EBA proposes criteria for identifying shadow banking exposures – Duplicate

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While regulators still disagree on the clear definition to be given to the concept of shadow banking, it is undeniable that the weight of shadow banking has grown steadily and, according to the FSB, now accounts for almost 50% of the global financial system, thus posing both cyclical and structural risks. After a detailed analysis of the various sources of risk weighing on the financial system by typology of shadow banking exposure, EBA proposes criteria for identifying shadow banking entities.

1.  The considerable weight of shadow banking in the financial industry

1.1.   The role of shadow banking in the real economy

Non-bank financial entities are playing a growing role in financing the real economy and managing household and business savings.

Shadow banking complements the traditional banking sector by :

  • Broadening access to credit for economic activity.
  • Supporting market liquidity, maturity transformation and risk sharing.
  • Promoting growth in the real economy.

Although shadow banking entities are not regulated at EU level like institutions, their operations encompass various forms of banking activity. They :

  • Receive funds from the public.
  • Long-term loans.
  • Accept immediately available deposits (i.e. maturity and/or liquidity transformation).
  • Assume the risk that the borrower may not be able to repay the loan.
  • Use borrowed money directly or indirectly to buy other assets.

1.2.   The ever-increasing weight of shawdow banking in the financial system

The relative size of shadow banking entities in emerging market economies has grown at a faster rate than in developed country economies. Specifically, lending by non-bank entities dependent on short-term funding has grown much faster in emerging economies than in developed economies.

Since 2015, the ESRB has been monitoring the risks associated with shadow banking entities in the EU on an annual basis. Shadow banking entities are expected to account for around 40% of the EU’s financial system in 2020 and have grown faster than banking institutions over the past decade, including in 2019.

Furthermore, the FSB states that shadow banking financial assets – comprising mainly pension funds, insurance companies and other financial intermediaries – represented 49.5% of the global financial system in 2019, compared with 42% in 2008.

2.  The mandate of the EBA defined by the crr and reinforced by the CRR2 with regard to the identification of shadow banking entities

EBA is mandated by the CRR to develop RTSs to specify the criteria for identifying shadow banking entities. In developing this RTS, EBA is required to take account of internationally agreed standards on shadow banking and to consider whether :

  • The relationship with an entity or group of entities may entail risks for the Bank’s solvency or liquidity.
  • Entities subject to solvency or liquidity requirements similar to those imposed by the CRR should be wholly or partially excluded from the obligation to produce regulatory reporting on shadow banking entities.

CRR2 has slightly modified the reporting requirements for shadow banking entities:

  • The CRR required institutions to report their 10 largest exposures on a consolidated basis to non-regulated financial entities.
  • CRR2 requires banks to declare their 10 largest exposures to shadow banking entities that carry out banking activities outside the regulated framework on a consolidated basis.

3.  The structure of the RTS in three main areas

The RTS relied primarily on the guidelines on limits applicable to exposures to shadow banking entities that conduct banking activities outside a regulated framework.

The draft RTS is a quite short legal text comprising three main articles dealing with the following points:

  • Clarification of the criteria for identifying both shadow banking and non-shadow banking entities.
  • Clarification of the definition of banking activities and services.
  • Clarification of the criteria for excluding entities established in third countries from the concept of shadow banking entities.

4.  Shadow banking risks on the banking industry

4.1.   Shadow banking risks highlighted during the 2008 crisis

The financial crisis has revealed the flaws in shadow banking, which are jeopardising the stability of the financial system:

  • Heavy dependence on short-term transactions.
  • Uncontrolled wholesale financing.
  • A general lack of transparency.

In this respect, EBA has identified certain concerns regarding shadow banking entities, namely :

  • Current risks and/or liquidity problems.
  • Interconnection with other financial entities.
  • Excessive leverage and procyclicality.
  • The opacity and complexity of the business.

4.2.   Structural risks and vulnerabilities

The following structural risks have been identified:

  • Taking risks.
  • Liquidity risk.
  • Price uncertainty and risks associated with leverage between certain types of investment funds and other non-bank financial institutions.
  • Interconnection and risk of contagion between sectors and within the non-bank financial sector, including national and cross-border links.
  • Business risks – procyclicality, leverage and liquidity risk – created using derivatives and securities financing transactions (SFT).

4.3.    Cyclical risks

The following economic risks have been identified:

  • A global recession and a sharp contraction in economic activity in the EU.
  • The increase in debt, the increase in credit risk and the risk of rating downgrades.
  • Uncertainty and high risks associated with an environment of low interest rates for longer.
  • Low liquidity and high volatility in some markets.

4.4.   Risks in the investment fund sector

The investment funds sector has links with:

  • The financial system through wholesale financing of institutions provided through non-bank financial entities, financing by institutions to investment funds or connections through repo markets and securities lending.
  • The non-financial system, including the real economy, by channelling investor funds to households and non-financial companies.

Contagion channels may also arise due to ownership links between asset managers and other financial companies.

