U22007 Legal Research Project

Shadow Banking and the Global Financial

Crisis: The Regulatory Response

(Legal Research Project)

Department of Law

Faculty of Humanities and Social Sciences

Graduate Diploma in Law (2011-2012)

Legal Research Project

Module U22007

Name: Jan-Patrik REIMANN

Candidate Number: ********

Word limit: 4,500 words (excluding footnotes and bibliography)

Adviser: Dr Stelios Andreadakis, Senior Lecturer in Law

Module Leader: Mr Jeff Young, Senior Lecturer

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Abstract

The purpose of this Legal Research Project is to study the shadow banking system and

its regulation since the global financial crisis of 2008. The shadow banking system is a newly

coined term, that is not yet (or only very scarcely) regulated or even clearly defined.

It has been remarked that the shadow banking sector played a major part in the leading

up to the crisis. While regulators have been quick to introduce stricter rules for banks and

insurance companies, the shadow banks have been left largely untouched by new regulations.

However, this has changed during the last year with the European Commission now strongly

expressing the desire to implement regulatory measures to ensure that the shadow banking

system will not be able to pose further system risks to the global financial stability.

This Project explores the proposals currently under debate in the EU and provides an

outlook of what supervision and regulations can be expected in the months and years to come.

Self-regulation is now regarded as unsatisfactory. However, legislators should also remain

careful not to over-regulate an already fragile financial system with the results possibly being

hurtful to the economy. Although the process is still at a very early stage, it is definitely

moving now and all stakeholders will want to observe the possible changes very carefully.

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Table of Contents

Abstract 2

Table of Contents 3

Introduction 4

(a) Shadow Banking 4

(b) What is the Shadow Banking System (SBS)? 5

(c) The purpose of shadow banking 7

(d) Recent European and Global Structural Changes in Financial Supervision 8

(e) Existing regulatory measures 9

(f) Current Legislative Proposals and Recommendations 10

(g) Recent stakeholder’s response 11

(h) Conclusion 12

Bibliography 14 - 19

(1) Books

(2) Journals

(3) News

(4) Speeches

(5) Online Sources

(6) Reports

(7) EU Legislation

(8) Other Legislation

(9) Case law

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Introduction

“Shadow banking is one of those interesting undefined terms”1 - “it’s the Wild West.”2

Project’s aim

As the above quotes illustrate, the shadow banking system still seems to be a mystery. This Legal

Research Project aims to bring light into the dark by studying the shadow banking system and its regulation

since the global financial crisis of 2008, which has plunged the world’s economy into the biggest depression

since the 1930s. The shadow banking system is a newly coined term, not yet (or only very scarcely) regulated in

the United Kingdom as in most other jurisdictions.

In the aftermath of the crisis, it has been remarked that the shadow banking sector had a major part to

play in the leading up to the breakdown of the US housing market and the collapse of major banking houses such

as Bear Stearns and Lehman Brothers. While regulators have been quick to introduce stricter rules for banks and

insurance companies with measures such as the Dodd-Frank Act in the US as well as the Capital Requirements

Directives (further implementing the Basel Accords) and Solvency II in the EU, the shadow banks have been left

largely untouched by new regulations. However, this has changed during the last year with the G20, the

Financial Stability Board (FSB), the Federal Reserve in the US and the European Commission now strongly

expressing the desire to implement regulatory measures to ensure that the shadow banking system will not be

able to pose further system risks to the global financial stability.

This Project explores the proposals currently under debate in the EU and provides an outlook of what

supervision and regulations can be expected in the months and years to come. Self-regulation is now regarded as

unsatisfactory. However, before new measures can be implemented the exact activities and entities of the

shadow banking system need yet to be defined. Legislators should also remain careful not to over-regulate an

already fragile financial system with the result possibly being hurtful to business. Although the process is still at

a very early stage, it is now definitely moving and all stakeholders will want to observe the possible changes

very carefully.

(a) Shadow Banking

The recent financial crisis highlighted numerous points of vulnerability in the global financial system. Since

then, regulators worldwide have introduced new legislation for financial services. However, one component

which is said to have played a large part in the crisis has been left out so far; the shadow banking system (SBS).

The UK government remarked3 in a 2010 consultation document that as the UK banking system is emerging

from the most serious financial crisis in over a hundred years, one of the fundamental causes of the crisis was the

growth of an unregulated SBS.

