Shadow banking refers to financial bodies that carry out bank-like functions despite not being banks and without being subject to standard banking regulations. Although it has led to financial innovation and improved efficiency, its lack of supervision has led to concerns about systemic risk and improper practices. A report by Belgian Social Democrat MEP Saïd El Khadraoui calls for more transparency and regulation. It was adopted by MEPs in plenary on 20 November.
About shadow banking
Shadow banking takes place via entities such as hedge funds, special investment vehicles and money market funds and financial contracts. It is a system that facilitates the creation of credit and transfer of risk across the global financial system. According to the Financial Stability Board (FSB), its size was approximately €51 trillion in 2011, having grown from €21 trillion in 2002.
Need for more transparency
During the financial crisis, banks were seriously affected by their exposure to the shadow banking system and despite new legislation, MEPs are still concerned about the risks arising from the links between banks and unregulated entities. Mr El Khadraoui wrote his own-initiative report in reaction to a Commission green paper on the topic. He said shadow banking is only beneficial to the real economy if there is full transparency and risks of a systemic crisis are well managed. Therefore both monitoring and rules need to be improved.
Measures suggested by the report
The report suggests different ways to make identifying systemic risks easier:
Creating a central EU database, possibly run by the European Central Bank, on repo transactions in all currencies, in order to have a full picture of the repo market. A repo - or repurchase agreement - is a financial contract whereby A sells a financial asset to B and agrees to repurchase it at a later date at a pre-fixed price
Setting up a central registry for all financial transactions, including trades in derivatives, in order to determine in real time who has purchased what from whom as well as what the transferred risks are.
Other suggestions in the report include imposing a maximum limit of the banks' exposure to unregulated entities to 25% of own funds and requiring all shadow banking entities sponsored by or linked to a bank to appear on the bank's balance sheet. There should also be a limit on the number of times a financial product can be securitised, which means packaged into a more liquid financial product and sold to the market.
The report also calls attention to the benefits and potential risks of having both retail and investment banking under the same roof. In the report's explanatory statement, Mr El Khadraoui asked the Commission to come up with a legislative proposal for a separation of retail and investing activities of banks.