European Commission Issues Communication Addressing New Sources of Risk in the Financial Sector

by McDermott Will & Emery
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On 4 September 2013, the European Commission published a long-anticipated communication that detailed far-reaching plans to reform the shadow banking industry. The envisaged reform project anticipates a five point approach, which has already been criticised as going both too far and not going far enough. This project is likely to be a long and highly politicised one.

On 4 September 2013, the European Commission (the Commission) published a long-anticipated communication, that detailed far-reaching plans to reform the shadow banking industry. Shadow banking refers to the system of credit intermediation carried out by a wide range of market participants who operate outside the mainstream banking infrastructure. Entities engaged in shadow banking play an important role in the European and global economies, offering investors varied alternatives to traditional bank deposits. The Commission valued the global shadow banking industry in 2010 at €51 trillion.
 

Despite its central role in worldwide liquidity, the shadow banking industry is subject to less stringent regulation than the mainstream banking industry. Given the enormous changes in the world’s financial landscape over recent years, shadow banking has come under heightened scrutiny since it was considered in depth at the 2010 G20 Seoul Summit.

The Commission issued a green paper in March 2012 in which the case for change was outlined, and the organisations that would be involved in this significant reform project were named. The Commission also endorsed the earlier 2010 recommendations of the Financial Stability Board, an international financial watchdog based in Switzerland, which classified the following activities and entities as those constituting shadow banking:

Entities operating outside the regular banking system that perform one of the following activities:

  •  Accepting or raising funding with deposit-like characteristics
  • Performing maturity and/or liquidity transformation
  • Undergoing or allowing credit risk transfer
  • Using direct or indirect financial leverage.
  • Activities that could act as important sources of funding of non-bank entities, including securitisation, securities lending, and repurchase transactions.

These distinctions were subsequently approved once more in the 4 September communication. Examples of organisations carrying out the above services, that have been listed as examples of shadow banking participants, include

  • Special purpose entities that perform liquidity and/or maturity transformation, such as securitisation vehicles and special purpose vehicles
  • Money market funds (MMFs) and other investment funds with deposit-like characteristics that leave them vulnerable to sudden large-scale withdrawals by clients
  • Investment funds
  • Finance companies and securities entities providing credit or credit guarantees
  • Insurance and reinsurance undertakings issuing or guaranteeing credit products.

At the heart of the Commission’s drive to overhaul regulation and scrutiny of operators in the shadow banking market is the need to reassure investors and to strengthen consumer confidence in the markets, as the European Union seeks to emerge from the fiscally unstable environment in which it has found itself mired for several years. The envisaged reform project adopts a five-pronged approach to realise this goal:

1. Increased transparency, through sophisticated regimes for the exchange of data, as well as the introduction of a central repository for derivative transactions.

2. Enhanced frameworks for certain investment funds, including new legislative arrangements to address the potential systemic risk posed by MMFs.

3. Reduced risks associated with securities financing transactions by way of a detailed European securities law.

4. A strengthened prudential banking framework in order to limit contagion and arbitrage risks, specifically with regard to regulated banks with major exposure to unregulated financial entities.

5. Phased-in greater supervision of the shadow banking industry, encompassing more developed risk-monitoring, both at Commission level and nationally, by the financial regulators of each of the 27 European Member States.

The Commission emphasised that its most recent announcement heralds only the first step in its “dynamic and forward-looking approach”, which will adapt regularly to meet the needs of consumers, address market risk concerns and align with the regulatory environment in which shadow banking participants operate.

Only one day after the publication of the 4 September communication, the governments of several major European countries, including Germany, have already expressed dissatisfaction with the proposed measures, deeming them to fall short of what should be introduced. In contrast with this, some players in the shadow banking market consider that the measures go too far, particularly the requirement to maintain “buffers” of capital to withstand runs on financial institutions.

These conflicting arguments corroborate the view that this project will be a long and highly-politicised one. Market participants and industry observers should monitor this development closely over the next eighteen months.

David McDonnell, a trainee solicitor at the London office, contributed to this article.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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