1 Schneider, A. ‘Deloitte Launches Shadow Banking Index’. CNBC. 29 May 2012. 05.20 hrs (00:30-01:00/04) http://video.cnbc.com/gallery/ [accessed 21 July 2010]. 2 Krugman, P. ‘Paul Krugman Explains What Exactly Went Wrong’ (2008). Zócalo Public Square Lecture Series, RAND Corporation, Santa Monica. http://zocalopublicsquare.org/ [accessed 15 March 2012]. 3 HM Treasury, Consultation Document: ‘A new approach to financial regulation: judgement, focus and stability’ (2010). Her Majesty’s Treasury, London, 26 July 2010. http://www.hm-treasury.gov.uk/ [accessed 15 November 2011].

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Ben Bernanke, the Chairman of the Federal Reserve System4, in April of this year called for new steps to

curb shadow banking5. In March, Lord Turner of Britain’s financial regulator, the Financial Services Authority

(FSA), demanded radical rule changes to protect financial stability from the risks of shadow banking6 and the

European Union’s Internal Market and Services Commissioner, Michel Barnier, went in the same direction,

asking for appropriate supervision and regulation7.

Estimates of the SBS’s size in the United States (US) currently range from $10 to $60 trillion8, compared to

$18 trillion of the traditional banking sector. This is worth around a quarter of the total financial system. With

those numbers, the SBS’s size could be as much as about four to 24 times the United Kingdom’s (UK) GDP9,

stated as $2.418 trillion10 for 2011. The peak of the SBS’s value was reached around the start of the recent global

financial crisis in the first quarter of 2008 and has since decreased by more than half11. The size of the SBS is,

however, constantly changing over time. With the possible introduction of new and stricter regulation on the

official banking sector, business is expected to move away from traditional banking and therefore leading to

growth in the unregulated SBS12. At the same time, if products currently forming part of the SBS become

regulated or guaranteed by the government, they will no longer belong to the SBS and move to the regulated

main banking sector13.

(b) What is the Shadow Banking System (SBS)?

As the SBS is not clearly defined, this question is difficult to answer. Descriptions are often very

different from each other and even contradictory. The SBS has been described as encompassing ‘bank like

products without bank like protections’ used by many institutions and millions of people14. One of its key

characteristics is therefore that, unlike regulated banks, the SBS has no access to benefits such as central bank

liquidity and deposit insurances15.

However, there can certainly be no black and white categorisation into two groups of financial

institutions. In fact, many licensed banks that fall under the relevant banking and regulatory laws may conduct

much of their operations in the SBS, even though they are not SBS institutions themselves. On the other hand,

there are those institutions that are clearly seen as being part only of the SBS. Their main products and activities

4 The Federal Reserve System is the central banking system of the United States.

5 Bernanke, B. S., ‘Fostering Financial Stability’ (2012). Speech at the 2012 Federal Reserve Bank of Atlanta Financial

Markets Conference, Stone Mountain, Georgia. 09 April 2012. http://www.federalreserve.gov/newsevents/speech/ 6 Turner, A., ‘Shadow banking and financial instability’ (2012). Lecture at Cass Business School, http://www.fsa.gov.uk/static/pubs/speeches/ [accessed 14 March 2012] 7 Taking action on shadow banking: avoiding new sources of risk in the financial sector (2012) European Commission Press Release. http://europa.eu/rapid/ [accessed 19 March 2012] 8 Schneider, see above, note 1. 9 Gross Domestic Product (GDP): the market value of all officially recognised final goods and services produced within a country in a given period (nominal) 10 International Monetary Fund (2012). ‘5. Report for Selected Countries and Subjects’. http://www.imf.org/external/pubs/ft/weo/2011 [accessed 2 June 2012]. 11 Schneider, see above, note 1. 12 Poszar, Z. and Singh, M. ‘The Nonbank-Bank Nexus and the Shadow Banking System’ (2011). International Monetary Fund (IMF) Working Paper 11/289, Washington D.C. http://www.imf.org/ [accessed 12 November 2011]. 13 Schneider, see above, note 1. 14 Ibid. 15 Cano, C. G., ‘On the Crisis’ (2012). BIS - Central bankers' speeches, Speech at the Universidad del Rosario School of Economics graduation ceremony, Bogotá, http://www.bis.org/list/cbspeeches/ [accessed 25 April 2012].

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consist of money market funds (MMFs)16 and repurchase (repo) agreements17, but they also include hedge funds,

structured investment vehicles (SIVs)18, special purpose entity (SPE)19 conduits as well as asset backed securities

(ABSs) and asset-backed commercial papers (ABCPs) such as mortgage backed securities (MBSs) and

collateralised debt obligations (CDOs)20. In the words of Paul McCulley, who coined the term ‘shadow banking’,

it is "the whole alphabet soup of levered up non-bank investment conduits, vehicles and structures."21

While the term ‘shadow banking’ has only been coined in recent years22, the system itself is not

something new at all. Shadow banking is indeed just a name given to a very large and important part of the

global financial system which had already existed since many decades.23 The name is perhaps misleading as the

institutions which make up this huge system are often well known and clearly visible. Only in so far do they lie

in the ‘shadows’ as their activities are often not caught by the financial regulators.

