February 7, 2012

Regulators Casting Light on Shadow Banks

Lack of bailout potential, opportunities for risk seen as concerns

Banking watchdogs are sniffing out a new target: shadow banks. Concerns that such institutions have no backstop in case of crisis and offer opportunities to engage in risky, if not illegal behavior, are pushing regulators for the G20 to look more closely at such institutions.

Reuters reported Tuesday that shadow banks–so christened by former PIMCO portfolio manager Paul McCulley–are in the spotlight because of the risks they present. Godfried De Vidts, director of European affairs at brokerage firm ICAP, said in the report, "Shadow banking is not really well named. It would be preferable to have a better description of what is a wide range of nonbank intermediaries. As it stands, it sounds a bit pejorative."

That said, De Vidts added, "In America, increased financial activity is taking place between nonbanks which are subject to little or no regulation, and Europe is catching up fast."

Shadow banks do not have government backing to support them in case of a run on funds. Also, according to the Financial Stability Board, a body mandated by the G20 group of the world's richest economies to create new rules for shadow banking they could be used to evade financial regulation and draw risky activities prohibited elsewhere.

The FSB has indicated that it will pursue both tougher rules, implementing such things as capital charges and limits on ways in which conventional banks may be exposed to shadow banks, and increased transparency.

Rick Watson, a managing director at the Association for Financial Markets in Europe, a group that lobbies on behalf of securities firms and investment banks, was quoted saying, "What we're doing now is looking at the types of data that the FSB will be gathering. The scope is pretty broad but it's important to get the facts on table and consider what activities could pose a risk."

As credit tightens, banks are turning to shadow banking to obtain more collateral and to exchange hard-to-sell bonds for more liquid ones. Sometimes corporations are providing this additional liquidity, instead of seeking to borrow from banks; thus, they become part of the shadow banking system. Money market funds, too, are concerned about tighter regulations, and the European repo market is also an FSB target.

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