The pendulum eases up on Shadow Banking regulation

After years of careful investigation into the dangers of shadow banking, some regulators appear to be concluding now that the benefits of liquidity provided by credit and maturity transformation may outweigh the inherent risks.

The most recent noise on this topic came from Reuters on August 25 in an article called “World leaders to put shadow banks on long leash.” According to the article:

“At their meeting on Sept. 5-6 the Group of 20 economies (G20) will endorse reforms but stop short of rushing through far-reaching changes because of the role shadow banking activities play in providing liquidity to the still fragile banking sector, according to people familiar with the G20’s work.”

While trade repositories are pretty low hanging fruit and we imagine they will move forward, there are other aspects of Shadow Banking reform that should get postponed or dropped altogether: securitizations for example are necessary to generate liquidity and share risk. Clearly, the maturity and liquidity transformation aspects of Shadow Banking aren’t all bad. We are glad to see regulators, at least at the G20 level, acknowledging this fact.

On a related note, we think that the most visible effort in Shadow Banking reform is more clampdowns on money market funds; our data show a clear rise in separately managed accounts that generally follow regulated money market guidelines but really ignore the most critical WAM and yield limitations.

We think that Europe will be the bellweather in Shadow Banking thinking – if Europe eases up then certainly everyone else will too. We noted earlier this week the EU’s comments on reducing rehypothecation (“Is the EU really thinking about restricting collateral chains? Boy, we hope not…).” Reducing or eliminating the ability of banks to rehypothecate collateral would mean a serious liquidity squeeze in affected markets. Meanwhile, the Fed appears to be lightening its stance as well. In early June the Fed discussed more concerns about securitization and Shadow Banking, but now wants to increase its repo activities as a means of managing market liquidity. Fire-sale risk and money market reform remain issues, but the general idea of Shadow Banking may now get a break.

This isn’t to say that the G20 has backed off entirely. According again to Reuters:

“While top firms will be relieved they won’t be singled out, the G20 is likely to brush aside their opposition to a requirement for them to apply a minimum discount – or “haircut” – on the value of collateral they take to cover securities lending and repos.”

This has been a major concern for some time since the idea was first published by the Financial Stability Board. We think it is patently dumb, and regulators could also do crazy things like mandate a 20% haircut for sovereign debt as non-cash collateral in a securities lending transaction, something that would certainly drain liquidity from financial markets, not add it. At the same time, we can see some justification for mandatory haircuts if done right. A regulatory mandate on collateral haircuts might just be on bilateral transactions, leading more market participants towards CCPs as an alternative where possible. This might turn out to be one of those things that supports the Basel Committee on Banking Supervision’s stance that bilateral trades are supposed to be more expensive than CCP trades.

On a related note, the FT published a snarky (for the FT) article yesterday, “Nothing screams shadow banking quite like a leveraged loan ETF.” Truly, credit and maturity transformation at its finest.

Update: the Bank of England released a speech today from Mark Carney saying that “the Bank of England will reduce the level of required liquid asset holdings” for UK banks. “That will help to underpin the supply of credit, since every pound currently held in liquid assets is a pound that could be lent to the real economy.” Talk about a pendulum swing.

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