The Bank for International Settlements (BIS) has contended that shadow banking, which played a key role in the financial tsunami that struck the global economy in 2008, still poses “potential threats to financial stability that must be monitored and checked”.
In his address at the Bank's annual general meeting in Basle on Sunday, the BIS Chief, Mr Jaime Caruana, sought higher standards for systemically important financial institutions and credible mechanisms for their orderly resolution, while there should be improvements in the statistics and processes for monitoring risks, nationally and globally.
He said that where credit booms and output were advancing strongly, authorities should consider imposing the Basel III counter-cyclical buffer to make banks more resilient.
Akin to all Basel Committee standards, Basel III sets out minimum requirements, and the transitional arrangements are the deadlines for adopting the new standards. The new standards would be introduced in a manner that does not impede global economic recovery, BIS said, adding that the July 2009 enhancements that beef up regulatory capital and disclosure requirements are due to take effect no later than the end of 2011. The Basel III requirements themselves begin to take effect from the start of 2013 and would be phased in by 2019.
Instances of shadow banking
In its 81st Annual Report, released on the occasion, BIS said shadow banking refers to credit intermediation that supervenes outside the traditional banking system and entails maturity or liquidity transformation.
According to the report, such instances include the activities of money market funds, lending by unregulated finance companies, the issue by specialised conduits and investment vehicles of commercial paper backed by longer-term assets, and the funding of securitisation activities through repo markets.
It further said large banks which is closely intertwined with the regulated system, typically draw substantial income from shadow banking activities and retain both direct and indirect credit and operational exposures to them through business lines such as loan origination, credit enhancements, backup liquidity lines, brokerage services, warehousing and credit issuance.
Positives, negatives
Stating that shadow banking could perform valuable functions, including facilitating credit extension to certain sectors and providing banks and investors with a range of vehicles for managing credit, liquidity and maturity risks, BIS said the banking crisis testified that shadow banking could also give rise to a number of risks in the broader financial sector.
It said some of these risks, such as those related to bank exposures through contingent credit lines, were being addressed through the improvements in bank regulation as well as through initiatives such as stronger regulation of credit rating agencies and money market funds.
It however acknowledged the difficult parts, especially those that call for a high degree of coordination across regulatory agencies, both within and across national boundaries. For instance, it said, judging the extent of liquidity mismatch in a bank-sponsored investment vehicle might require input from banking and market regulators in several jurisdictions.
Reducing the risks
Underlining the need to minimise the potential threats of shadow banking to financial stability, BIS said, foremost, firm-level disclosures and system-wide statistical frameworks must be improved to ensure that the build-up of risks could be monitored properly. It said improved data need to be accompanied by regular monitoring of those indicators that could be informative about the nature and locus of potential systemic risks.
Second, gaps in regulation need to be identified and addressed with the goal of reducing risky build-ups of leverage and m maturity and liquidity mismatches, wherever these occur in the financial system.
BIS contended that rules that mitigate these risks in a consistent way across different entities and activities would reduce the scope for regulatory arbitrage. Given the global nature of many shadow banking activities, these efforts need to be coordinated at the international level, the world's central bankers' central bank said, adding that at the request of the G-20, the Financial Stability Board (FSB) plans to submit recommendations on these issues in the course of this year.