On 19th March the European Banking Authority (EBA) issued a consultation paper which sets out its approach to limiting exposures from banks to the shadow banking sector, proposing that the large exposures regime be used to restrict exposures, in addition to existing Pillar II requirements.
Regulators have recommended the imposition of sectoral large exposure (LE) limits on several occasions in recent decades, although these have never been formally implemented in EU legislation. Instead under Basel 2, Concentration Risk became a component of the Pillar 2 regime, enabling regulators to impose additional capital requirements on those firms which regulators deem to have inappropriate balance sheet concentrations. The Guidelines in the consultation paper (CP) represent the EU's first stage in implementing the FSB's policy framework for mitigating the risk of banks' interactions with shadow banks, as one of their five key areas to strengthen oversight and regulation in this area. This is principally based on the BCBS' framework for measuring and controlling large exposures, including shadow banking entities, which was published in April 2014.
Regulators are concerned about shadow banking: as the EBA sets out in the introduction to its consultation paper there are both micro- and macro-prudential regulatory concerns which arise from banks having significant exposures to shadow banking entities.
The micro-prudential concerns are that:
- shadow banks are often leveraged, and involved in maturity and liquidity transformation, but are generally not subject to the same level of prudential regulation as banks,
- shadow banks do not have access to deposit protection schemes, and
- shadow banks do not have access to central bank liquidity support.
The macro prudential concerns arise from the potential for exposures from banks to shadow banks to give rise to contagion risks from the unregulated shadow banking sector to the regulated banking sector.
The CP defines shadow banking as entities that:
- are carrying out credit intermediation activities, defined as bank-like activities involving maturity transformation, liquidity transformation, leverage, credit risk transfer or similar activities; and
- are not within the scope of prudential consolidation nor subject to solo prudential requirements under specified EU legislation (or equivalent third country legal frameworks). Central Banks and municipal type entities specifically referred to in CRD IV are also not to be regarded as shadow banking entities.
The EBA approach is stated to be consistent with work undertaken by the FSB, which has identified the four key features of credit intermediation as: (a) maturity transformation (borrowing short and lending/investing on longer timescales); (b) liquidity transformation (using cash-like liabilities to buy less liquid assets); (c) leverage; and (d) credit risk transfer (transferring the risk of credit default to another person for a fee).
Such shadow banking entities include money market funds (MMFs), special purpose vehicles engaged in securitisation transactions, securities and derivatives dealers and companies engaged in factoring, leasing or hire purchase, and other entities carrying out credit intermediation. Indicators used by the EBA of credit intermediation are set out below.
Indicators that an entity is undertaking credit intermediation activities:
- taking deposits and other repayable funds
- lending
- financial leasing
- guarantees and commitments
- trading for own account or for account of customers in specified forms of financial instrument
- participation in securities issues and the provision of services relating to such issues
- money broking and
- portfolio management and advice.
The guidelines go on, however, to state that the definition of shadow banking in the CP is not exhaustive, so banks will have to set their own policy as to whether an entity is a shadow banking entity. The CP also requires banks to apply their own approach to aggregation of entities in the sector, but indicates that where banks are in doubt, entities should be regarded as connected for exposure purposes.
The definition of a shadow banking entity is fairly broad, and whilst specific exclusion has been made for UCITs that do not invest in MMFs, and third country equivalent firms, there is no specific consideration of who would meet that equivalence.
All securitisation special purpose vehicles would be caught as shadow banking entities under the current proposal. Many of these entities rely on liquidity facilities provided by banking entities and there are consequences of limiting these interactions which could have a significant effect on the current markets, particularly given the broader Capital Market Union aims of encouraging a robust and liquid securitisation market.
The EBA's approach requires that banks should set their own limits, both individual and aggregate, for exposures to shadow banking entities – taking into account factors such as interconnectedness, and the financial position and credit quality of the entities concerned.
Where this is not possible, banks would be required to utilise a "fallback" option, which has two potential variants:
Option 1 would require an aggregate exposure limit to all shadow banking sector entities of 25% of capital;
Option 2 would use the fallback approach only for those exposures which cannot be risk-assessed appropriately (that is, exposures which can be assessed would be subject to individual limits, and those which cannot be assessed would be subject to an aggregated limit of 25% of capital).
The EBA notes that this is an initial step towards addressing the concern over potential contagion from the shadow banking sector to the banking sector. The EBA intends to collect data from banks to enable them to assess the extent of exposure from banks to shadow banks and whether there is a need for further quantitative limits on exposures. They also note in the CP that National Competent Authorities retain the ability under Pillar 2 to impose additional capital requirements on banks who are felt to have excessive exposures to the shadow banking system.
It is clear that this consultation will provoke considerable interest and we are confident that the EBA will welcome feedback and comments from a wide range of banks and other interested parties.
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