Shadow Banking Update

On 13 November 2015, the FSB published three reports relating to shadow banking.

The first, “Transforming Shadow Banking into Resilient Market-based Finance: Regulatory framework for haircuts on non-centrally cleared securities financing transactions” details qualitative methodologies to be used by market participants that provide securities financing to calculate haircuts on collateral received.  It requires that haircuts should be based on the market risks of the assets used as collateral and be calibrated at a high confidence level, using a long historical time period that includes at least one stress period.  Haircuts should also capture “other risk considerations”, where relevant, including:

• liquidation risk;
• “wrong-way risk”; and
• specific characteristics of the collateral, such as:
  • asset type;
  • issuer creditworthiness;
  • residual maturity;
  • price sensitivity;
  • optionality;
  • complexity of structure;
  • expected liquidity in stressed periods;
  • the frequency of collateral valuation and margining;
  • counterparty credit considerations;
  • foreign exchange risk; and
  • correlation risk between securities accepted as collateral and securities loaned.

In the case of portfolio haircuts, the following risks should also be factored in:

• procyclicality;
• market risk ;
• geographical/sector/issuer concentration;
• Illiquidity risk; and
• non-correlation between price and spread relationships between lent securities and collateral portfolio assets.

The report also details a framework of numerical haircut floors – to be implemented by the end of 2018 – that will apply to non-centrally cleared securities financing transactions (whether margined at the transaction level or the portfolio level) in which financing against collateral other than government securities is provided to non-banks.  The framework is intended to apply to transactions where the primary motive is to provide financing, rather than to borrow or lend specific securities.  However, “collateral upgrade” transactions (borrowing securities against other securities that attract higher haircuts) are also included.  The actual haircut floors are as set out below (these are consistent with the recent consultation paper on haircut floors for non-centrally cleared securities financing transactions published by the BCBS):

Residual maturity of collateral	Haircut level
	Corporate and other issuers	Securitised products
<=1 year debt securities and Floating Rate Notes (FRNs)	0.5%	1%
>1 year, <=5 years debt securities	1.5%	4%
>5 years, <=10 years debt securities	3%	6%
>10 years debt securities	4%	7%
Main index equities	6%
Other assets within the scope of the framework	10%

The second report, “Transforming Shadow Banking into Resilient Market-based Finance: An Overview of Progress” details the FSB’s two-pronged strategy to address the financial stability risks in shadow banking and transform it into resilient market-based finance, namely:

• The creation of a system-wide monitoring framework to track developments in the shadow banking system with a view to identifying the build-up of systemic risks and initiating corrective actions where necessary; and
• The development of policies to strengthen oversight and regulation of shadow banking, with a focus on measures that seek to:
  • mitigate risks in banks’ interactions with shadow banking entities;
  • reduce the susceptibility of money market funds to “runs”;
  • improve transparency and align incentives in securitisation;
  • dampen procyclicality; and
  • assess and mitigate financial stability risks posed by other shadow banking entities and activities.

The report details the ‘next steps’ that the FSB plans to take in order to advance this strategy:

Date	Action
End of 2015	Development of guidance on the scope of consolidation for bank prudential regulation
End of 2015	Implementation of the regulatory framework for haircuts on non-centrally cleared SFTs at the international level
January 2016	Implementation of policy recommendations related to structural aspects of the securities financing markets – specifically, the introduction of CCPs within inter-dealer repo markets
March 2015	Preparations of findings on the possible harmonisation of regulatory approaches to re-hypothecation of client assets and review possible financial stability issues related to collateral re-use
Q2 2016	Publication of the results of FSB peer review of its policy framework for shadow banking entities
Q2 2016	FSB evaluation of the case for developing further policy recommendations for shadow banking entities and reporting of results to the G20
Q3 2016	Operationalisation of global securities financing data collection and aggregation
Q4 2016	Publication of results on annual monitoring exercise into global trends and risks in the shadow banking system
2016	Implementation monitoring for money market funds and securitisation

The final FSB report, “Global Shadow Banking Monitoring Report 2015”, presents the results of the fifth annual monitoring exercise into shadow banking.  It uses data as of end- 2014 for 26 jurisdictions, together accounting for about 80% of global GDP and 90% of global financial system assets.  It details an enhancement to the monitoring methodology, which involves classifying non-bank financial entities into five ‘economic functions’, based on the high-level policy framework published by the FSB in August 2013, as set out below:

• Management of collective investment vehicles with features that make them susceptible to runs;
• Loan provision that is dependent on short-term funding;
• Intermediation of market activities that is dependent on short-term funding or on secured funding of client assets;
• Facilitation of credit creation; and
• Securitisation-based credit intermediation and funding of financial entities.

This classification is designed to narrow the focus of monitoring efforts to those parts of non-bank credit intermediation where shadow banking risks may occur.

The report goes on to provide an assessment of the risks inherent in the activities of shadow banking entities and consideration of the risks arising from the interconnectedness between banks and “Other Financial Intermediaries”[1].  It also looks at the size and trends of all non-bank financial intermediation and examines new data collected on credit intermediation undertaken by entities within the financial system to assess potential shifts in the providers of credit to the economy.

[1] financial intermediaries that are not classified as banks, insurance companies, pension funds, public financial institutions, central banks, or financial auxiliaries

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