Opacity in shadow banking & The Capital Markets Union

Regulators stand little chance of increasing resilience in the shadow banking sector without sufficient transparency and comparable data. The industry sees no cause for concern, and new regulation may in fact push the sector further into the dark.

By Gustav Højmark-Jensen


Just as the novel coronavirus crisis continues to emphasise the need for comparable data and transparency, so did the financial crisis of 2008 illuminate the need for more comprehensive supervision and tracking of shadow banking.


This realisation prompted the leaders of the G20 to expand the membership and strengthen the authority of the Financial Stability Board (FSB) in 2009.

Soon after, the FSB began targeting shadow banking and improving its data collection. In 2011, the efforts of the FSB led to the first report that monitored the global shadow banking sector.

Now, a new report is released each year, tracking the size and development of the shadow banking sector across the FSB’s jurisdiction which spans the G20, several EU nations and other interesting nations such as the Cayman Islands.


But in its latest annual report from January 2020, the FSB warned that there were “continued data gaps and a lack of granularity” which “impede a more forward-looking identification of potential financial stability risks.”


Researchers and experts agree that when it comes to efficient regulation of the shadow banking system, there are still several issues to be dealt with by authorities.


Data management – are regulators up for it?

According to Professor Elias Bengtsson, former principal economist at the ECB and economic advisor at Sweden’s central bank, the most important task for the FSB is to get the data collectors to agree on definitions and standards, ensuring that regulators receive comparable data.

While Prof. Bengtsson acknowledges that there has already been a lot of improvement on how data is collected, he problematises regulators’ abilities to analyse and process the data that they receive. “Questions remain as to whether regulators are getting the right data from various shadow entities” Prof. Bengtsson says.


Brian Thuesen, a team leader at C WorldWide Asset Management, an asset management company with almost $6bn in its portfolio, also expresses doubt when it comes to regulators’ ability to analyse and process data. "I sincerely doubt that regulators have the capacity to keep up”, he says, and continues “they [regulators, ed.] are finding themselves carpet bombed with large amounts of data, and one could be tempted to question their ability to use it effectively.”


According to Thuesen, the requirements concerning data collection, set by the regulators and enforced by the national authorities, are so complex that both its quality and comparable potential can be called into question. “Does a minor financial entity in Denmark understand the rules for data collection in the same way as a large Spanish bank for example?", Thuesen asks.


A former asset management CEO, Morten Sterregaard-Feltsen, now COO and co-founder of AI Alpha Lab, an investment advisory company, says that the sheer amount of regulation currently imposed on companies within the financial intermediation sector is getting out of hand. “In general, for an asset management company, there is a tidal wave of regulation. It is really crazy” he says.


Sterregaard-Feltsen also faults the complexity of the regulation and the strain it puts on a firm’s legal department. “We were required to be detailed to a point where it did not make sense” he says.

Usually, Sterregaard-Feltsen is a big fan of regulation, especially when it comes to regulating “exciting products with huge upsides and high leverage”, he says. But in his opinion, recent measures of regulation such as MiFID II have gone too far in its level of detail and complexity.


MiFID (I & II) is an EU flagship when it comes to bridging the data gap and identifying transactions and investment procedures according to the European Securities and Markets Authority (ESMA).


Some experts argue that regulation such as MiFID II would have alerted regulators about the conduct of Lehman Brothers before it was too late.


More transparency still needed

According to Ewald Engelen, Professor of Financial Geography at the University of Amsterdam, the Lehman Brothers’ bankruptcy highlights exactly why more data and transparency is necessary for regulation to be effective. “There was no general, accessible repository where one could chase the connections and hence the liabilities of different financial agents to one another”, Prof. Engelen explains.

Even after the successful implementation of MiFID II and many other macroprudential measures across Europe and the US, regulators need to do more according to Prof. Engelen. “We need much higher transparency requirements”, he says, iterating that there are still large gaps of data and a lack of transparency in the shadow banking sector.


Prof. Engelen is especially critical of the usage of special purpose vehicles (SPVs), offshore financial centres (OFCs) and regulatory arbitrage in the absence of sufficient data collection. “There is a very minimalist notification duty, especially concerning special purpose vehicles in the Netherlands”, he explains.


