Vítor Constâncio: Shadow banking - the ECB perspective
Speech by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
European Commission Conference "Towards better regulation of the shadow banking
system", Brussels, 27 April 2012.
* * *
Dear Commissioner Barnier,
Ladies and Gentlemen.
I am pleased to be here today at this conference to address the "better regulation of the
shadow banking system". The term shadow banking is widely used to cover activities related
to credit intermediation, liquidity and maturity transformation taking place outside the
regulated banking system. This term should not have a pejorative meaning as shadow
banking activities perform basic functions of the financial system. It has however the merit of
clearly indicating the nature of the problem. Indeed, it is evident that before the crisis part of
the shadow banking system has significantly expanded by moving from light into shadow, by
shifting regulated banking activities into institutions, transactions or markets which are not
within the scope of regulation.
In this context, today I will first address the general problems created by the unregulated
shadow banking as well as the main guidelines for the necessary regulatory reform that is
progressing internationally under the aegis of the FSB. In the second part of my remarks I
will focus on repo markets, given their importance for the functioning of money markets and
consequently for central banks. To address concrete practical issues, I will make some
proposals on how to create a database, which I believe is indispensable to provide us with
basic information about the functioning of the European repo market, at least on a similar
basis to the one existing in the US. I will also briefly discuss some policy proposals
concerning repo markets that have been raised in the international debate.
I. The relevance of shadow banking for European financial stability
The activities of shadow banking before the crises were widely mentioned as triggers or
factors contributing to the financial crisis. These activities can be largely traced back to the
prevalence of the originate-to-distribute banking model, which gave the possibility to transfer
part of the balance sheet and the related regulatory requirements from the regulated to the
unregulated part of the financial sector.
Shadow banking includes entities involved in securitisation and other activities extending the
intermediation process, such as special vehicles and other financial intermediaries.
Differently from the U.S., in continental Europe lending activity per se is seldom moved
outside the regulated financial system. Also, securitisation activities in Europe and in the
euro area never attained the level observed in the U.S., notwithstanding the large drop in US
issuance after the financial crisis.
On the funding side, a main component of shadow banking is the secured lending markets,
particularly the repo market. In the U.S., the money market funds are usually included in the
shadow banking sector and were an important source of funding for other shadow financial
institutions, like securitisation vehicles, via the purchases of their short-term debt. They are
much less important in the euro area. However, in this respect, the relevance of their
intermediation activity varies across countries and they are more closely tied to banks,
therefore providing a powerful link between the shadow and the regulated banking sector.
As policy makers, we are interested in the possible dangers for financial stability arising from
shadow banking activities. In particular, we are concerned about the implications of these
activities for global liquidity. If shadow banks are involved in a large share of the activities of
the financial sector, it is more likely that in periods of stress liquidity dries up very quickly in
certain markets leading to sudden stops in funding. Also, shadow banking extends the
intermediation chain and increases the associated contagion risks.
There are various forms of interplay between the regulated banking system and the shadow
banking system resulting in a substantial amplification of systemic risk. One of the elements
for the US market, has been the "run on repos" of shadow banking entities that were funded
using asset-backed-securities as collateral. When the value of these assets declined
dramatically, these entities, which could not access central bank liquidity, got quickly into
trouble.1 "Bank runs" involving shadow banking entities have systemic risk implications since
they can quickly spill over to the regulated financial sector. This happens via contagion
propagating through market dynamics - liquidity squeeze, fire sales - or via the
interconnectedness with the regulated banking sector. Shadow banking activities exacerbate
the build-up of leverage and asset price bubbles and therefore amplify the procyclicality of
the financial system.
Based on these characterisation and the available data, recent estimates published recently
by the ECB2 put the value of the assets of shadow banking in the euro area to about one half
of the assets of the banking system. In the U.S., in view of the lower weight of banks in the
overall financial system, the size of the shadow banking, although not much higher than in
Europe in absolute terms, is practically equal to the total assets of the banking sector. In the
euro area, there is a certain degree of heterogeneity and most importantly, there is a high
degree of interconnectedness between the European banking sector and the shadow
banking. Some segments of the shadow banking provide funding to the regulated banks and
the liabilities of financial vehicles set up outside the balance sheet of banks may actually be
guaranteed in some form by the originator banks.