To define shadow banking within the global financial system, it makes sense to clarify first what

shadow banking is not. Judges have often tried to define banks in their own words. In the 1960s Lord Denning,

MR, laid down the classic test in United Dominions Trust Ltd v Kirkwood24 as “an establishment for the custody

of money received from, or on behalf of, its customers”. However, exactly this definition does no longer only

apply to traditional banks. A large part of the SBS would easily pass Lord Denning’s test. It is therefore

apparent, that for the purpose of modern financial regulation with its increasingly sophisticated financial

products, the Kirkwood test is no longer desirable.

Banks in the traditional sense are institutions that engage in lending and borrowing. They take money

deposits from some customers and lend it to others. However, and even more importantly, they have access to

their respective countries’ central banks25. Technically, a bank is any company that has a banking licence. These

are usually granted by a countries’ central bank. In the UK, the central bank is the Bank of England which

originally supervised banks. However, this function is now carried out by the Financial Services Authority

(FSA)26. Once we have found a financial institution with a banking licence, there are still largely three types of

banks to be distinguished from each other: commercial banks, investment banks and universal banks (both

commercial and investment banks together). Commercial banks are those which are also commonly called high

street banks. They take deposits from their customers (individuals, companies and governments) and also lend

money to them. Lending to people is called retail banking while lending to businesses and governments is

16 Money market fund (MMF): an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial papers. 17 Repurchase agreement (repo): the sale of securities together with an agreement for the seller to buy back the securities at a later date. 18 Structured investment vehicle (SIV): a finance company borrowing money by issuing short-term securities at low interest rates and then lending that money by buying longer term securities at higher interest rates, with the difference in rates going to investors as profit. 19 Special Purpose Entity (SPE): a legal entity created to fill a narrow or temporary objective. Often used to hide debt or ownership (see Enron scandal). 20 Collateralised debt obligation (CDO): an investment security backed by a pool of bonds, loans and other assets. 21 O’Donnell, J. ‘European Union to shine light on shadow banking’ (2012). Reuters, Brussels, 27 April. http://uk.reuters.com/ [accessed 10 May 2012]. 22 McCulley, P. ‘Speech at Economic Policy Symposium’ (2007). Jackson Hole, Wyoming. 23 Pozsar, Adrian, Ashcraft and Boesky, ‘Shadow Banking’ (2012). Federal Reserve Bank of New York, Staff Report No. 458. http://www.newyorkfed.org/ [accessed 10 March 2012]. 24 (1966) 2 QB 431 (CA) 25 Cranston, R., Principles of Banking Law (2nd ed.), Oxford University Press, New York, 2002. 26 http://www.fsa.gov.uk/

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wholesale banking. The other group, investment banks, help companies and governments raise money. Most of

the world’s biggest banks do both types of banking27.

Now that we roughly know what a bank is, the issue is further complicated by the fact that, although the

SBS mainly operates outside the traditional main banking sector, it also involves many traditional banking

institutions. This means that many institutions which would otherwise be classified as belonging to the

mainstream banking sector, engage in activities which fall into the SBS. Therefore, the shadow and the main

banking worlds are highly intertwined and connected, making it difficult for the laymen and expert alike to

distinguish between the two.

(c) The purpose of shadow banking

The classic and original purpose of a bank is to take deposits from customers and to lend money to fund

businesses, projects and construction. This is especially the case for those people and organisations that need

money the most, such as small fast-growing ones. Yet, it is often difficult for exactly those businesses and people

to raise or borrow money from banks, as they usually require securities such as already existing assets. When

people can’t get what they want from the regulated sector, they get it from the unregulated shadow banks.

Shadow banks often can provide credit cheaper than mainstream banks. They take on risks that regulated banks

are either not willing or not allowed to take. This means that they offer financial services to businesses or people

who would otherwise not have access to this money.

A perfect example of this can be witnessed in contemporary China28, where the banking business is

going so well that they can easily afford lending exclusively to big businesses with low risk29. This leaves many

people and businesses with outstanding credit demands. As they cannot get the money from banks, they move to

the SBS. This problem shows nicely that the underlying basis of shadow banking is something fundamentally

democratic. As it gets increasingly difficult to raise capital (equity) or borrow money (debt) from banks, other

financial institutions are stepping in to fill this gap in demand. Those non-banks therefore provide finance

solutions to those who otherwise would not be able to get access to money.

