Andreas Dombret: Systemic risks of shadow banking
Speech by Dr Andreas Dombret, Member of the Executive Board of the Deutsche
Bundesbank, at the Salzburg Global Seminar "Out of the shadows: should non-banking
financial institutions be regulated?", Salzburg, 20 August 2013.
* * *
When talking about shadow banking we should be clear what we mean. I subscribe to the
FSB's definition of "credit intermediation involving entities and activities outside the regular
banking system". What I deem to be relevant from my financial stability perspective is that
such entities create bank-like risk without being subject to banking regulation. Obviously, the
non-banking financial sector is composed of a very heterogeneous set of agents. Some of
them - such as insurance corporations and pension funds - usually have very long-term
investment horizons and can therefore potentially serve as a stabilising element for the
financial system. To be clear on this point: I firmly believe that insurance corporations can be
systemically important institutions, too. Thus, effective resolution regimes for Global
Systemically Important Insurance corporations need to be developed and implemented.
The overall effects of the so-called shadow banking system and its activities on financial
stability are ambiguous. Theoretically, non-banking financial institutions that perform
banklike activities are associated with diversification and specialization benefits. Therefore, it
could be assumed that they contribute to efficiency gains and greater financial system
resilience. However, empirical evidence from the financial crisis suggests that the activities of
shadow banking entities might often be driven by the motive of exploiting regulatory
arbitrage. Altogether, the economically beneficial attributes and systemically stabilising
effects of entities and activities of the shadow banking system are not always that obvious. In
particular, developments prior to the financial crisis revealed that the activities and entities of
the shadow banking system can also pose a threat to the stability of the financial system as a
whole.
The risks inherent in the shadow banking system pertain to both dimensions of systemic risk:
the cross-sectional (interconnectedness) dimension as well as the time-serial (procyclicality)
dimension. I see these potential threats as being caused mostly by maturity and liquidity
transformation, the build-up of leverage and credit risk transfer conducted by the shadow
banking system. All of those activities are not evil per se, but the ensuing systemic risks need
to be contained. All activities must be made transparent, in particular vis-à-vis supervisory
authorities, and they must be adequately regulated. In that regard, I welcome the global
regulatory initiative on shadow banking - under the leadership of the FSB - and I am closely
following initiatives at the regional and national level.
I want to comment on three specific aspects of the systemic risk posed by shadow banking:
first, the risk of runs on money market funds (MMFs); second, the potential procyclicality of
securities financing transactions; and third, the linkages between banks and shadow banking
entities.
Regarding money market funds' liquidity risk: due to their perceived deposit-likeliness,
constant net asset value MMFs face a relatively high risk of investor "runs" in times of crisis.
Thus, the mandatory move to variable net asset value MMFs might be the single most
important regulatory action to make the MMF segment more stable. I expect the European
Commission to implement that move in Europe soon - in line with the ESRB's
recommendation of December 2012. It was with keen interest that I also observed the recent
proposal by the US Securities and Exchange Commission to adopt similar measures.
Regarding securities financing transactions: In an environment of ample liquidity, securities
financing transactions can obviously contribute to a procyclical build-up of leverage in the
financial system. Going one step further in a typical chain of transactions, the practice of
collateral re-hypothecation intensifies interconnections in the financial system, while at the
same time lacking the necessary transparency for clients and supervisors. Therefore, I
support the recommendations envisaged at global level to increase regulatory reporting and
public disclosure requirements for financial institutions' securities financing activities. With
the results of thoroughly conducted impact assessments at hand, the imposition of somewhat
tougher regulatory measures, such as minimum standards for calculating collateral haircuts,
can be considered.
The last issue I want to cover are the interconnections between banks and entities of the
shadow banking system. With the global implementation of Basel III capital and liquidity
requirements for the banking sector, there are increasing incentives to shift risky activities to
shadow banking entities, where regulation is less stringent. However, such regulatory
arbitrage poses risks to the stability of the entire financial system. To effectively regulate the
direct ownership links between banks and shadow banking institutions, the scope of
regulatory consolidation needs to be internationally harmonised. Also, minority participations
of banks, such as investments in the equity of funds belonging to the shadow banking
system, require an internationally consistent, risk-sensitive application of Basel capital
standards.
And, last but not least, large exposures of banks vis-à-vis counterparties of the shadow
banking system need to be adequately measured and controlled by looking through complex
investment structures. Finally, the effectiveness of regulatory requirements with regard to
shadow banking must be constantly assessed and their implementation should be peer
reviewed at the global level. As outlined, addressing the liquidity risk of money market funds,
procyclical credit expansion via securitised financing, and interconnections between banks
and shadow banks are key regulatory reforms. Adequately regulated, it should be possible to
effectively mitigate systemic risks posed by such non-banking financial institutions and
enable them to affect financial stability more positively.