II. The regulatory debate on shadow banking
Following the mandate received by the G20, the FSB has made remarkable efforts to
prepare policy recommendations addressing shadow banking. It has been clear from the
outset the importance of pooling expertise and resources from several authorities, as a
comprehensive assessment of all the financial sectors was needed to clearly understand the
problem. This has been possible thanks to the steering of the FSB. To give an indication of
the complexity of the matters, the FSB put in place five different workstreams, also relying on
the support of international standards setters. Two of these workstreams address specific
regulatory issues, including the regulatory treatment for money market funds and
securitisation. The other workstreams assess broader issues, such as the banks' interactions
with shadow banking entities, the need for new regulation on shadow banking entities, and
systemic risks stemming from practices in securities financing and repo markets.
This last topic is of close interest for central banks, and I will devote some specific
consideration to it. Before that, I would like to make some more general observations.
First, given that one of the main risks stemming from shadow banking relates to regulatory
arbitrage, it is important, and indeed crucial in Europe, to ensure consistency of policy
initiatives across countries. In this context, I note that in the US the Dodd-Frank Act
prohibits banks from proprietary trading (the so-called Volcker rule) and restricts investments
in hedge funds and private equity by commercial banks and their affiliates. The imposition of
such restrictions is not being considered by the FSB, which is looking instead at a possible
enhancement of the prudential requirements related to the interplay between banks and
hedge funds. This could create the potential for an asymmetry leading to distorted regulatory
incentives.
Second, also on the basis of the FSB analysis, we need to look with new eyes at the EU
regulatory framework and ask ourselves whether it can properly address systemic risks
stemming from shadow banking. In the past, regulation was sectoral-based, without specific
consideration of the interconnections existing in reality between financial sectors. In this
context, I welcome the Commission's Green Paper, which contains a very helpful preliminary
analysis on whether the regulatory initiatives undertaken so far in Europe are addressing
such new perspective. It also indicates outstanding policy issues on which further regulatory
initiatives might be needed.
The Green Paper is also referring to the need for Europe to establish a permanent process
for the collection and exchange of information by all relevant authorities to address shadow
banking entities and activities. In this regard, I note that the ESRB, as the EU
macroprudential body with authority over the whole EU financial sector, is well placed to conduct a
continuous monitoring of systemic risks stemming from shadow banking.
III. Policy issues concerning securities financing: the ECB's views
I would like now to focus on the repo market, which is of particular importance for central
banks.
The repo market is a key source of financing for the banking sector and the shadow banking
system. Most recent estimates of the size of the repo market in the US are in the range of
USD 12 trillions in early 2010.3 There are no official data on the overall size of the repo
market in the euro area, but according to the latest December ICMA survey, the total value
of outstanding repos on the book of the 64 offices of 59 financial groups in the EU in
December 2011 was of EUR 6.2 trillion in gross terms. Secured lending via repos has been
increasing significantly in the past recent years in detriment of unsecured forms of interbank
lending in money markets. Indeed, we estimate that since 2002 the daily turnover of the
interbank secured lending more than doubled whereas the unsecured part of that marked
decreased slightly.
Secured financing provides benefits over unsecured lending, especially during turbulent
market times. At the same time, however, the reliance on secured financing provides a
powerful channel of transmission of shocks in the financial system. The decline in collateral
values translates in additional collateral calls possibly compounded with higher haircuts and
margins requirements. A system in which financial institutions rely substantially on secured
lending tends to be more pro-cyclical than otherwise.
Government bonds accounts for two third of the EU-originated collateral used in repo
transactions.4 The powerful shock amplification system of these markets became particularly
evident over the last couple of years with the loss in value of the debt of some euro area
countries.
In Europe, an increasing share of repos is cleared via central counterparty clearing houses
(CCPs) - with a share of 32% of outstanding amounts in December 2011 according to the
ICMA survey, which is multicurrency in scope. CCPs' share seems to be even larger, about
50% in the euro repo market, according to the ECB annual money market survey. CCPs
increasingly interpose themselves between the original counterparties in repo market
transactions, although this trend may reverse if counterparty risk would recede to pre-crisis
levels. The rest of the euro repo market relies largely on bilateral trading, clearing and
settlement modalities (about 40%) and, increasingly, on triparty repo which represents
slightly more than 10% of the market. Triparty repo is certainly a dynamic segment which
after the 2008 contraction shows again a growing trend.
I would like to make some preliminary considerations on three policy issues that are currently
at the centre of the international debate on repo markets.
First, the pro-cyclical nature of margin requirements used in securities financing
transactions.
Recent analytical studies (largely based on empirical studies on US markets) have
highlighted that margin requirements and haircuts in repo markets are pro-cyclical. To
counter this effect, it has been proposed that minimum haircuts could be applied permanently
as a means of limiting system leverage or used temporarily in response to overheated
market conditions as a macro-prudential tool.