Still, this explanation is only half of the truth. In modern global finance it is also the powerful financial players

that make daily use of the SBS as a large credit intermediation system involving maturity and liquidity

transformation through sophisticated securitisation mechanisms and the repo market. Money market funds

(MMFs) also form an important part of the SBS. They act like banks in many ways, but don’t have the access to

the safety net that a bank has. They remain a particular source of risk30, as their short term deposits are prone to

runs. MMFs were treated as cash on deposit even though they are not banks. This is one of the reasons they were

given the nickname ‘shadow banks’31. Indeed, during the financial crisis, the real contraction in credit came from

non-bank financial institutions – MMFs, hedge funds, SIVs. They melted away from the money markets at the

first hint of banks in trouble32. Hedge funds are generally considered to form part of the SBS, although some

27 Cranston, see above, note 23. 28 Gongloff, M. ‘China’s Shadow Banking System: The Next Subprime?’ (2011). Wall Street Journal Blog, Market Beat, 25 October. http://blogs.wsj.com/marketbeat/ [accessed 18 April 2012]. 29 Chan, H. H. ‘China shadow banking: dancing in the dark’ (2012). Financial Regulatory Forum, Reuters, 08 February. http://blogs.reuters.com/financial-regulatory-forum/ [accessed 18 April 2012]. 30 Derby, M. ‘Bernanke Calls For More Regulations’ (2012). Wall Street Journal Live (03), http://on.aol.com/video/ [accessed 10 April 2012] 31 McCulley, see above, note 21. 32 McCulley, see above, note 21.

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experts exclude them on the basis that they are more investment than bank like33. The UK, which is the hedge

fund centre of Europe, will be particularly cautious in observing regulatory developments in this area.

Taking all the above into consideration, it can be said that the SBS activities play an important part in

the financial system. They exist largely outside the main banking system and are not caught by financial

oversight and regulatory structures. The SBS, unlike the traditional banking system, does not enjoy access to

central bank funding or safety nets like deposit insurance.

The main issue of the SBS is therefore seen from a point of systemic risk. There is also a reasonable

concern that global financial regulation, which has increasingly become stricter in recent years, leads to more

business moving into the SBS. If this is the case, then the purpose of the regulations fails as these financial

transactions will then again occur away from the reach of the regulators. It is therefore important to understand

these yet little regulated activities to ensure a truly effective regulatory model.

(d) Recent European and Global Structural Changes in Financial Supervision

The financial crisis of brought the debate about stricter control of financial institutions into the global

headlines. While governments around the world have been quick to introduce more stringent capital

requirements for banks through the Basel-III accords and the same for the insurance industry with Solvency II34,

it has often been criticised that these measures do not stretch far enough to the most important threats of systemic

risk. It is clear that the SBS has not been the primary focus of regulatory changes yet.

The regulatory response to the 2008 financial crisis has been international and coordinated through the

G2035. This global group of finance ministers and central bank governors, which represents about 80% of the

world’s economy, has been growing in importance since the crisis and has now replaced the G8 as the main

economic council of wealthy nations36. The 2009 G20 London summit in April 2009 established the Financial

Stability Board (FSB) as a successor to the Financial Stability Forum (FSF) which had existed for the preceding

20 years37. Based in Basel, Switzerland, the Board includes all G20 major economies, former FSF members, the

European Commission, the Bank for International Settlements (BIS), the European Central Bank (ECB), the

International Monetary Fund (IMF), the World Bank and the Organisation for Economic Co-operation and

Development (OECD). As formerly the FSF, the FSB’s aim is to promote international financial stability and to

advise on global regulatory standards. One of its subdivisions is the Standing Committee on Supervisory and

Regulatory Cooperation (SCSRC), which is chaired by Sir Adair Turner who is, at the same time, Chairman of

the UK’s FSA. This Committee will address coordination issues that arise among supervisors and regulators. It

will also help with contingency planning for cross-border crisis management at major financial institutions and

advise on crisis management issues more broadly. It is of paramount importance for tackling the SBS issues38.