Prof. Engelen focuses on shadow banking activity in the Netherlands for a reason.


Research by Corpnet, a financial research group, shows that the Netherlands is the largest OFC in the EU. This means that multinational corporations use the Netherlands as a conduit to gain certain tax advantages through a series of SPVs, or holding companies, located in the Netherlands.


According to Prof. Engelen, regulators and tax offices should be equipped with “see-through capacities” in order to identify what is going on inside these SPVs, how they are linked and “what sort of regulatory arbitrage constellations that are being created through these chains of SPVs”, he says.


This would, in Prof. Engelen’s opinion, be a necessary step for EU regulators and authorities to take if they want to increase transparency in the sector. “Once you have the data, then regulators can say ‘hey, this is unacceptable’. Without it, without that transparency, we do not know what we are dealing with”, he says.


Similarly, the fight against the coronavirus pandemic would most likely have been a losing battle without the ability to track cases, patterns, deaths and recoveries. Data and transparency provide the worlds’ health authorities with a fighting chance to mitigate the spread and avoid panic, just like financial data provide the world’s banking and market authorities with the information they need to reduce risk and mitigate crises.


However, increased regulation may not always be the answer.


When regulation becomes a balancing act


According to Dr. Simone Varotto from the International Capital Market Association Centre, a financial research organisation, much of the regulation imposed on traditional banks after the financial crisis indirectly drove the growth of the shadow banking sector.


Under strict rules, banks are forced to limit the amount of risk they hold on to. Similarly, traditional banks were able to lend less due to new liquidity, capital and leverage requirements, Dr. Varotto explains.


“This then pushes the financial activity outside the formally regulated banking sector and into the less regulated areas of the non-banking or shadow banking sector”, Dr. Varotto says, indicating how the decreased capacity in the traditional banking system made borrowers turn to the shadow sector.


In its 2017 report on the adequacy of post-crisis policy tools, the FSB identified no new financial stability risks from shadow banking that would “warrant additional regulatory action at the global level”, indicating the FSB’s awareness of the boundary problem.


Instead, the FSB voiced its commitment to transform shadow banking into a resilient market-based finance sector, alluding to the balancing act that regulators are faced with in their attempts to regulate most efficiently and maintain a useful monitoring framework.


According to Prof. Bengtsson, the regulatory frameworks implemented by the Basel Committee on Banking Supervision (BCBS), the global standard-setter for central banks and banking authorities in 28 jurisdictions, squeezed the profit margins of banks significantly as it restricted the amount of mortgages they could issue.


The consecutively updated BCBS regulation, usually referred to as the “Basel frameworks”, dictate standardised risk-rates on mortgages and many other macroprudential initiatives such as higher capital requirements that banks must comply with.


Challenged on its profit margins by the Basel requirements, the traditional banking system intensified its use of the facilities for securitisation and asset transformation that the shadow banking sector provide.


If the banks off-loaded the mortgages via the process of securitisation, they would quickly be able to offset the new capital requirements. Without breaking the regulatory rules set out by the BCBS, the securitisation of mortgages would allow banks to transform lengthy and often very low yielding assets into highly liquid ones.


According to Prof. Bengtsson, this procedure was very attractive for the banks, as it allowed them to both profit and avoid the new regulation. “The bottom line is that the tougher the regulators get, the more they toughen the requirements, the more money will flow on the side via securitisation and these shadow constructions”, Prof. Bengtsson says.


While the existence of both a traditional banking system and an alternative shadow banking system is beneficial in terms of diversifying risk and allowing for alternative routes of funding, there is an elusive balance to be struck between efficient regulation and incentivising financial activity to move outside regulatory confines.


Finding the equilibrium may be further complication by the international nature of shadow banking, the breaking up of the intermediation chains and the ease of moving money, according to Prof. Bengtsson. “There is no way to calculate where this boundary should be set. You can make the best efforts to get the regulation right, and only after a decade will you find out whether you were right or wrong”, he says.


The international nature of the shadow banking system and the many different national regulators that deliver data to authorities like the FSB make it increasingly difficult to regulate efficiently, according to Prof. Bengtsson. “It remains a very daunting task for the regulators”, he says.


