European Union: European Banking Authority Shadow Banking Guidelines – Part 3: The Rationale And Context Behind The Guidelines

To view previous alerts in this series, please click here.

In the third of our series of updates on the European Banking Authority (EBA) consultation paper on the draft EBA Guidelines on limits to the exposures that EU regulated banks should have to shadow banks (the Guidelines), we examine the rationale for this undertaking by the EBA. This update will provide the context for the requirements laid down by the Guidelines that apply to the regulated banking sector.

In its consultation paper, the EBA has identified both micro-prudential and macro-prudential risks stemming from exposures to shadow banks. We look at these in turn.

Micro-prudential Risks

The consultation paper issued by the EBA has recognised that credit intermediation activities, such as maturity transformation and liquidity transformation, which are typically undertaken by both regulated banks and shadow banks, are "inherently risky". Regulated Banks are typically subject to a regime of prudential regulation, and their ability to access liquidity assistance from central banks offers a degree of protection against these risks. Shadow banks, however, are generally not subject to a prudential regulatory regime and do not have access to central bank liquidity. If a regulated bank were to have significant exposure to a shadow bank in financial distress (with a material level of default in respect of its investments, for example), there could be knock-on effects if the shadow bank then defaulted on its obligations to the regulated bank, potentially requiring the shadow banks assets to be sold at fire sale prices and exposing the regulated bank to losses.

Recognition of the contagion effects between shadow banks and the regulated banking sector has prompted the attempt to limit the exposure that individual regulated banks established in the European Union have to shadow banks, both on an aggregated basis (i.e., a ceiling of exposure to all shadow banks) and to individual shadow banks.

Macro-prudential Risks

The exposure of regulated banks to shadow banks also creates various macro-prudential risks. The Guidelines seek to address, in particular, the systemic risk to the financial system that stems from the provision by regulated banks of funding lines to shadow banks carrying out bank-like activities. This funding into shadow banks is often characterised by sharp changes in fund flows and volatility. During cyclical upswings, for example, there might be a considerable amount of overlending by regulated banks, increasing the ability of shadow banks to engage in highly leveraged financial activities and expanding the amount of credit availability for the real economy. In a downturn, regulated banks can overreact by significantly reducing their lending to shadow banks, thus causing shadow banks to contract their own lending activities. This can lead to volatility in the onward flows of funds into the real economy. The exposures of regulated banks to shadow banks potentially accentuate the normal fluctuations of the credit cycles of the economy and could have repercussions on financial stability and the macro-economic environment by magnifying the impact of credit expansion and contraction. The EBA hopes to reduce the factors that amplify the credit cycle by limiting the overall risk exposure that regulated banks have to shadow banks on an aggregated basis and hence reduce the volatility of the onward flow of funds.

Regulatory Arbitrage

In its consultation paper, the EBA has also identified the risk that regulated banks might seek to increase their exposure to shadow banks as a means of engaging in regulatory arbitrage. This is considered to be more than a theoretical possibility, particularly in light of increased regulatory restrictions on banks and the latter's consequent desire to obtain exposure to higher yielding, riskier assets using different approaches.

Again, exposure limits may help to reduce this risk.

Are Exposure Limits the Answer?

It is suggested that limits to the exposure of regulated banks to shadow banks, both at an individual and an aggregate level, may indeed be the most effective way of managing the micro-prudential risks arising from their interaction. The approach proposed in the Guidelines will help regulated banks mitigate the risk of loss.

From the perspective of macro-prudential risks, the imposition of exposure limits may not be as effective since shadow banks could obtain leverage from sources other than regulated banks, such as insurance companies, pension funds or indeed other shadow banks. Limiting the macro-prudential risks can be better achieved through leverage limits imposed on shadow banks directly rather than or, possibly in addition to, exposure limits imposed on regulated banks.

Similarly, while exposure limits may have some positive effect in limiting regulatory arbitrage, it seems more logical to disincentivise regulatory arbitrage by limiting the benefits to regulated banks of doing indirectly that which they cannot do directly.

The Consequences of Exposure Limits

The EBA has, of course, recognised that some shadow banks play a "valuable role in providing alternative sources of funding to the real economy". Indeed, one of the key lessons learned from the global financial crisis, from both a micro-economic and macro-economic perspective, was that over-reliance on a specific source of financing creates systemic risks for the real economy. There is therefore a sound policy reason for not inhibiting the development of the shadow banking sector, which the EBA recognises. However, the demand for alternative sources of financing, as well as the need to ensure that the costs of the financing are minimised, could well be a catalyst for excessive leverage within the shadow banking sector. The management of exposure limits to the shadow banking sector might therefore play a role in helping to control credit expansion in order to achieve financial stability.

In our next update on the shadow banking sector, we will focus on the implementation of exposure limits contemplated in the Guidelines. We will examine the compliance process in relation to regulated banks and the ways in which a compliance function could be effectively organised.

Ropes & Gray will continue to monitor developments in this area.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions