Bringing shadow to light

An outlook of the shadow banking industry

By Jennifer Liu and Brian Lum

Shying away from the spotlight briefly, shadow banking has come back to the top of regulators’ agenda. At the World Economic Forum in Davos, Switzerland this year, Mark Carney, chair of the Financial Stability Board (FSB), reminded the audience that central bankers will finally address this “forgotten bit of reform” as they try to complete an overhaul of financial regulation over the next two years.

In fact, the FSB has teamed up with other organizations such as the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision (BCBS) to work on a shadow banking reform framework. It focused on the following five specific areas in which it believed policies are needed to mitigate the potential systemic risks associated with shadow banking:

1. Spillover effect – mitigating this effect between the regular banking system and the shadow banking system
2. Money market funds (MMFs) – reducing the susceptibility of MMFs to “runs”
3. Other shadow banking entities – assessing and mitigating systemic risks posed by these entities
4. Securitization – assessing and aligning the incentives associated with securitization
5. Secured financing contracts (e.g., repos and securities lending) – dampening risks and pro-cyclical incentives associated with these contracts that may exacerbate funding strains in times of “runs”

Focusing its work effort, FSB has enhanced the monitoring of the shadow banking system. For example, FSB conducted its second annual monitoring exercise in 2012. The broadened coverage included 25 jurisdictions, compared with 11 from the year before. FSB also developed policy recommendations[1] to strengthen the regulations of the shadow banking system.       

FSB has issued the recommendations for public consultation and is targeting to issue the final version in September 2013.

It is not hard to tell that some of the recommendations resonate with the tone of overall financial regulatory reforms that are taking place. Improving market transparency, introducing prudent practices, leveraging capital treatment as incentives and encouraging central clearing are some of the themes already observed in the Dodd-Frank and Basel III initiatives.

What does this mean for shadow banking entities and how can they succeed in this new world post-crisis? Such firms can take several steps to help ease the way for upcoming regulatory reforms:

• Recognize the paradigm shift in the industry. Financial institutions need to realize a safe and sound financial system is the order of the new world. Shadow banking inevitably will be kept under scrutiny by regulators and, once the FSB recommendations are finalized, new regulations are expected to follow. 
• Align strategic focus with the reforms. In the new regulatory landscape, shadow banking entities cannot operate the way they did before. As they move closer to a regulatory framework similar to the traditional banking sectors, firms should focus their strategies on how to optimize their business in the new environment. 
• Create opportunities from the new regulatory requests. The financial reforms can seem overwhelming to the shadow banking industry. However, challenges always bring opportunities. For example, the reporting requests from regulators can be viewed as a burden to firms. On the other hand, firms can turn the reporting requests into an opportunity to streamline reporting and identify ways to leverage the reports. Well used, these reports can serve as a valuable tool to help shadow banking entities provide transparency into their business lines and support business strategy formulation.

How do you think regulatory reforms will affect the shadow banking sector? Join the discussion.

[1] Summary of Shadow Banking Policy Recommendations – Financial Stability Board, Strengthening Oversight and Regulation of Shadow Banking: http://www.financialstabilityboard.org/publications/c_130129xx.pdf