Four fixes to make shadow banking a little bit safer

Date published: 26 January 2017

Yesterday’s shadow banking report from the Financial Stability Board sets out the right analysis of the problems caused by financial firms’ re-use and re-hypothecation of collateral but lacks strong recommendations. Finance Watch suggests four initiatives that the European Commission could take to fill in the gaps, and so improve financial stability for the EU’s banks, citizens and taxpayers.

In its ongoing bid to regulate shadow banking, the Financial Stability Board (FSB) has turned to the intriguing world of “collateral re-use”. Collateral is any asset pledged as security against a loan or other liability. Collateral re-use is when a firm uses some collateral pledged to it as security for its own borrowing from a third party. It’s as if your mortgage lender decided to borrow money from another bank and pledged your house as security. This is not a perfect comparison - houses are not fungible for a start - but it helps to convey the idea of one asset serving as security for two borrowers.

In financial trading there can be more than two borrowers; a whole chain of parties could pledge the same asset against their individual liabilities. You don’t need to be a financial expert to see the potential for problems.

Yesterday’s report shows that the Financial Stability Board’s financial experts understand the problem very well. [1] The FSB published the findings of its Re-hypothecation and re-use Experts Group, which updates a policy framework published in August 2013.

The new report recommends that regulators start monitoring the amount of collateral being re-used at a global level but does not call for a harmonised regulatory approach.

We think this is a missed opportunity. Without proper rules in all the main trading jurisdictions, a system-wide over-reliance on collateralised funding could easily become a problem waiting to happen.

What’s the problem?

The FSB describes how collateral re-use risks financial stability by contributing to a build-up of system leverage (because more debts can be created from a single asset) and interconnectedness (by linking parties in the collateral chain to the same risks). Both of these make the financial system more pro-cyclical, which is bad for the economy. In a crisis, sudden price changes in the securities used as collateral and obstacles to clients who want to access their securities could turn a small financial problem into a system-wide panic.

Finance Watch agrees with the FSB’s analysis (to read our take on it, see the annex to our December 2014 report, "A missed opportunity to revive “boring” finance?") We would add that as banks come to rely more and more on collateralised funding, collateral re-use will make banks’ funding more unstable and will worsen moral hazard among too-big-to-fail banks.

Don't make collateralised funding the new normal

By now, collateralised funding is an important source of funding for large banks. The Commission’s push to revive securitisation under its Capital Markets Union will only make it more so.

But rather than normalising this, we’d like to see regulators set the financial system on a safer course towards less dependence on collateral. This calls for some common sense measures including limiting the growth of collateralised funding and curtailing the re-use of collateral.

Unfortunately, the FSB opted to leave the problem to national regulators:

“The FSB has concluded that there is no immediate case for harmonising regulatory approaches to re-hypothecation. At the same time, the FSB encourages its member jurisdictions to implement Recommendation 7 in its Policy Framework for Addressing Shadow Banking Risks in Securities Lending and Repos published in August 2013, which provides a common basis for authorities to design their regulations with respect to re-hypothecation of client assets."

Harmonising financial regulation has never been easy and is probably getting harder in today’s more nationalist political environment. But at a time when some jurisdictions are competing to host financial institutions, the FSB’s hands-off approach looks like a recipe for inaction. 

Four fixes

As it seems difficult to create a global standard at the moment, we believe the European Commission should investigate ways to fill in the gaps, so that at least EU citizens will have a degree of protection, and perhaps to set a standard for other jurisdictions to follow. Here are some things the Commission could look at:

  • Revisit relevant regulations, such as the recent Securities Financing Transaction Regulation, to set a minimum haircut for bank and non-bank firms engaged in securities financing. A haircut is the margin that borrowers pay upfront to secure their liability; setting it at a higher level would reduce the amount of leverage from collateralised funding entering the system.
  • Increase capital requirements for large banks that operate close to the minimum allowable liquidity standards, and/or consider putting a tax on their non-core liabilities. The FSB has already endorsed the use of capital measures in this way.
  • Put quantitative limits on all re-hypothecation of client assets. The FSB recommended banning financial intermediaries from re-using client assets to fund their own-account activities; this is sensible but other forms of collateralised funding also need controlling.
  • Raise the premiums that banks pay to their national deposit insurance schemes in line with their asset encumbrance. Deposit insurance schemes are more likely to be needed if a bank has pledged more of its assets as collateral, as it has less to repay depositors.

Conclusion

More than ever, the plumbing of the EU’s financial system needs to be safe and work for all citizens, not just large financial firms. Collateral re-use creates an insatiable demand for safe and liquid debt instruments to use as collateral. This helps to explain the rush to revive securitisation and so create more collateral to meet that demand.  But given the systemic risks described by the FSB, we think policymakers should help banks to emerge from the shadows and avoid normalising the use of collateralised funding.



[1] Transforming Shadow Banking into Resilient Market-based Finance; Re-hypothecation and collateral re-use: Potential financial stability issues, market evolution and regulatory approaches, http://www.fsb.org/wp-content/uploads/Re-hypothecation-and-collateral-re-use.pdf

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