Daunting or not, if regulators find a way to mitigate the transparency concerns and strengthen the sector across national jurisdictions, it could mean the salvation of otherwise indebted nations with rigid banking structures, especially in the EU.

In fact, some international institutions and policy makers are already prioritising the benefits of an integrated shadow banking system over the lack of transparency.

The Capital Markets Union - The EU’s plan to bank on market-based financing

Despite transparency concerns, the European Commission remains committed to rejuvenate millions of SMEs with a new platform for securitisation. An expert calls the platform institutionalised shadow banking hidden behind new rhetoric, but the Commission sees no cause for alarm.


By Gustav Højmark-Jensen.


Access to funding is a pressing problem for the EU’s more than 25 million small and medium-sized enterprises (SMEs) according to the European Commission (EC). And it is about to get a lot worse as the coronavirus pandemic continues to force nations into lockdown.

More than 100 million people are employed in SMEs across the EU, and any disruption of cash flow and subsequent lack of funding would have real implications for millions of jobs across multiple economies.


If traditional lenders are unable to meet the needs of the many businesses, the funding gap would leave a significant role to be played by the shadow banking system. Alternative sources of cash and more liberal risk profiles could turn out to be the salvation for already battered economies across the EU.


The latest figures from the OECD show that SMEs in EU member states hit the hardest by the last financial crisis, such as Italy and Hungary, are already struggling to find financing. With high levels of public debt, high interest rates and an unstable market, the Italian stock of SME loans decreased by 17% between 2013 and 2017. In Hungary, the stock of SME loans fell by 19% over the same period.

Enter, the Capital Markets Union (CMU). According to the EC, the CMU is an attempt to rejuvenate funding opportunities for the millions of SMEs in the EU that cannot obtain funds through regular channels. With the CMU initiative, the EC aims to standardise securitisation and better facilitate a new way for SMEs to raise capital via investors.


But while the CMU may seem like the perfect means to an end, a range of issues persist, and researchers question whether the EC has thought its implementation of securitisation fully through.


“EU facilitated shadow banking”

According to Ewald Engelen, Professor of Financial Geography at the University of Amsterdam, who has done substantial research on the CMU, the EC has allowed the proposed benefits of shadow banking to take precedent over the phenomenon’s fundamental data-gaps and lack of transparency.

“It is odd that furthering or extending the shadow banking system is seen as the solution to the vulnerabilities that was caused by the very same shadow banking system”, Prof. Engelen says and underlines that “that is what we are currently witnessing with the introduction of the Capital Markets Union”.


In the green paper that outlined the goals and rationale of the CMU it is clear that securitisation is the proposed platform for the integration of the financial markets. However, the document gives no mention to shadow banking.


All the legislative legwork has already been completed and ratified, although some measures are still being phased in, according to the Directorate General for Financial Stability, Financial Services and Capital Markets Union (FISMA), the EC’s administrative branch in charge of the implementation process.


According to a Commission official, the CMU initiative is a long-term project that would hopefully “put forward the building blocks for creating an alternative to traditional banking in Europe”, she says.


With the coronavirus pandemic there is an ever stronger demand for alternative funding, according to the same sourse. In fact, a Commission official sees the implementation of the CMU as one of the main proponents of the EU economic recovery after the coronavirus crisis.


However, according to Prof. Engelen, the CMU is nothing but a shadow banking system in disguise, “a rhetorical smoke screen”, he calls it. In reality, the CMU is about securitisation, and without sufficient data requirements or transparency measures in place, institutionalising it on this level could pose serious risks, according to Prof. Engelen.


It is all about the details

According to a Commission official, times have changed significantly since the financial crisis in 2008. But due to the previous role of securitisation and the problematic associations linked to the process still being “fresh” in the minds of some European MEP, many found it hard to think of securitisation in a new way, even though it holds tremendous potential to save the struggling SMEs of the Eurozone.


However, the kind of securitisation that the CMU proposes is very different from what it was during the last financial crisis, according to a Commission official. In his opinion, the framework that the CMU proposes is “simpler, more transparent and standardised so that it is easier to understand”, he says.


