Shadow Banking: The Regulatory Landscape at the Dawn of 2014

In the wake of the 2008 crisis, it soon became apparent that the fault lines of the global financial system extended far beyond the regulated banking sector to the less regulated “shadow banking” sector.  Nonbank financial entities including (but not limited to) money market funds, special purpose vehicles, insurance companies, and asset management firms, engaged in activities analogous to traditional bank deposit taking and lending, such as securities lending, repurchase agreements (“repos”), and securitization, yet were not subject to similar prudential regulations.  Failures at these institutions, which led to cascading failures throughout the financial system, prompted financial regulators to reevaluate the long-held assumption that these entities and their credit intermediation activities did not pose systemic risk. When national and international efforts to address this risk commenced, efforts were primarily organized on the basis of identifying “entities” and “activities” that promoted bank-like credit intermediation.

Our article addresses how this bipartite approach to shadow banking has evolved, the consequences of this strategy, and the status of current reforms as we enter 2014. We note that the concept of shadow banking activities has, at both the global and national level, focused to an increasing extent on the risks associated with short-term financing. Both the Financial Stability Board (“FSB”), which was established to coordinate the work of national financial regulators at the international level, and financial regulators in the US are looking closely at securities lending, repos, and securitization. However, the regulatory approach with respect to shadow banking entities has diverged at the global and national level; the FSB approach to “shadow banking entities” is organized by sector (such as money market funds, insurance, and reinsurance), whereas the US entities-based approach, reflected in the Dodd-Frank Act, focuses primarily on size. As a result, under the US approach, nonbank entities from vastly different sectors are grouped into one category – SIFIs (i.e., systemically important financial institutions) – and then subject to bank-like prudential regulation by the Federal Reserve Board, a key bank regulator in the US.

We conclude that activities-based reforms are a more promising means of addressing shadow banking risks at both the national and international level. Where entity-specific reforms are necessary, the US would benefit from the FSB’s sector-based approach, which targets specific sectors and entities within those sectors, rather than the blunderbuss approach of targeting just large systemically important financial institutions whose failure would materially affect financial markets, and broadly treating them all the same. The US would also benefit from the FSB’s policy of relying on existing regulatory bodies with relevant sector-expertise in the formation of legal and policy recommendations. We conclude by observing that, while shadow banking reform efforts have been divided into “entities” and “activities”, regulators must give greater consideration to how entity-based and activity-based reforms interact.

The full article is available here.