banking should cater for them in advance and ensure adaptability.
Proportionality: The new regulatory system should calculate the risk of shadow banking system created for financial sector and the counter measures will be proportionate in quantum.
Focus: The new policy recommendations should carefully focus on the desired objectives and analyse the shadow baking system accordingly (FSB, 2012).
To comply with the mentioned guidelines, it is necessary that authorities redefine their data collection methods and contact international financial institutions to join hands in this project. A support can be provided by the trade repositories (TR), which can portray the image of the entire market. Keeping in view the scope and geographical representation, the FSB can calculate meaningful data about these TRs and the new systems. (FSB, 2012)
To successfully enact policies that address shadow banking at the international level, transparency and trust should play an important role in the new system. It is, therefore, mandatory that desired goals are made public and the concerned bodies collectively design the survey methods. Considering that international financial bodies enjoy sound credibility in this regard, the FSB can take benefit from their exposure and experience by including them in the process of regulation. (FSB, 2012).
As careful evaluation of the Workstream proposal is also required, authorities should consult with end-investors and fund managers to reach common benefits, win-win situations. Regulatory authorities can calculate collateral requirements in the light of defined standards. To start with, a framework should be introduced to analyse pro-cyclicality risk in securities transactions on numerical floors. (FSB, 2012).
Another required consideration for designing policy recommendations in the shadow banking system is to include test of harmonisation of client asset rules for likely achievement of client asset protection objectives. As the risk is spread over operational, economic and legal aspects, there is strong need to focus on hypothecation. Furthermore, all the entities involved in repo market and security lending must be identified so that regulatory standards can be developed for all. As regulations are imposed and enforced, the requirement of compliance with standards can help develop systems in different jurisdictions in which the regulatory standards will be based on guidelines uniformly controlling all the entities (FSB, 2012).
In conclusion, shadow banking has a variety of forms that is continuously evolving throughout time based on the market conditions and regulations. Considering its high linkage with the traditional banking, there is a drive to implement effective regulatory, supervisory and financial policies that aims to guarantee stability in the financial sector. Thus, FSB in conjunction with other international standard setting bodies are working to develop policy recommendations that aim to strengthen the oversight and regulation of the shadow banking at the international level. To complete this, there must be first a clear understanding of what is meant by the Shadow Baking System, what approaches should be taken to monitor the shadow banking system, what key areas should be explored to take the proper measure that will address shadow banking issues and what guiding principles provides foundation for the policies to be implemented.
