The Commission has today adopted a communication on shadow banking and proposed new rules for money market funds (MMFs). The communication is a follow-up to last year’s Green Paper on Shadow Banking (IP/12/253). It summarises the work undertaken so far by the Commission and sets out possible further actions in this important area.
The first of these further actions – the proposed new rules for money market funds – is unveiled today and aims to ensure that MMFs can better withstand redemption pressure in stressed market conditions by enhancing their liquidity profile and stability.
Internal Market and Services Commissioner Michel Barnier said: “We have regulated banks and markets comprehensively. We now need to address the risks posed by the shadow banking system. It plays an important role in financing the real economy and we need to ensure that it is transparent and that the benefits achieved by strengthening certain financial entities and markets are not diminished by the risks moving to less highly regulated sectors.”
Shadow banking is the system of credit intermediation that involves entities and activities that are outside the regular banking system. Shadow banks are not regulated like banks yet engage in bank-like activities. The Financial Stability Board (FSB) has roughly estimated the size of the global shadow banking system at around €51 trillion in 2011. This represents 25-30% of the total financial system and half the size of bank assets. Shadow banking is therefore of systemic importance for Europe’s financial system.
Since the beginning of the financial crisis back in 2007, the European Commission has undertaken a comprehensive reform of the financial services sector in Europe. The aim is to establish a solid and stable financial sector – essential for the real economy – by addressing the shortcomings and weaknesses highlighted by the crisis. But risks must not be allowed to accumulate in the shadow banking sector, in part because new banking rules could be pushing certain banking activities towards this less highly regulated shadow banking sector.
Money market funds (MMFs) are an important source of short-term financing for financial institutions, corporates and governments. In Europe, around 22% of short-term debt securities issued by governments or by the corporate sector are held by MMFs. They hold 38% of short-term debt issued by the banking sector. Because of this systemic interconnectedness of MMFs with the banking sector and with corporate and government finance, their operation has been at the core of international work on shadow banking.
Main elements of today’s communication on shadow banking and draft regulation on money market funds:
The Communication sets out the issues at stake in relation to the shadow banking system and the measures already taken to deal with the risks related to shadow banking such as the rules governing hedge fund activity (MEMO/10/572) and reinforcing the relationship between banks and unregulated actors (the provisions related to securitisation exposures in the revised Capital Requirements legislation (MEMO/13/272).
It outlines the priorities identified on which the Commission intends to take initiatives in areas such as:
- provision of a framework for money market funds the new rules proposed today (MEMO/13/764) cover money market funds (MMFs) that are domiciled or sold in Europe and aim to improve their liquidity profile and stability:
- Liquidity management: MMFs would be required to have at least 10% of their portfolio in assets that mature within a day and another 20% that mature within a week. This requirement is there to allow the MMFs to repay investors who want to withdraw funds at short notice. In order to avoid that a single issuer bears undue weight in the net asset value (NAV) of an MMF, exposure to a single issuer would be capped at 5% of the MMF’s portfolio (in value terms). For standard MMFs, a single issuer could account for 10% of the portfolio.
- Stability: to take account of the constant NAV, MMF’s propensity to require sponsor support to stabilise redemptions at par, the new rules would require this type of MMF to establish a predefined capital buffer. This buffer will be activated to support stable redemptions in times of decreasing value of the MMFs investment assets.
- transparency of the shadow banking sector: to be able to monitor risks in an effective manner and intervene when necessary, it is essential to collect detailed, reliable and comprehensive data on this sector.
- securities law and the risks associated with securities financing transactions (principally securities lending and repurchase transactions). These transactions can contribute to an increase in leverage and strengthen the pro-cyclical nature of the financial system, which then becomes vulnerable to bank runs and sudden deleveraging. Furthermore, the lack of transparency of these markets makes it difficult to identify property rights (who owns what?), monitor risk concentration and identify counterparties (who is exposed to who?)
- provision of a framework for interactions with banks. The high level of interconnectedness between the shadow banking system and the rest of the financial sector, particularly the banking system, constitutes a major source of contagion risk. These risks could notably be addressed by tightening the prudential rules applied to banks in their operations with unregulated financial entities.
Furthermore, particular attention will be paid to the supervision arrangements of shadow banking entities/activities in order to ensure that specific risks are adequately addressed. Certain areas such as the set-up of resolution tools for non-bank financial institutions and a structural reform of the banking system require further analysis and will be clarified later.
Ultimately, the aim is to ensure that the potential systemic risks to the financial sector are covered and that the opportunities for regulatory arbitrage are limited in order to strengthen market integrity and increase the confidence of savers and consumers.
The Commission’s communication is in line with the Financial Stability Board’s recommendations, which will be endorsed by the G20 Leaders in Saint Petersburg on 5-6 September 2013.
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