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Regulating shadow banking: Maximising efficiencies, minimising risks

Shah Ahsan Habib | Published: November 25, 2019 20:45:17 | Updated: December 03, 2019 21:29:34


[Concluding part of a four-part write-up on shadow banking]

Mapping of shadow banking provides a basis for reviewing the appropriate perameter for monitoring. Generally, two approaches are applied to estimate 'entity-based' approach and an 'activity-based' approach when mapping the broad shadow banking system. An 'entity-based' approach alone would not be insufficient owing to the limitations of balance sheet data for risk analysis, such as measuring off balance-sheet exposures and financial derivatives, and owing to the need to account for specific interactions between entities. Therefore, analysts consider an 'activity-based' approach in order to provide a broader analysis of linkages between the shadow banking system and the regular banking system.

 In order to assess the engagement of entities in shadow banking activities, a framework of metrics has been developed by the European Systemic Risk Board (ESRB) under the broad heads of maturity transformation, liquidity transformation, leverage, credit intermediation, and interconnectedness with the regulated banking system.  However, these risk indicators have a number of limitations when focusing on more specific sources of risks. As shadow banking activities can take place across complex financial intermediation chains which can include banks, insurance corporations and pension funds, it is important to also consider an activity-based approach to capture risks that cut across entities. However, a full assessment employing an activity-based approach also presents particular challenges owing to data limitations. Practically, national-level analysis is necessary for the purposes of systemic risk identification and for implementing the applicable micro- and macro-prudential policies.

As observed by the Financial Stability Board (FSB), there are two reasons why shadow banking may need to be regulated. The first reason is the possibility that the shadow banking system is used as a way to escape regulation and is used to do things that could be done under the traditional regulated system, increasing the probability of systemic events. And the second reason is that the activities involve high leverage and maturity, liquidity and credit  transformation, and therefore make the shadow banking system, just like the traditional banking system -- vulnerable to panics and systemic events. Efforts are on to address challenges associated with shadow banking activities both at national and international levels. At the November 2010 Seoul Summit, the G20 leaders have warned of a potential that regulatory gaps may emerge in the shadow banking system and requested the FSB to develop recommendations to strengthen the oversight and regulation of the shadow banking system. To this end, the FSB has developed a two-prong strategy. First, it has created a system-wide monitoring framework to track developments in the shadow banking system with a view to identifying the build-up of systemic risks and enabling corrective actions where necessary. Second, the FSB has coordinated to develop policies in five areas where oversight and regulation needs to be strengthened to mitigate the potential systemic risks associated with shadow banking: one, mitigating the spill-over effect between the regular banking system and the shadow banking system; two, reducing the susceptibility of money market funds to runs; three, improving transparency and aligning incentives associated with securitisation; four, dampening pro-cyclicality and other financial stability risks associated with securities financing transactions; and five, assessing and mitigating systemic risks posed by other shadow entities and activities. When implemented, this integrated set of policies should mitigate financial stability risks emanating from shadow banking and help to transform it into resilient market-based financing that will support sustainable economic growth.

In a recent development, China's central bank has drafted new rules to tackle risks from shadow banking, in a tacit acknowledgment that a host of measures in recent years to control off-balance sheet credit have failed to control risks. Regulators have permitted the rise of shadow lending, which is necessary to generate the overall credit growth required to meet the government's ambitious yearly growth targets without overburdening bank balance sheets. At the same time, they have sought to prevent the build-up of systemic risk. 

In connection with monitoring the inclusive finance landscape through a shadow banking lens, it is important to recognise that the landscape of inclusive finance is evolving rapidly and particularly in the digital arena where the change in scale can be rapid and dramatic. While current innovations holding the promise of reaching un-served and underserved customers sustainably and affordably thus far generally do not involve the kinds of maturity and liquidity transformation that helped to trigger the financial crisis. FSB advised regulators and supervisors to monitor the trends in the shadow banking sector 'to address bank-like risks to financial stability emerging outside the regular banking system while not inhibiting sustainable non-bank financing models that do not pose such risks.' This is about assessing the trends in the shadow banking sectors in terms of the size and growth rates 'both in absolute terms and in relation to the total debt, GDP, and the size of the regulated banking system'.

The regulation of shadow banking activities aims to correct market failures, government failures, and other distortions. Regulation can maximise economic efficiency by correcting market failures that arises from shadow banking network and operations. Because of the potential to increase efficiency, regulation should not necessarily be focused on limiting shadow banking. Instead, regulation should be focused on maximising efficiencies and minimising shadow banking's potential to increase risk. As part of effective monitoring, gathering data, cases and information on shadow banking activities are crucial for addressing information failure. Regulators need arrangement to reduce principle-agent failure in the shadow network, and incentivise market participants to monitor their performances at different stages and levels. Regulatory arbitrage should be reduced by regulating traditional banks less or by regulating shadow banking activities more. Probably, it is not feasible to reduce regulatory burden from the traditional banking system, and thus, redesigning regulatory and monitoring arrangements might contribute to reducing regulatory arbitrage. 

In November 2015, a conference on 'Financial Inclusion and Shadow Banking: Innovation and Proportionate Regulation for Balanced Growth' was held in Moscow, co-hosted by the Bank of Russia and the Alliance for Financial Inclusion (AFI) that highlighted the importance of nonbank financial intermediaries (NBFIs) in driving innovation and channeling funds for financial inclusion and economic growth, especially in emerging economies and developing countries. The adopted Moscow Resolution on Financial Inclusion and Shadow Banking called for collecting information to better understand the features of shadow banking in their jurisdictions, innovations in the financial sector and the oversight and regulatory frameworks they have implemented for shadow banking activities and entities. It also called for case studies that highlight successful approaches to developing and implementing proportionate regulatory frameworks which differentiate between properly regulated and resilient forms of market-based financing and unsupervised financial intermediaries that pose material risks to financial stability.

As a regulatory approach, shadow banking activities for inclusive drives must be treated separately from those of others that have financial instability concerns. Especially, new financial innovations and e-platforms that facilitated the growth of shadow banking should be controlled and supervised delicately to optimise benefits and ensure financial sector stability. On the one side, risk may rise from rapid credit growth associated with new financial inclusion institutions and instruments, and from unregulated parts of the financial system; and on the other, broader access to deposits that lead to a more diversified base of deposits could significantly improve the resilience of the overall financial system and thus financial stability. Thus it is not about restricting shadow banking, rather regulation should be focused on maximising efficiencies and minimising risks. Financial inclusion markets need to be well monitored in order to mitigate challenges of indiscriminate lending and possibilities of malpractices. However, if regulation, particularly with regard to consumer protection, is too strict, it will limit innovation.

Shah Ahsan Habib is Professor and Director Training at the Bangladesh Institute of Bank Management (BIBM).

ahsan@bibm.org.bd

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