The group of G20 has invited the FSB to review the SBS and give recommendations for supervision and

regulations. Accordingly, the FSB has recommended measures to strengthen oversight and regulation of shadow

33 Schneider, see above, note 1. 34 Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (Solvency II). 35 G20: Group of Twenty Finance Ministers and Central Bank Governors www.g20.org 36 CNN, ‘Officials: G-20 to supplant G-8 as international economic council’ (2009). Cable News Network, Turner Broadcasting System, Inc., 25 September 2009. http://articles.cnn.com [accessed 14 March 2012]. 37 Financial Stability Board (FSB), http://www.financialstabilityboard.org/about/ [accessed 14 March 2012]. 38 http://www.fsa.gov.uk/

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banking39 in October 2011 and gave an overview of the progress of the G20 recommendations for strengthening

financial stability40.

On a similar note, and as part of the global regulatory debate, the EU created a new framework for

financial supervision. In place since 2011, it consists of a new European Systemic Risk Board (ESRB) to ensure

that macro-economic risks are detected sufficiently early. Based on the three traditional financial sectors

(banking, capital markets and insurance) it is divided into three sectoral European supervisory authorities

(ESAs): the European Banking Authority (EBA)41 based in London, the European Insurance and Occupational

Pensions Authority (EIOPA) in Frankfurt42 and the European Securities and Markets Authority (ESMA) in

Paris43. These authorities have a key aim to establish a ‘Single Rule Book’ for financial supervision and

regulation within the EU44. Generally, the EU has shown a leading incentive in financial services regulation. The

EU‘s roadmap for Financial Reform45, published in October 2010, has as its objective the full alignment with the

commitments on financial reform stipulated by the G20.

In 2010, the UK government created the Independent Commission on Banking (ICB), asked to consider

reforms to the UK banking sector to promote financial stability and competition. In November 2011 the ICB

published its final report46, chaired by and commonly named after Sir John Vickers. They recommended

measures for the main banking sector such as ring-fencing retail from investment bank activities within large

banks. The report also suggested that the failure of Lehman Brothers might have been prevented had regulation

of the SBS already been in place. However, it has been criticised, that the report neglected the SBS problem47.

(e) Existing regulatory measures

Regulations for the banking sector have either already been implemented or are on their way with new

capital requirements based on the three Basel Accords and the insurance sector is currently seeing regulatory

changes with the Solvency II Directives scheduled to come into effect in 2014.

To be more precise, there are already existing EU measures addressing the SBS. One of those measures

are the Capital Requirement Directive IV (which will implement the Basel III global framework in Europe) and

the International Financial Reporting Standards (IFRS) as indirect regulation through banking and insurance

39 Financial Stability Board (FSB), ‘Shadow Banking: Strengthening Oversight and Regulation’ (2011), Recommendations of the Financial Stability Board, 27 October 2011. http://www.financialstabilityboard.org/publications [accessed 28 October 2011]. 40 Financial Stability Board (FSB), ‘Overview of Progress in the Implementation of the G20 Recommendations for Strengthening Financial Stability (2011). Report of the Financial Stability Board to G20 Leaders, 04 November 2011. . http://www.financialstabilityboard.org/publications [accessed 04 November 2011]. 41 REGULATION (EU) No 1093/2010 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 24 November 2010 establishing a European Supervisory Authority (European Banking Authority), amending Decision No 716/2009/EC and repealing Commission Decision 2009/78/EC. 42 REGULATION (EU) No 1094/2010 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 24 November 2010 establishing a European Supervisory Authority (European Insurance and Occupational Pensions Authority), amending Decision No 716/2009/EC and repealing Commission Decision 2009/79/EC. 43 REGULATION (EU) No 1095/2010 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 24 November 2010 establishing a European Supervisory Authority (European Securities and Markets Authority), Amending Decision No 716/2009/EC and repealing Commission Decision 2009/77/EC. 44 European Commission, see note 47. 45 European Commission, ‚’The European Union‘s roadmap for Financial Reform’ (2010). Directorate-General for the Internal Market and Services, October 2010. http://ec.europa.eu/internal_market/finances/ [accessed 14 March 2012]. 46 Independent Commission on Banking (ICB), ‘Final Report – Recommendations’ (2011). London, September 2011. http://bankingcommission.independent.gov.uk/ [accessed 14 September 2011]. 47 National Institute of Economic and Social Research (NIESR), Beyond Vickers: NIESR Proposes Alternative Approaches To Bank Regulation (2012). Press Release, 03 February 2012, London. http://www.niesr.ac.uk/ [accessed 10 February 2012].

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regulation. Furthermore, for investment firms, the Markets in Financial Instruments Directive (MiFID) 48 will be

extended to cover all high frequency traders and more commodity firms, therefore enlarging the scope of current

prudential regulation to make future regulatory arbitrage more difficult. Additionally, Solvency II and the

Alternative Investment Fund Directive will be regulating the insurance sector and investment funds.

