Paul Tucker: Shadow banking - thoughts for a possible policy agenda
Speech by Mr Paul Tucker, Deputy Governor for Financial Stability at the Bank of England,
at the European Commission High Level Conference, Brussels, 27 April 2012.
* * *
It is excellent that the EU Commission has published a consultative paper on shadow
banking and is holding this conference today. The Commission's paper fits well with the
approach that the G20 Financial Stability Board is taking. The issues here are very important
since, as the international community reregulates the banking industry, more activity is
almost bound to be booked outside banking.
We need at some point to move on to policy. I am therefore going to use today's occasion to
put on the table some thoughts for a possible concrete policy agenda. I am doing so in the
spirit of wanting to help nudge this work into its next stage. And I should be clear that the
FSB, where our work is led by Adair Turner, have not yet articulated our collective preferred
policy approach.
The definition of "shadow banking" employed by the FSB and the EU Commission is,
paraphrasing, credit intermediation, involving leverage and maturity transformation, that
occurs outside or partly outside the banking system.1 That is very close to the definition I
used in a speech two years ago calling for work on shadow banking, except that in addition
to leverage and maturity transformation I include "monetary services".2
I want to make three broad points about this. First, it is very clear that "shadow banking" is
not the same as the non-bank financial sector. This is not a debate about the appropriate
regulatory framework for the whole of finance. For example, the vast majority of hedge funds
are not shadow banks, and don't trade in the credit markets or especially illiquid markets.
Second, non-bank intermediation of credit is not a bad thing in itself. Indeed, it can be a very
good thing, helping to make financial services more efficient and effective and the system as
a whole more resilient. We must remember that as we make policy.
But, as we know from this crisis and from previous ones, true shadow banking can weaken
the system.
Regulatory arbitrage, which is always with us, can distort and disguise channels of
intermediation.
That leads me to my third general point. Shadow banking comes in lots of shapes and
colours. There are degrees to which any particular instance of shadow banking replicates
banking. The liquidity offered by some shadow banks relies pretty well entirely, and more or
less openly, on committed lines of credit from commercial banks. In these cases, the liquidity
insurance offered by the shadow bank is "derivative"; there is a real bank in the shadows. But
for other shadow banks, liquidity services are offered such back-up lines. In those
without
cases, claims on the shadow bank have, in effect, become a monetary asset. Examples
probably include money market mutual funds and an element of the prime brokerage
services offered by securities dealers to levered funds.
With that brief bit of scene setting, I will quickly set out my current thinking on policy. The
objective should not be to curb non-bank finance in general, but to recognise where a form of
intermediation is banking in substance or in the risks it creates for the system as a whole.
Shadow banks that are really part of banks
Many examples of shadow banking are sponsored by banks or are operated by them, or
both. They are effectively part of their "parent" bank. In the run up to the present crisis,
prominent examples were Structured Investment Vehicles, ABCP conduits, and money
funds. Many benefitted from financial support from their "parent" during 2007-08. For such
situations, the following could usefully apply:

Shadow banking vehicles or funds that are sponsored or operated by banks should
be consolidated on to bank balance sheets
Consolidation might require changes in accounting rules. That could take time. These
vehicles and funds should nevertheless be treated as consolidated in the application of Basel
3 regulatory capital requirements etc. If necessary, Pillar 2 should be used to achieve that.
(The Basel Supervisors Committee will, I hope, consider this in its contribution to the FSB
work).
Banks' provision of committed lines of credit to independent shadow banks
Even where a shadow bank is not de facto or de jure part of a banking group, many are
fundamentally dependent on banks - through committed lines of credit. Anyone running a
maturity mismatch is exposed to liquidity risk - liabilities being called before assets fall due or
before they can be sold in an orderly way. Banks can provide insurance against such liquidity
risk because their deposit liabilities are money; they can lend simply by expanding the two
sides of their balance sheet simultaneously, creating (broad) money. But, for the system as a
whole - ie taking a macroprudential perspective - providing committed lines to shadow
banks is riskier than providing such lines to non-bank businesses. Shadow banks are liable
to call on their lines just when the banking system is coming under liquidity pressure itself.
That should be reflected in regulatory policies on banks' liquidity exposures. I suggest that:
 the draw-down rate assumed in the Basel 3 Liquidity Coverage Ratio should be
higher for committed lines to financial companies than for lines to non-financial
companies. That is, banks should hold more liquid assets against such exposures.
Without a policy of that kind, there will be a strong incentive for maturity-transformation to be
undertaken off bank balance sheets but with an umbilical cord back to the banking system. It
should apply not only to vehicles used for securitisation but more generally.
Money funds
Money funds do not use committed lines of credit from banks. Claims on money funds have,
in effect, become monetary assets in the hands of savers. In parts of the world, especially
the US, they are treated like current accounts. Given the restrictions on their asset holdings,
they resemble narrow banks, in mutual-fund clothing. But for a normal mutual fund, as an
open-ended investment vehicle, the value of investments in it with the value of the
fluctuates
vehicle's asset portfolio. By contrast, most money funds hold themselves out as offering par
under any circumstances; when they "break the buck", they must unwind. Their investors run
at that prospect; and so the funds themselves are flighty investors. Compared to most types
of shadow banking, money funds do not borrow - in the usual sense. But by promising par,
they are in effect incurring debt-like obligations. And they can be exposed to leverage. At
least in the run up to the crisis, some invested in levered paper, some of it in what amounted
to Russian Doll shadow banking - a money fund buys short-term ABCP backed by CDOs,
etc.
What I suggest here is that:

Money Market Funds should be required to choose between being
- Variable Net Asset Value (NAV) funds or Constant NAV funds
- Any remaining CNAV funds should be subject to capital requirements of some
kind
- All should be subject to "gates" or other measures that can be used to delay
withdrawals, to make runs less likely.
That package would not completely prevent runs; regular mutual funds can suffer runs. But it
would make them somewhat less brittle.
Europe should want a global standard or at least a globally consistent approach to money
funds. Much the largest money-fund industry in the world is based in the US. But it is not
confined to domestic, US intermediation. It is internationally active - lending to banks,
corporates and sovereigns around the world. That underlines the importance of the outcome
of the deliberations of the SEC and of the US Financial Stability Oversight Counsel in this
area. We have to hope that the US authorities will take action - making not only their own
domestic financial system safer, but the global system safer.
If, against our hopes and expectations, that proves not to be the case, authorities in Europe
and elsewhere will need to think through what if any measures we could sensibly take to
make our part of the global financial system more resilient to the faultline that the money fund
industry currently represents. One possibility would be for

bank supervisors to limit the extent to which banks could fund themselves
short-term from US money funds and from other fragile/flighty sources, including
CNAV money funds domiciled elsewhere.
I should stress that such a policy need not be targeted at US funds per se. It is also a
question of the prudence of the banks that borrow. So it could be cast in terms of the liability
structure and sources of funding of the banking system. The Basel 3 Net Stable Funding
Ratio may help a bit with this.
And I should add that on some fronts - notably transparency - Europe should aim to catch
up with the progress the US has already made.
Securities dealers, finance companies
Some shadow banks are "businesses", not funds or vehicles. These non-bank financial
intermediaries finance themselves externally in the markets. Some such financing is
short-term and so effectively runnable, as events showed. In those cases:

If they are financed materially by short-term debt, they should be subject to
bank-type regulation and supervision of the resilience of their balance sheets.
That would apply to some kinds of finance company. It might apply to securities dealers too.
In the EU, many dealers are "investment firms" and so are already subject to the same
Directives as banks on capital adequacy. That is not true of finance companies in many
jurisdictions.
Perhaps there should be a size threshold for applying bank-style capital and liquidity
regulation to such non-bank banks.
Securities dealers and the "rehypothecation" of client assets
That last set of points was about firms acting as principals. Major issues arise from the use of
client assets - money and securities - to finance the principal risk-taking of some financial
firms. This has become apparent from the Lehman and MFG bankruptcies. Quietly in the
background, something extraordinary has happened over the past decade or so. Let me
explain.
You place £X of your securities portfolio with your broker/dealer in safekeeping (as a
subcustodian in a way). You borrow a much smaller amount of money from your broker and,
reasonably enough, they take some of your securities as collateral; in effect, they have
financed your holding of that part of your securities portfolio. An observer might think the rest
of your portfolio would sit in a segregated client account. Not a bit of it. Unless you have
been very careful, the broker/dealer has repoed out your securities for cash, and used the
proceeds to finance its own businesses. To make this simpler, imagine you have placed
surplus cash with your broker-dealer. As likely as not, it is being used to finance the dealer's
business.
Whether we are talking about your cash or your securities, if you can call them on demand
and they are being used to finance your broker's business, that used to be called .....
banking.
I suggest the following in this area:
 Only banks should be able to use client moneys and unencumbered assets to
finance their own business to a material extent; and that should be a clear principal
relationship. Legal form should come into line with economic substance.

