Including updates on shadow banking, regulating ETFs and credit rating agencies


EC consults on shadow banking

Spring is nearly upon us and as the weather improves people may start stepping into the shadows to take rest from the sun. Banks may need a respite as they face higher capital and liquidity requirements, deleveraging, poor economic growth prospects, ongoing concern about the true health of their balance sheets and more intensive supervision. At least this is the opinion of regulators such as the Financial Stability Board (FSB), which believes that more stringent regulation and supervision may push banks further into shadow banking.

In this year’s Cass Lecture on 14 March, Lord Adair Turner provided important insights into the FSB’s evolving understanding of the risks posed by shadow banking. The FSB is due to present its proposals for shadow banking system reform to the G20 leaders by the end of the year. Against this background, on 19 March, the EC launched a Green Paper looking at the EU’s approach, taking the initial step towards a regional regulatory regime.

The FSB has defined shadow banking as entailing ‘credit intermediation which occurs outside or partially outside the banking system, but which involves leverage and maturity transformation’. This is only the start. As Lord Turner’s comments illustrate, the major issue is not just the activities of shadow banks themselves but the interconnectivity between shadow banking activities and traditional banking and the links to the real economy. According to Turner, the FSB’s proposals will need to be forward looking, anticipating future developments when markets begin to pick up because ‘on some measures shadow banking is now a shadow of its former self’, global regulators cannot be complacent as future shadow banking activity is not likely to adopt the ‘specific forms’ seen in the last crisis.

His comments flag some of the potential challenges in conceiving proposals at the international level, in the first instance, and then percolating these down into a ‘future proof’ regional regime. He noted that shadow banking activity was not nearly as prolific in the EU has in the United States, prior to the crisis, but this ‘did not insulate the European banking system from shadow banking losses and risks, for key parts of the European banking system were involved in the shadow bank intermediation of credit flow from US savers to US borrowers’.

Essentially, he stressed shadow banking has to be understood as involving both in some cases new forms of non-bank interaction between the financial system and the real economy, and as entailing far more complex links within the financial system itself, including between banks and non-bank institutions’. The future regime will need to focus on ‘the fundamental drivers of instability across the whole financial system’, not just at a regional level.

The EC’s paper picks up on some of these concerns. It suggests that ‘shadow banking’ is based on ‘two intertwined pillars’. The first relates to entities outside the traditional banking system which engaged in one of the following:
  • accepting funds (deposit-like activities)
  • performing maturity and/or liquidity transformation
  • undergoing credit risk transfer
  • using financial leverage.
The second pillar relates to activities that could act as important sources of funding of non-bank entities (which captures securitisation, securities lending and repurchase transactions (repos)). The Commission has put forward a non-exhaustive list of entities and activities which relate to ‘shadow banking’. These include, special purpose entities, money market funds, some investment funds (such as ETFs), non-bank entities providing credit or credit guarantees and securitisation. Monitoring of these entities has improved in recent years, according to the Commission, but there is still a ‘pressing need’ to fill the current data gaps on the interconnectedness between banks and the shadow banking system on a global basis. Further disclosure and transparency requirements from non-bank entities may be required in the future, possibly gathered and analysed by global/ pan-European regulators.

The paper suggests that the future supervisory regime needs to be integrated with the macroprudential framework to understand the ‘hidden credit intermediation chains’ and its systemic importance. Shadow banking issues may also require extending the scope and nature of prudential regulation, although the Commission provides no details at this stage. It does believe, however, that ‘a specific approach to each kind of entity and/or activity must be adopted’, through complementary actions in terms of indirect regulation, appropriate extension or revision of existing regulation and new regulation specifically directed at shadow banking entities and activities. Some regulatory measures, such as a series of amendments to the Capital Requirements Directive, improvements to International Financial Reporting Standards (in particular IFRS 7, 10, 11 and 12), Solvency II, MiFID II, AIFMD, UCITS IV already address some of the issues. However, the Commission lists different issues in relation to banking, asset management, securities lending and repurchase agreements, securitisation, and ‘other shadow banking entities’ which raise questions and outlines the additional regulatory measures it believes may be required.

Comments to this consultation close on 1 June 2012. The Commission has also organised a public hearing on shadow banking in Brussels on 27 April 2012. Input to the green paper and feedback from the public hearing will inform a ‘wide-ranging’ consultation later in the year - which may lead to legislative proposals in 2013. In parallel, however, the FSB is expected to release a consultation paper in the next few weeks. It will be very important that industry consider these two consultations together, because already the difficulties in embedding any appropriate additional measures into the increasingly complex EU regulatory regime, while still retaining flexibility and reactivity to future market developments, is shaping up as a Herculean challenge.


IOSCO outlines principles on regulating ETFs

The International Organisation of Securities Commissions’ Standing Committee on Investment Management (IOSCO) published a draft set of common investor-protection and financial stability principles on Exchange Traded Funds (ETFs) on 14 March 2012. The principles apply to ETFs that are organised as collective investment schemes, and do not encompass other exchange-traded products (ETPs) like exchange-traded commodities or other vehicles.