Although these measures go some way towards addressing the SBS, the European Commission wishes to

implement further measures.

In the US the so-called Dodd-Frank Act49, passed in 2010, included legislation which went into the

direction of regulating the SBS. It included provisions saying that the Federal Reserve System, the central

banking system and regulator of the US, has the power to regulate all institutions of systemic importance.

Furthermore, the Act required registration for hedge funds which have assets totaling more than $150 million.

Dodd-Frank and Basel III may limit risks in the securitisation industry for the near future. Dodd-Frank

proposes a large number of rules in the form of risk-retention requirements, additional disclosure, limits on

transactions between banks and their affiliates (for ABCP conduits, for instance), and new rules for the use of

credit ratings and Basel III imposes additional pressure on banks through higher capital buffers and more

stringent liquidity requirements.

Furthermore, in 2011 the FSB named 29 banks worldwide as systemically important financial

institutions (SIFIs)50. Out of them ten were based in the Eurozone, eight in the US, four in Britain, three in Japan,

two in Switzerland, and one each in Sweden and China. Those banks are now subject to stricter controls and

regulations. The regulators also implemented international financial reporting standards (IFRS) which have been

welcomed by the financial world. While these measures mainly affect the traditional financial sectors, they may

also prove useful for the SBS.

(f) Current Legislative Proposals and Recommendations

In 2010, the former Committee of European Banking Supervisors (CEBS), which’s tasks and activities

have now been overtaken by the London-based European Banking Authority (EBA), published its last annual

report51. The CEBS indicated that implementation and supervision of banking regulations that used to follow the

‘comply or explain’ mechanism has increasingly become more stringent and less voluntary as a lesson learned

from the financial crisis.

Currently, the European legislators are still on their way to enact a new set of regulations to control and

supervise these financial institutions. In March 2012 the European Commission published a pre-legislative green

paper52 on shadow banking53. To date, it is the latest proposal for regulating the SBS. It has to be emphasised,

that we are still at a very early stage. The FSB report of October 2011 specified five workstreams which it has

48 MiFID: Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC. http://eur-lex.europa.eu [accessed 15 January 2012]. 49 Dodd-Frank Wall Street Reform and Consumer Protection Act (as approved by the House-Senate Conference on H.R. 4173 on June 29, 2010 and subsequently approved by the U.S. House of Representatives on June 30, 2010) 50 Financial Stability Board (FSB), ‘Policy Measures to Address Systemically Important Financial Institutions’ (2011). http://www.financialstabilityboard.org/publications/ [accessed 04 November 2011]. 51 Committee of European Banking Supervisors (CEBS), Annual Report (2010). London. http://www.eba.europa.eu [accessed 18 February 2012]. 52 A green paper released by the European Commission is a discussion document to stimulate debate and launch a process of public consultation in a specific area. It is often followed by a white paper, containing proposals for further development into EU law. 53 European Commission (2012) Green Paper on Shadow Banking. http://ec.europa.eu/ [accessed 19 March 2012].

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launched to analyse key issues in more detail and develop effective policy recommendations. Three of the

reports are due to be published in July 2012, and the remaining two in September and December of the same

year. With the global importance and relevance of these issues, responsibility for each report has been given to

the Basel Committee on Banking Supervision, the International Organization of Securities Commissions and

FSB Task Force subgroups. They are specifically considering regulatory reforms for banks’ interactions with

‘shadow bank’ entities, MMFs, securitisation, other ‘shadow banking’ entities and securities lending and repos.

The workstreams bring together the EU and other major jurisdictions, including the U.S., China, and Japan,

which are each considering appropriate measures. The FSB will review the workstreams through its SCSRC and

is expected to produce a comprehensive analysis of the risks and regulatory responses before the end of 2012.

(g) Recent stakeholder’s response

The European Commission invited stakeholders to share their comments on the green paper. In June

2012, the European Banking Federation (EBF), which represents the interests of almost 5000 banks, published

its response to the proposals54. While the EBF’s comments were generally supportive of the proposals, one of the

main criticisms was, rather unsurprisingly, that the risks, entities and activities that should be included within the

scope of the shadow banking are not yet clearly defined. Before determining the necessary modifications of the

current EU regulatory framework, we should wait until the FSB has explicitly stated which activities and entities

it will count as being part of the SBS. The EBF also criticised the name ‘shadow banking’ as a vague, pejorative

and arbitrary term of an important and stable source of alternative funding for banks and their customers.

