Bridging the Gaps in EU Financial Regulation: A shadow banking perspective
Can the shadow banking sector be comprehensively regulated?
As part of a recent high-level conference in Warsaw titled “EU Financial Markets: East meets West”, the Young Researcher Group of the European Banking Institute, together with the EURO-CEFG and CEELG, co-organised a young scholars workshop on: “bridging the gaps in EU financial regulation”. This workshop took place on 17 November 2018. Selected young scholars presented research that stimulated discussion with senior researchers from academic institutions in the EU. I was one such selected young scholar and during this workshop, I spoke about bridging the EU regulatory gap between the traditional banking sector (TBS) and the shadow banking sector (SBS). Dr Spendzharova of Maastricht University provided insightful comments.
My presentation proceeded as follows: the 2007 Global Financial Crisis (GFC) has led to unprecedented regulatory reform in the traditional banking sector (TBS). New EU regulations and directives, such as the BRRD, the CRD IV, the CRR (which implements the Basel Accords) and more broadly the European Banking Union seeks to ensure the systemic stability of the prudentially regulated TBS, the safety and soundness of individual credit institutions and the future resilience and resolvability of its components as a whole. This however, is not the only banking sector, there also exists another form of banking – shadow banking. The shadow banking sector (SBS) encompasses a varied set of entities, activities and transactions; it is a sector that now accounts for over 40% of the EU financial system, and performs much the same functions as the TBS, but does so outside the prudential regulatory perimeter.
One example of the TBS and the SBS performing the same functions is through ‘maturity transformation’. The TBS engages in maturity transformation when it uses deposits (such as our monthly wages), which are short-term, to fund loans (such as mortgages) that are longer-term. The SBS does something similar through money market funds (MMFs) by raising short-term funds in the money markets through issuing shares to investors; the MMF then uses those raised funds to buy assets with longer-term maturities. MMFs’ shares can be redeemed at par and the instantaneous liquidity and stable value makes them an attractive alternative to bank deposits. However, neither sector is immune to maturity transformation risks. While there are the deposit guarantee schemes of the TBS, and the Money Market Funds Regulation (EU) 2017/1131 of the SBS, the fact is that if depositors/investors in either of the sectors try to withdraw/redeem at once, then there is risk of panic and therefore a run – good examples of this are Banco Popular in 2017 and the “breaking of the buck” during the GFC.
The Rise of Shadow Banking
How then has the SBS risen to prominence? There are four steps of reasoning. First, many commentators argue that the evolution of prudential regulation has inadvertently fuelled the growth of the SBS. In particular, the Basel Accords are both expensive and burdensome for banks, and regulators are essentially forcing banks to disclose information and hold minimum capital reserves. Second, while it is not disputed that the tightening of prudential regulation strengthens the resilience of the TBS, the flipside is that it does so by limiting the profitability of the TBS. The upward trajectory of forcing the TBS to strengthen capital and liquidity has the paradoxical effect of negative trajectories for banks’ profitability in the EU. A recent study by Roland Berger demonstrates that the profitability of EU banks has decreased by 9% between 2009-2015. While there is currently no empirical evidence for a causal relationship between regulatory pressure and profitability, this drop in profitability implies that regulatory pressure and the associated costs pose a real challenge for EU banks. Third, given that the TBS is so heavily regulated, consequently impeding profitability, it is unsurprising that there is incentive to circumvent the rules by exploiting regulatory arbitrage and migrating activities to the SBS. Regulatory arbitrage can be defined as: the restructuring of financial activities to circumvent burdensome regulation. The central issue is that as regulation within the TBS tightens, by default the SBS will continuously gain traction. This argument becomes particularly acute when we discover that “It takes roughly two hours to assemble a team of finance geeks and lawyers to devise a product or transaction that will bypass any new rule or regulation coming our way”. Fourth, while many commentators view regulatory arbitrage as a negative, regulatory arbitrage can also be viewed positively as it facilitates financial innovation by creating new ways to conduct business. The SBS is a case in point given that there is now a genuine economic demand for services conducted in the SBS. The SBS is, indeed, a hotbed for innovation. It is unstifled by the rules and the growth of the SBS may be understood as one consequence of evolving legal and regulatory structures stemming from the TBS
Bridging the Regulatory Gap
Can we bridge the regulatory gap between the TBS and the SBS? While regulation is necessary from a financial stability perspective, the flipside is that over-regulation can have the perverse effect of limiting profitability and stifling innovation. Various commentators remain sceptical that the SBS can ever be comprehensively regulated. For example, some argue that the SBS is far too diverse to regulate effectively, while others argue that regulatory efforts consistently fail to catch up with new developments. I would add to these comments and state that there is also a severe lack of granular data within the SBS. Therefore, it is very difficult to regulate something you do not know a huge amount about and of course, we do not know what the SBS will look like in the future due to its complexity, diversity and constantly evolving nature. Supervisory bodies, such as the FSB, the ESMA and the ESRB have introduced numerous publications on the issue of regulating the SBS but the fact remains, it is an issue yet to be substantially tackled. The results to date are no greater than piecemeal solutions. It is unfortunate that supervisors and regulators alike do not seem to be tackling this problem head on. But one thing is for sure, and perhaps this answers why focus has not been turned to the SBS - if it were to be regulated to the similar severity of the TBS, then, by default, the SBS will likely circumvent those rules and find alternative ways of engaging in financial markets – which could, I think, lead us back down the familiar dark path of 2007.