Like other index funds, ETFs have proven popular with investors because they provide a tax efficient means of diversifying a portfolio. What sets them apart is that they are generally cheaper, provide stock-like features (e.g. those of limit orders, short selling and options) and can be bought and sold more flexibly on the markets. The latter has proven a selling point for investors given the strong bias towards highly liquid instruments in the post-financial crisis trading environment.

Because of these features, the ETF market has grown exponentially over the last decade. ETFs have been around in some shape or form since the late 1980s but the development of online trading platforms during the 2000s has been a catalyst for its growth. In December 2011, global ETF assets reached US$1350 billion - up from US$711 billion in 2008 - according to figures compiled by Blackrock. In 2011, there were 3,011 ETFs with 6,612 listings from 155 providers. The popularity of ETFs in Europe and emerging markets has been particularly strong. Since April 2009, the EU has had more listed ETFs than the US. In emerging markets, ETFs’ assets under management have doubled since the end of 2008.

The dynamic growth of ETFs has drawn the attention of regulators. Notably, both the Financial Stability Board and the Bank of England have expressed concerns about potential systemic risks created, particularly, the general opacity and complexity of synthetic ETFs (derivative-backed). According to BlackRock, synthetic ETFs represented around 40% of the total share of ETFs traded in 2011. In Europe both the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) have been working in this area but the IOSCO principles should provide a wider framework for these initiatives.

IOSCO’s draft principles are not particularly contentious. They call for greater and more accurate disclosure, further transparency of an ETF’s portfolio, more responsibilities given to intermediaries who recommend ETFs and measures to address any potential conflicts of interest. The latter may require some structural change in firms such as the introduction of firewalls or requiring those who create/change the index compilation rules to be not affiliated with those who manage the underlying portfolio. Regulators may also consider limiting the ability to change the rules for index compilation and require public notice to be given beforehand as another means of mitigating the potential for conflicts of interest.

IOSCO recommends that collateral, together with financial guarantees, should be prudently valued and sufficiently liquid to mitigate counterparty risk. By satisfying these conditions, in the event of counterparty’s default, the ETF should find it easier to either find a new counterparty to the swap contract or turn to physical replication.

IOSCO highlights that transparency for ETF trading varied between jurisdictions. Generally, the larger the portion of trades done on exchanges as opposed to business done on OTC bilateral deals, the better the transparency. However, more work across all countries is required. IOSCO believes that national regulators need to improve their monitoring of trading flows and consider establishing an audit trail system to buffer their market surveillance capabilities.

The financial crisis is still very much ‘ringing in the ears’ of regulators. The consequences of a regulatory regime failing to keep up to speed with technology advancements and changing market conditions is still very apparent for all parties involved. Clearly, sizeable movements in the market landscape - which may result in less than favourable customer outcomes or which have systemic risk implications - will be given heightened attention by regulators. The force of the market may ultimately overwhelm regulators, who are still scrapping for adequate resources. Regulators need to ensure that they don’t exacerbate swings in the marketplace by applying rules inconsistently. In this regard, there are many other types of exchange traded products other than ETFs which warrant some attention.

Overall, IOSCO’s principles are welcome and should be relevant regardless of the predominant regulatory framework. However, they do not represent a one-size-fits-all approach and IOSCO recommends that local regulators adapt the principles to best suit their individual environments. They also propose that the principles may be used as industry best practice guidelines as opposed to strict regulatory requirements. The consultation closes on 27 June 2012 after which IOSCO will publish final rules later in the year.


US credit rating agencies approved under new EU regulatory regime

Regulatory frameworks for credit rating agencies (CRAs) in the United States, Canada, Hong Kong and Singapore are all in line with European rules (EU Regulation (EC) No 1060/2009), according to the European Securities and Markets Authority (ESMA). EU banks and other financial institutions can continue to use credit ratings issued by CRAs established in these countries after the 30 April 2012 deadline. As the big three CRAs are all from the US, this is an important development and, some may think, one less headache for firms to deal with.

Last December, ESMA endorsed credit ratings issued by CRAs established in Australia. ESMA is currently working to finalise assessments on the regimes in Argentina, Mexico and Brazil and to conclude the necessary co-operation agreements ‘as soon as possible’. However, ESMA cannot guarantee that its assessment on these countries will be finalised before 30 April 2012 and firms which use ratings issued by CRAs headquartered in those countries may have to consider some interim solutions as the deadline draws in.

Regulators in the EU, as elsewhere, are moving, systematically, to reduce the reliance on external credit ratings for regulatory purposes, in a concerted effort to make financial institutions more responsible for undertaking their own due diligence and beefing up their internal risk management capabilities. In parallel with increased supervision by ESMA, prudential regimes for both insurers (Solvency II) and banks (the Capital Requirements Regulation and Directive proposed by the Commission last July), both limit reliance on external credit ratings for regulatory reporting. Similar amendments to the UCITS IV Directive (Directive 2009/65/EC) and the Alternative Investment Fund Managers Directive (Directive 2011/61/EU) are also currently being negotiated in Brussels.

ESMA’s most recent decisions provide an aspirin to reduce the immediate headache of these developments but the underlying pain of ensuring that internal systems are adequate is still yet to be thoroughly diagnosed and treated by many firms.