For non-banks, any client moneys and unencumbered assets should be segregated
and should not be used to finance the business to a material extent. It should,
however, remain permissible for non-banks to lend to such clients on a collateralised
basis to finance their holdings of securities ("margin lending").
This is an area where regimes vary enormously around the world or are non-existent. For
example, the US domestic regime is stricter on this than Europe. We need a global
discussion.
Securities lending, repo and collateralised-financing markets
So far I have discussed funds or vehicles or firms that are in economic substance shadow
banks. We also need to think about the markets that firms and vehicles can use to develop a
de facto banking business. Perhaps the key such markets are securities lending and repo -
or, more generally, collateralised borrowing.
Before proceeding I must stress that these markets are vital to efficient capital markets.
The crucial economic function of market-making entails intermediaries going short, and so
needing to cover their position by borrowing securities. And repo has enriched the money
markets.
But it is also true that anyone holding a securities portfolio can build themselves a shadow
bank using the securities lending and repo markets. One simply lends out the securities at
call for cash, and then one employs that cash by making loans or buying credit-assets with a
longer maturity. This is leverage and maturity mismatch.
That example assumes the shadow-banking business is built by the investor who holds the
securities outright. But, of course, nothing is so simple. The first lender of securities might
lend against securities collateral and do no more; that is relatively common in European
markets. But the entity that has borrowed those securities could themselves repo out the
borrowed securities for cash, and employ the cash in a lending or credit-asset business. And
so on - ie at any point in the chain of securities lending, an intermediary can build
themselves a shadow banking business. Such chains can prove fragile for all sorts of
reasons - because many securities are at call, and because many secured lenders try to
realise their collateral instantly upon default.
It is also worth mentioning that some asset managers have no - zero - appetite to hold the
underlying paper outright in the event of their counterparty defaulting, either because the
assets are not covered by investment mandates or the fund managers do not know how to
manage them, etc.
What I suggest on this front is:

There should be greater market transparency, perhaps ideally via a Trade
Repository with open access to aggregate data, so that the world can see what is
happening in these very important but opaque financing markets. (That would be
helpful for market participants themselves).

Financial firms and funds should not be able to lend against securities that they are
not permitted or proficient enough to hold outright.
 Non-bank financial firms should be regulated in how they employ cash collateral.

The authorities should be able to step in and set minimum haircut or margin levels
for the collateralised financing markets (or segments of them). (That would need to
be pursued at international level.3 It might be linked to central bank haircuts).
Some of those points are aired in the FSB's report on securities lending and repos published
today4 and will, I hope, be explored intensively in the coming months.
I will expand slightly on the last point in my list. The amount of leverage available in the
system depends, of course, to a significant degree on the haircuts applied in chains of
secured financing transactions; leverage is the reciprocal of the haircuts. The resilience of
the system is therefore impaired when a bout of exuberance drives down haircuts. The
authorities need to be ready to place constraints on that - through minima that either apply
continuously or are specially introduced when conditions are overheating.
There is already an official exercise underway to frame the determination of minimum margin
levels in the parts of the derivatives market that will not be centrally cleared. At some point
down the road, this will need to be brought into a coherent framework with any measures on
the collateralised-financing market. Doing so would require deciding whether to apply the
same or different approaches to the inter-dealer market and dealer-customer transactions.
Conclusion: innovation, evolution and surveillance
Those are just a few thoughts for debate, based on some current manifestations of shadow
banking. I have not even covered the existing waterfront. For example, we need policies on
those levered credit funds that offer near-instant withdrawal rights. In the EU distinctions
need to be made within the Alternative Investment Fund Managers Directive and UCITs
regime, which allows risky structures to be branded as retail products.
But it would be foolhardy to imagine that we can frame policies today that will stand the test
of time. The financial system will evolve, and we need to permit innovation. A policy
framework on shadow banking therefore needs to be adaptive. And it mustn't try to shut
everything down. As I said at the outset, non-bank finance is not intrinsically a bad thing. We
will need effective surveillance of what is going on and what concentrations of risk are
emerging - through outfits like the FSB's committee on vulnerabilities and, in the EU, through
the European Systemic Risk Board. And we will have to make discerning policy judgments
that are explained and consulted upon. That is exactly what the EU, alongside the FSB, is
now embarked on.