However, when assessing such proposals, it should be noted that the main pro-cyclical factor
may not be the level of the haircuts or margins but the level of market prices for collateral
which can be irrationally high in a boom and correspondingly low amidst fire sales in a crisis.
Moreover, a relevant share of the EU repo market is constituted by bilateral trades which
cannot be easily controlled by a regulatory agency.
Such proposals will need to be carefully assessed as regards their impact on the money
market and the possible effect on monetary policy implementation.
This brings me to my second consideration: should we encourage the use of CCP in
repo markets?
During the crisis, the volume of repos declined with the exception of a few market segments.
The reduction in outstanding repo values was however less pronounced for CCP-cleared
repos than for other repo segments. It is well known that some CCPs actually saw an
increase in their business at a time when counterparty-risk adverse market participants
turned to safer avenues.
The good performance of CCPs could be explained by the fact that it addresses effectively
most of the vulnerabilities which affected repo markets during the 2008 crisis. When cash
lenders withdrew from the market due to misperceptions of the credit and liquidity risk,
CCP-cleared repos were significantly less affected. Amidst a general decline of repo market
trading at the peak of the crisis, some euro area CCPs actually saw an increase of volumes.
This happened because CCPs provide effective protection against counterparty risk by
interposing themselves between the original repo parties.
From a financial stability perspective, properly supervised and overseen CCPs act as a
firewall against the propagation of default shocks and can mitigate counterparty credit risk,
enhance market transparency, facilitate collateral liquidation, and foster standardisation of
repo terms and eligible collateral. There is also the advantage that policy makers can monitor
the cleared repo markets since CCPs are regulated institutions.
Therefore, moving repo clearing to CCP seems to be the appropriate solution which by
the way is already gaining ground in Europe, having already attained half of the market.
Third, some repo and securities lending market practices raise concerns from a
financial stability point of view. This is the case for practices related to cash collateral
reinvestments in securities lending and to rehypothecation by prime brokers of securities
given as collateral by hedge funds. I support the work on-going by the FSB on finding
adequate regulatory responses, which should be aimed to constrain negative incentives and
increase disclosure.
The three issues I discussed merit careful reflections. The ECB will support the
developments of policy solutions at European level also giving its contribution to the
Commission's consultation.
IV. How to enhance the monitoring of repo and securities financing markets
I would like now to focus on enhancing the monitoring of the repo markets. This market is
largely an OTC market where rates and volumes are difficult to observe in real time with the
implication that there is no comprehensive source of information in Europe. There are some
important trading platforms where operations of short-term and more standard maturity take
place, which can provide us some useful information. However, significant limitations or
shortfalls do exist as regards existing data sets.
First, market data are not timely and hardly comparable. The ICMA survey is conducted
every 6 months, the ECB Money Market Survey every year and the ECB Money Market
Study biannually. Timelier sources of data are available among others from CCPs or from
trading platforms e.g. Eurex Repo Euro Market, ICAP BrokerTec or MTS. As regards the
ECB Money Market survey, there will be a pilot phase with a limited panel of banks to have a
quarterly review. However, most data refers mostly or exclusively to the interbank market.
Second, there are significant limitations as regards data stemming from market
infrastructures. Data are fragmented and not complete, and are also not easily retrievable
for analytical purposes5.
Finally, there are no statistical sources available as regards the repo and securities
financing markets.
One recent initiative will be of some help, notably the global initiative coordinated by the
Committee on the Global Financial System (CGFS) and by the ECB, together with other
central banks of the Eurosystem, which plans to launch a qualitative quarterly survey on
credit terms and conditions in euro-denominated securities financing and over-the-counter
(OTC) derivatives markets. This survey is driven in particular by a need to monitor
developments in securities financing, i.e. lending collateralised by securities, and OTC
derivatives markets, as well as in shadow banking more generally. The survey will provide
information about changes in credit terms applied by the largest banks for lending against
euro-denominated security collateral and for OTC derivatives transactions with key
counterparty types, as well as about main reasons behind the changes in those terms. This
makes it a valuable monitoring and potentially early warning tool to support risk surveillance
work and the risk identification process.
5
First, available data is not complete. Repos that are settled in the books of custodian banks or in commercial
bank money are not reflected, for instance in payment systems settling in central bank money, as TARGET.