4.5.   Risks in the bond fund sector

Bond funds :

  • Have strong links with the banking sector, given their exposure to companies in all sectors through their holdings of debt securities.
  • Engage in credit intermediation and can also carry out maturity and liquidity transformation.

4.6.   Risks in the money market funds sector

Money market funds (MMF) :

  • Have very strong interconnections with the banking sector insofar as they provide short-term financing to financial institutions and businesses and engage in a certain amount of maturity and liquidity transformation, given that a large proportion of money market fund assets are bank debt securities and deposits.
  • Play an important role in managing the liquidity of non-banks.

As a result, tensions in the money market funds sector could lead to serious liquidity problems for institutions and institutional investors.

4.7.   Risk in the real fund sector

Real estate is a highly illiquid asset class. Open-ended real estate funds may face outflows at higher frequencies, which may expose them to liquidity transformation risks.

4.8. Risk in the hedge Fund sector

EU hedge funds are regulated entities, mainly subject to alternative investment fund managers. They generally use more leverage than other types of funds and are generally reserved for professional investors.

4.9. Risk in the venture capital fund sector

Venture capital funds are collective investments that tend to invest in equities and debt issued by unquoted companies. They tend to incur little liquidity or maturity transformation risk, as their repayment risk is limited by their long-term financing and closed-end structures.

4.10.   Risk in the SPV sector

SPVs are special purpose entities engaged in securitisation activities, whereby they facilitate the transfer of credit risk from the originating financial institutions and credit to purchasers of securities issued by the SPV. SPVs may also hold deposits and loan receivables, debt securities and shares and units in investment funds.

Special purpose entities :

  • Fulfil narrow, specific and temporary objective conditions and are generally part of complex ownership networks within multinational groups.
  • Can issue debt securities and engage in liquidity transformation.
  • Have complex cross-border links that make them vulnerable to vulnerabilities, and the lack of data at EU level hinders systemic issues, risk monitoring of their activities and links.

4.11.     Risk in the brokerage market

Securities and derivatives brokers are investment firms specialising in securities trading that are authorised to provide investment services to third parties. They can undertake liquidity and maturity transformation and are therefore an important part of the non-banking sector from a systemic risk perspective.

4.12.   Risk in the financing firms sector

Financing firms that lend include leasing, factoring, mortgage and consumer loan companies, specialising in asset finance for households and non-financial companies.

They engage in credit intermediation outside the scope of banking regulations when they carry out lending activities. Different countries have different prudential rules for dealing with the liquidity and debt risk posed by finance companies. In some countries, the assets of finance companies are partially consolidated into banking groups, thus falling within the scope of banking regulations, while other countries do not impose any prudential policy.

4.13.     Risk mapping summary

The range of activities carried out by the above-mentioned entities shows common trends, as they are involved, to a greater or lesser extent, in :

  • Transforming maturitiess.
  • Transforming liquidity.
  • Levrage.
  • The transfer of credit risk.
  • Credit intermediation.
  • Market activities (in particular SFTand derivatives).
  • Reuse of guarantees.

5.  Criteria for identifying shadow banking entities

5.1.   The general principle of identifying shadow banking entities

Entities that carry out banking activities or services that have been authorised and are supervised are not considered to be shadow banking entities.

All other entities that provide banking activities and services are shadow banking entities. However, specific rules apply to certain collective investment undertakings. In the case of entities established in a third country, the draft RTS distinguishes between banks and other entities:

  • Banks would not be identified as shadow banking entities provided they are authorized and supervised by a supervisory authority that applies banking regulation and supervision based at least on the Basel Core Principles for effective banking supervision.
  • Other entities would not be identified as shadow banking entities provided that they are subject to a regulatory regime recognized as equivalent to that applied in the EU to such entities in accordance with the equivalence provisions of the relevant EU legal act.

The EBA Guidelines have developed a definition of the terms “shadow banking entities”, “banking activities” and “regulated framework”, as the CRR does not define these terms. The approach adopted in the EBA guidelines to identify shadow banking entities excludes certain entities from the scope of the definition. These excluded entities are :

  • Those that are subject to an appropriate and sufficiently robust prudential framework.
  • EU credit institutions.
  • EU investment firms.
  • EU insurance companies.
  • Entities of this type established in third countries that are subject to prudential requirements that are equivalent to those applied in the EU.
  • Entities subject to consolidated prudential supervision (whether under EU legislation, applicable national legislation, or the equivalent legal framework of a third country).

The RTS provides a formula according to which institutions that are authorized and supervised by a supervisory authority in a third country that applies banking regulation and supervision that are at least based on the Basel core principles must not be considered as a shadow banking entity.

As a result, an EU bank with exposures to a non-EU bank should check whether that client meets these criteria (i.e. is authorized and supervised by an authority that applies at least the Basel Core Principles) to decide whether its exposures should also be reported separately as exposures to a shadow banking entity (if it is one of the 10 largest such exposures).

5.2.   Decision tree for identifying shadow banking entities

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6.  References

EBA/RTS/2022/06.

7.  Abbreviations

EBA: European Banking Authority.

ESRB: European Systemic Risk Board.

NBFI: risks related to non-bank financial intermediation.