Similar to the new Deloitte Shadow Banking Index’s approach55, the EBF suggests excluding investment funds

from the SBS definition. They remark that European investment funds or their managers must already comply

with either the proposed AIFM Directive56 or the UCITS Directive57, which together have a broad scope for

regulation. The AIFM Directive58 (Alternative Investment Fund Managers Directive) proposals, already in force

since July 2011, proposals have to be written into national statute books by 2013, and will then begin to bite.

Even more logical would be the exclusion of closed end investment funds, as they are not prone to the risks of

runs.

The EBF’s response further advises to make the fullest use of already existent legislation such as the

Capital Requirements Directive59 and Commission Regulation (EC) No 809/200460 which also partially regulate

54 European Banking Federation, ‘EBF Response to European Commission Green Paper on Shadow Banking’, June 2012.

http://www.ebf-fbe.eu [accessed 01 June 2012].

55 Deloitte, ‘The Deloitte Shadow Banking Index - Shedding light on banking’s shadows’ (2012). Deloitte Center for Financial Services, Deloitte Development LLC, New York. http://www.deloitte.com/assets/ [accessed 30 May 2012]. 56 Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on Alternative Investment Fund Managers and amending Directives 2004/39/EC and 2009/…/EC. 57 DIRECTIVE 2001/107/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 21 January 2002 amending Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) with a view to regulating management companies and simplified prospectuses. 58 AIFMD: Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010. http://eur-lex.europa.eu [accessed 20 January 2012]. 59 DIRECTIVE 2009/111/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 16 September 2009 amending Directives 2006/48/EC, 2006/49/EC and 2007/64/EC as regards banks affiliated to central institutions, certain own funds items, large exposures, supervisory arrangements, and crisis management.

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securitisation and ABS transactions. As regards repos and securities lending, transactions which are of

fundamental importance for credit institutions to ensure their liquidity, the EBF would regard the European

harmonisation of settlement systems61 (which still operate under different legal and regulatory frameworks) as a

major step to reduce failures in these markets. With reference to a paper from the European Repo Council62, the

EBF’s commentary documents that there is no general risk of a run for repos or MMFs.

Generally, the EBF’s response promotes the enhanced application of existing rules, while underlining

the importance of the general principle that the same financial activities should be subject to the same regulation

and supervision globally. The European Commission should therefore continue to actively participate in the FSB

discussions and implement any recommendations in parallel with other key jurisdictions around the globe.

(h) Conclusion

We saw that both in the US and the EU, legislation has been introduced to regulate the financial sectors

since the 2008 crisis. While they partly address the shadow banking problem, the SBS has not received particular

attention since the end of last year. There is now however a clear political and regulatory will visible around the

globe to tackle this issue. As the specific aspects are still under investigation, particularly by the FSB’s

workstreams, their publication of those reports later this year will be impatiently awaited by the financial sector.

It seems quite clear at this point, that some regulation is going to be introduced in the near future. What exactly

this will be can only be speculation now. The call for stronger regulation by the Federal Reserve Governor

Daniel Tarullo, on 12 June 201263, was the latest so far in a number of high profile calls for SBS policy changes

this year.

It is also likely that new shadow banking activities will emerge in the future. In response to the recent

regulatory proposals, a London-based accountant was reported to be pessimistic about regulator’s success. He

said that the shadow banking sector will always be difficult to regulate as it contains individuals who are more

intelligent than regulators and able to stay one step ahead64. While it can be argued that innovators will always

outpace regulators. This should not discourage us from implementing regulations to prevent risk in global

financial stability.

The alternative is the argument formerly advanced by the Larosière Report65 which makes it clear that

regulation alone cannot solve all problems of financial stability. Other factors such as corporate governance need

to be taken into account. This year again Larosière reminded that one should not go ‘overboard’ with financial

regulation66. Over-regulation should be avoided as it slows down economic growth. European central bankers are

60 COMMISSION REGULATION (EC) No 809/2004 of 29 April 2004 implementing Directive 2003/71/EC of the European Parliament and of the Council as regards information contained in prospectuses as well as the format, incorporation by reference and publication of such prospectuses and dissemination of advertisements. 61 European Repo Council, ‘A white paper on the operation of the European repo market, the role of short-selling, the problem of settlement failures and the need for reform of the market infrastructure’ (2010). ICMA, Zurich, 13 July 2010. http://www.icmagroup.org/assets/ [accessed 05 June 2012]. 62 European Repo Council, ‘Shadow banking and repo’ (2012). ICMA, Zurich, 20 March 2012. http://www.icmagroup.org/assets/ [accessed 05 June 2012]. 63 Torres, C. ‘Fed’s Tarullo Calls for Tougher Shadow Banking Oversight’ (2012). Bloomberg, 12 June 2012. http://www.bloomberg.com/news/ [accessed 12 June 2012]. 64 Zafar, A. ‘NIESR urges gov’t to crack down on shadow banking’ (2012). FTAdviser, Financial Times Business, London, 09 February 2012. http://www.ftadviser.com/ [accessed 10 February 2012]. 65 The High-Level Group on Financial Supervision in the EU, Report (2009). Brussels, February 2009. http://ec.europa.eu/internal_market/finances/ [accessed 10 October 2011]. 66 de Larosière, J. ‘We should avoid going overboard with financial regulation’ (2012). Newsletter, The Eurofi High Level Seminar 2012, Paris, 29 March 2012. Http://www.eurofi.net [accessed 10 April 2012].

