Shadow Banking - Policy Frameworks and Investor Perspectives on Markets-Based Finance

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Shadow banking refers to the process of credit intermediation that is conducted outside the regular banking system. It represents a diverse ecosystem spanning wholesale markets–based credit intermediation and alternative lending channels and includes a broad range of entities, activities, and interconnections among financial institutions.

At its core, the shadow bank credit intermediation process typically involves short-term funding or borrowing to facilitate longer-term lending or investment in less liquid assets, resulting in maturity transformation, liquidity transformation, credit risk transfer, or leverage.

In this report, we examine the scope of the shadow banking system, evaluate the policy frameworks applicable to different shadow banking entities and activities, and survey the perspectives of investment professionals on key shadow banking issues. The purpose is to inform the development of shadow banking policy initiatives from the perspective of investors.

Examples of shadow banking entities in economies with advanced financial sectors, such as the United States and Europe, include money market funds, which have deposit-like funding characteristics and invest in money market instruments with different maturities; hedge funds, which may use leverage to finance their trading positions in securities or financial instruments with differing liquidity profiles; and securitisation vehicles, such as asset-backed securities, which transfer credit risk among different investors. Shadow banking also includes securities financing transactions and the reuse of collateral for further financing.

In addition, shadow banking includes a range of alternative lending channels that are predominant in Asia. These alternative lending channels include a variety of nonbank loan companies, microfinance companies specialising in credit provision to small enterprises, trust companies, peer-to-peer lending, and various forms of retail-oriented loan provision.

Shadow banking provides a significant and valuable source of nonbank finance that can support real economic activity as well as improve the efficient functioning of financial markets. Yet, shadow banking can pose several risks to financial stability if not adequately supervised, including runs on shadow bank entities, procyclicality in financial markets, interconnectedness, counterparty risk, and collateral chains that multiply leverage. Furthermore, shadow banking may lack transparency, and the inadequacy of data on shadow banking activities and exposures makes monitoring costly and prohibitive.
We propose detailed policy considerations to strengthen market integrity in Box 1. In summary,
  1. CFA Institute supports transitioning towards a variable net asset value (VNAV) pric- ing model for all money market funds over an appropriate time period that should be long enough to allow investors and fund sponsors to adjust investment policies and mandates accordingly.
  2. Securitisation policy initiatives should focus on (i) increasing standardisation and sim- plification of issuance structures and (ii) improving transparency via initial and ongo- ing disclosures to investors. Detail on each of these elements is provided in Box 1.
  3. A robust framework surrounding the reuse of collateral in relation to securities financ- ing transactions is needed to prevent financial stability risks. Elements should include greater transparency for securities financing transactions via reporting to trade reposi- tories and investors, harmonised rules on collateral reinvestment, and consistent imple- mentation of international policy frameworks. Further detail is provided in Box 1.
Summary of Findings

■  Shadow banking entities and activities are characterised by the existence of maturity, liquidity, or credit-risk transformation, and/or leverage.
These risk transformations can pose risks to financial stability, including disorderly liquidation risks from money market funds or investment funds, procyclicality in financial markets, and counterparty risk and interconnectedness, as well as general opaqueness from limited data availability or complexity in the credit intermediation process. All of these risks have the potential to create systemic risk.
■  Significant parts of the shadow banking sector are well regulated.
Regulation of investment funds marketed towards retail investors is comprehensive; in the context of shadow banking risks, it addresses liquidity transformation via liquidity risk management and redemption rules as well as exposure risks via portfolio concentration limits, in addition to other measures.
Regulation of other investment funds, such as hedge funds and private equity funds, is substantive in Europe but less extensive in the United States. European regulation of alternative investment funds addresses liquidity risk, leverage, transparency, and investor protection considerations; in the United States, private funds must register with the Securities and Exchange Commission and are subject to certain reporting requirements.

■ Other parts of the shadow banking sector are undergoing regulatory reform, such as money market funds.

▲  Regulatory proposals related to money market funds address maturity transformation via portfolio maturity limits and liquid assets requirements. They also address the risk of runs via limited redemption facilities and proposals to switch from constant net asset value (CNAV) to variable net asset value (VNAV) pricing. 
▲  The specific provisions related to redemption policies and liquidity risk manage- ment for money market funds differ between the United States and Europe.
 Regulatory measures related to securitisation seek to address the potential misalign- ment of interests between originators and investors along the chain from loan origina- tion to issuance, as well as potential inadequate transparency over issuance structures and collateral.