Furthermore, there is no link in TARGET data to the settlement of the securities leg of a repo transaction,
therefore repo-related cash transfers cannot be separated from other payments. Analytical efforts are
ongoing to design algorithms that identify the repo-related payments indirectly, but this may not be enough for
repo market monitoring purposes. Repo-related deliveries of securities for collateral purposes are not singled
out from other instructions to deliver securities, for instance from outright trades. Furthermore, participants in
payment and settlement systems are largely banks; therefore the shadow-banking dimension is not reflected
in payment balances even when banks act as intermediaries for non-bank entities. Second, reflecting the
European market and the post-trade landscape, data is fragmented across infrastructures and countries. The
euro repo market relies on a variety of securities clearing and settlement systems (CCPs, CSDs and ICSDs,
triparty agents, custodian banks) and data may be available only in different formats. Third, data is not easily
available. Even in those cases where the national supervisors and overseers may have access to the repo
data available at the local market infrastructure (for example at CCPs) this is not enough to build a complete
picture and timely monitor developments in the market. A central view is indispensable to gain insight from the
wider financial stability perspective.
V. Proposal for a database on the euro repo market
The ECB has a keen interest in obtaining detailed information on repo market activity
both for monetary policy implementation and financial stability considerations.
Any financial transaction that significantly affects the functioning of money markets is
relevant for the transmission mechanism of monetary policy as well as for the operational
framework of monetary policy implementation. The continuous gain in importance of the repo
market is consequently of great importance for the Eurosystem.
An assessment of financial intermediaries' funding environment and financing activities is
also a key element of any financial stability analysis. The monitoring of underlying
developments on the basis of a regular data collection would benefit the ECB's tasks in
pointing to potential risks stemming from this market.
While differences in market structure ought to be taken into account, the U.S. model may
provide a starting point for a European blueprint. In the U.S. primary dealers voluntarily
report on a weekly basis on their trading activities, as well as on their cash and financing
positions, in a wide variety of underlying securities6 differentiating according to the
counterparty type.
To improve the data availability for repo markets, it could be argued that some existing
surveys can be enhanced and the frequency of the reporting increased. However, the
information collected would not fill the information gap for the non-bank segment of the repo
market.
So how to improve the data availability to monitor the repo market?
Ideally, a central database would serve the purpose. Trade repositories have been a solution
adopted to foster transparency in other market segments, as in case of the OTC derivatives
alongside the introduction of mandatory clearing. In the case of repos, however, it has to be
considered that transactions are to a large extent already channelled to formal infrastructures
for clearing and settlement purposes. For instance, Central Securities Depositories (CSDs)
already centralise in their systems, for their respective market, information relating to repo
that can be derived from the settlement instructions. It could be argued that they de facto
perform already a function that is similar to that of a trade repository. CCPs, triparty agents
and custodian banks for the bilateral segment are in a similar position with respect to repos
of their participants, or customers.
A central database fed by infrastructures and custodian banks to the extent that they
internalise repo settlement in their own books, would be the place for the much
needed central view on repo market and its participants, both banks and non-banks.
This solution would have to be investigated from a technical point of view. For instance,
infrastructures would have to report data based on a common format to be defined taking
into account their respective special focus. To name one, CCPs would have to report
prenetting repo data, whereas CSDs would have to retrieve and report data on the ordering
party, often a customer of the CSD participant.
Therefore, I propose the creation of a EU Central Database on Euro Repos as a joint effort
by public authorities and the financial industry, similarly to the model followed in the U.S. Due
to its role in macro-prudential financial stability and the closeness of repo to monetary policy,
and as it is the case with the Federal Reserve, the ECB would be well placed to centralise
the data gathering for the euro repo market.
For a solution to be possible, however, it would be required the support of the European
Commission by taking the necessary legislative initiative for the creation of a basic reporting
framework at the EU level for market infrastructures. This would aim at ensuring that the data
gathering would provide a complete and uniform picture of the euro repo market, while also
safeguarding any legal and confidentiality requirements regarding the use of the data. The
market would also benefit from this solution: reporting infrastructures would have to set-up
procedure to retrieve and transmit the data, but they may offer an additional service to their
participants given the economic value of information.
Ultimately, not only authorities, but market participants and the financial markets more widely
would benefit from the general increased transparency on the euro repo market.
VI. Conclusions
This conference today by the Commission is a crucial moment in setting the stage for some
key policy decisions in order to avoid financial stability risks stemming from shadow banking.
In my view, among the list of actions to be considered, the establishment of a set of timely
data concerning the repo market would be of key importance for supervisors, central banks
and market participants. In order to make a first step, I propose the preparation of a detailed
feasibility study for the repo market database in cooperation with the European Commission.
I hope that the preliminary considerations I developed today will foster further reflections and
timely actions.
Thank you for your attention.