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also emphasising that good institutional governance is the key to better crisis management67 and a recent report68

by the Group of Thirty suggests that governance of financial institutions is of great importance for a harmonised

global framework for crisis management in the banking sector69 and as the ideal approach for supervising and

regulating monitoring the SBS70. Eurofi, a European think tank dedicated to financial services, even considered

building up Chinese walls between banks and shadow banks71, while academics72 are generally waiting for the

FSB progress reports73.

Clearly, there has been done much since the crisis with CRD, the new Basel Accords, further

implementation of MiFID, Solvency II, Dodd-Franck, and corporate governance. While these measures were

largely aimed at the traditional institutions, the time has now come for the SBS. Entities such as MMF and the

repo market have become under increased scrutiny also by the American SEC74.

For financial regulation the bigger global picture is of paramount importance. What the US government

does is often followed by the rest of the world. This is largely due to the US being the largest global economy

and also since US financial institutions dominate the international financial markets. Not least, the sub-prime

mortgage crunch and with it the financial crisis of recent years started in the US. However, this time it seems that

the EU is leading the way with strong activity from the European Commission, although the main workload is

still undertaken by the global FSB. Leading bankers themselves call for a global approach on regulation as the

customers they serve are increasingly global in operation75. This must surely be the right way to go. In a global

financial world, rules must ideally be the same in all jurisdictions. Otherwise the game of regulatory arbitrage

and financial innovation will start again.

All in all, it is still not clearly defined what exactly the SBS encompasses. The reports due to be

published this year by the FSB will therefore hopefully place us in a better position to judge what measures will

need to be done.

67 Orphanides, A. ‘Strengthening governance is key to better crisis management’ (2012). Newsletter, The Eurofi High Level Seminar 2012, Paris, 29 March 2012. Http://www.eurofi.net [accessed 10 April 2012]. 68 Group of Thirty Working Group, Special Report: ‘Toward Effective Governance of Financial Institutions’ (2012). Group of Thirty, Consultative Group on International Economic and Monetary Affairs, Inc. , Washington. http://www.group30.org [accessed 20 April 2012]. 69 European Commission, ‘An EU Framework for Cross-Border Crisis Management in the Banking Sector’ (2009). Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee, the European Court of Justice and the European Central Bank, COM(2009) 561/4, Brussels. http://eur-lex.europa.eu [accessed 25 November 2011]. 70 Morrison & Foerster LLP, News Bulletin: ‘Stepping Into the Shadows’, 21 April 2011. http://www.mofo.com [accessed 21 November 2011]. 71 Eurofi Financial Services in Europe, ‘Shadow banking – Improving the consistency of banking and non-banking regulations’ (2011). The Eurofi G20 High Level Seminar 2011, February 2011, Paris. http://www.eurofi.net [accessed 20 October 2011]. 72 O'Sullivan, K. P. V. and Kinsella, S. 'Chasing shadows: Europe prepares to regulate shadow banking' (2012) Journal of Banking Regulation, 13, 173–177. http://www.palgrave-journals.com/ [accessed 28 April 2012]. 73 Financial Stability Board, ‘Strengthening the Oversight and Regulation of Shadow Banking’ (2012). Progress Report to G20 Ministers and Governors, Basel: Switzerland, 16 April 2012. http://www.financialstabilityboard.org/publications/ [accessed 17 April 2012]. 74 (Bank) run: occurs when many customers withdraw their deposits because they believe that the financial institution might become insolvent. It can destabilise the institution since it is left out of cash and thus faces sudden bankruptcy. 75 Moulds, J. ‘It’s simple, global markets need global rules’ (2012). Newsletter, The Eurofi High Level Seminar 2012 , Paris, 29 March 2012. Http://www.eurofi.net [accessed 10 April 2012].

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as the format, incorporation by reference and publication of such prospectuses and dissemination of

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