▲  Similar regulatory frameworks apply in the United States and Europe with regard to risk retention, prospectus, and transparency requirements.
▲  International bodies, including the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO), are leading the development of policy guidance on securitisation, including prudential frameworks and the criteria for determining “quality” securitisation.
In other areas of the shadow banking sector, such as securities financing transac- tions, the Financial Stability Board (FSB) has developed policy frameworks that may inform the development of further regulatory initiatives. 
The FSB framework is designed to increase transparency and reporting for securities financing transactions and provide greater consistency regarding the treatment, type, and amount of collateral held against certain transactions.
Currently, regulation of securities financing transactions varies among jurisdictions and is less extensive than for other areas of the shadow banking system.
Against a backdrop of lower lending by banks undergoing the process of deleveraging and balance sheet repair, developing a robust framework for orderly and sustainable securitisation markets has become a key policy objective.
Investment professionals surveyed by CFA Institute identified the following areas of focus for policy and regulatory initiatives:
  • ▲  Improving transparency and disclosures over shadow banking activities in general
  • ▲  Increasing standardisation and simplification of issuance structures in securitisation markets
  • ▲  Implementing a more robust collateral framework
  • ▲  Strengthening data collection and monitoring capabilities over shadow banking activities and exposures
Box 1. Policy Considerations
We recommend the following policy considerations to strengthen market integrity.
1. Money market funds
CFA Institute recognises the risks to financial stability posed by money market funds (MMFs) and supports regulatory actions to reduce these risks in a structural manner. In an October 2012 survey, CFA Institute members supported MMFs’ developing liquidity risk management mechanisms to help manage potential instances of mass redemptions; stronger disclosures about the risks of investing in MMFs (and the differences from bank deposits), especially with respect to funds that offer a constant net asset value; and that sponsors of MMFs that provide capital guarantees to investors be subject to capital requirements.
Ultimately, CFA Institute supports transitioning towards a VNAV model for all MMFs over an appropriate time period that should be long enough to allow investors and fund sponsors to adjust investment policies and mandates accordingly. Supervisors should also monitor flows to bank deposits and other possible alternatives to CNAV MMFs to ensure that potential risks are identified.

2. Securitisation
Overcoming issues related to product and market fragmentation, transparency, and illi- quidity are central to improving the securitisation market. To that extent, policy initiatives should focus on increasing standardisation and simplification of issuance structures as well as improving transparency via initial and ongoing disclosures to investors.
Standardisation and simplification should focus on the following aspects:

▲ Issuance structures, including the distribution of risks across tranches  
▲ Structure of any credit enhancements or guarantees  
▲ Legal terms applicable to relevant contracts, including pooling and servicing agreements  
▲ Definition of eligible assets, including whether the asset pool comprises real or synthetic loans and the underlying economic activity being supported Standardisation of legal frameworks across geographic markets is also desirable to improve the ease and certainty of enforcing ownership rights and creditor protections. Transparency initiatives should focus on the collection of pertinent, standardised pool and flow data in central repositories. Existing data warehouses support this aim, and their scope should be expanded. Specifically, investors require access to information on 
▲ the asset class being financed, including links to underlying loan-level data, such as that available in European DataWarehouse; 
▲ the transaction’s structure, including risk characteristics, scheduled and actual cash flows, subordination levels, servicing arrangements, and the nature and extent of risk transformation; 
▲ the type of transaction participants (i.e., type of risk seller and risk buyer; individual participants may be anonymous); 
▲ the aggregate market size, trends, and pricing data across asset classes and regions; and 
▲ the transaction history, including details of any secondary market activity, such as post- trade data
  The ability to map a more holistic view of transaction data would improve market transparency, encourage investor participation, and thereby support liquidity in securitisation mar- kets. Attention should also be given to regulatory compliance costs to avoid imposing undue burdens on suppliers and demanders of securitisations.

3. Securities financing transactions and collateral
A robust framework surrounding the reuse of collateral in relation to securities financing transactions is needed to mitigate the build-up of excessive leverage in the financial system and prevent associated financial stability risks. Key aspects of a robust collateral framework include the following:

▲ Restrictions on rehypothecation based on client net indebtedness

▲ Greater transparency for securities financing transactions via reporting transaction data to trade repositories and reporting to clients
▲ Rules on collateral reinvestment, such as restrictions on the maturity of reinvested assets and counterparty liquidity standards
▲ Harmonised requirements for central clearing of repo transactions
Moreover, the FSB’s policy framework on securities financing transactions and collateral haircuts should be implemented consistently by national regulators. 

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