In fact the overall goal of the proposed securitisation model is to do away with the “overly complicated structures and the misalignment between the originators and the investors”, a Commission official explains.


But Prof. Engelen is not persuaded by the proposed “standardised” nature of the securitisations. “I have had an expert look at the paperwork, and there is nothing simple, nothing transparent and nothing standardised about the proposed securitisations”, he says.


While a Commission official agrees that securitisation is a complex financial instrument, he says that what the CMU is trying to do is to make it easier for specialised investors to assess the various securitisation structures and the underlying risk.


“This information will be made available through a central repository of information, accessible for all investors in the EU”, a Commission official says, and explains that this would make due diligence processes much easier in the new framework.


But Prof. Engelen is still not convinced: “It is simply the industry practice that was in existence before the outbreak of the last financial crisis that is now being transformed into Europe wide law”, he concludes.


However, according to the representatives from the EC, the goal of the CMU is to introduce and implement an entirely different approach to securitisation. An approach guided by new, simple, transparent and standardised regulatory measures that softens up some of the regulatory backlash that was directed at securitisation after the global financial crisis.

However, what worries Prof. Engelen even more is that only very few people in the member states seem to take an interest in the CMU and the nature of the initiative. “The majority of the European people haven’t got a clue. If they have even heard of it, they think ‘it’s Brussels, what does it have to do with me?’”, he says.


According to the Prof. Engelen, the individuals that actually understand the CMU are already “embedded” in the shadow and traditional banking sector and the wider financial industry.


But this alleged absence of public interest in the CMU could also have something to do with the fact that the term ‘shadow banking’ has undergone profound change in recent years. Experts argue that semantics matter, especially when it comes to shadow banking.


Nothing has changed but the name

According to Elias Bengtsson, former principal economist at the ECB and Professor of Economics at the University of Gothenburg, there has been a shift in the attitude towards shadow banking on both an institutional and societal level.


“If you see the language surrounding the Capital Markets Union and how it’s being ‘sold’ to the general public in the policy documents from the European Commission, you can really see that there is a big shift in the attitude”, says Prof. Bengtsson and explains that one can now observe a very strong shift in the language, narrative and terminology of shadow banking, compared to what the term used to represent, especially in the financial crisis of 2008.


“Now, people are less keen to talk about the shadow banking system as much as they like to talk about the parallel banking system or market-based finance”, Prof. Bengtsson says.


According to him, the implementation of the CMU clearly reflects a shift in the mentality of some regulators and policy makers.


Prof. Engelen however believes that the new terminology goes further than just a reframing. From his perspective, it has finally dawned on countries and regulators alike; that shadow banking has permeated the traditional banking system and financial market to an extent where it can no longer be separated.


According to Prof. Engelen, regulators and policy makers realised that fixing the issues in shadow banking would mean the abandonment of fundamental economic realities.


Therefore, they opted for “the easy way out” – a rebranding, according to Prof. Engelen. “I can imagine that in the process of thinking through what shadow banking actually is and how it is implicated in the growth models of a large number of countries, they [policy makers, ed.] ultimately came to the conclusion that ‘we cannot get rid of shadow banking, it has become such a crucial component of our political economies, so we need to come up with a new narrative. We need to get rid of the term shadow banking, so let’s rebrand it’”, Prof. Engelen explains.


Regardless of whether the rebranding of the shadow banking system was the result of such a conscious realisation process, its presence in the wider economy is a reality. While it may have developed in the dark, it is certainly out in the open today. Just as the financial disruption caused by the coronavirus pandemic poses a challenge, so does the CMU pose a test for how shadow banking will fare on an institutional level.


No matter the terminology, there will always be those who see shadow banking as a problem and those who see it as a solution. It remains up to policy makers and authorities to ensure that the interaction with financial markets happens in a transparent and safe way. However, with total shadow banking assets currently standing at close to $200 trillion, the question is for how long regulators can keep the sector in check.


According to Prof. Engelen, nothing but the rhetoric has changed since the last crisis. “The machinery that was proven to be so vulnerable has not changed. It is just as vulnerable now, or perhaps even more so, because the level of debt, leverage and the size of the sector have only increased. Too big to fail, too big to jail, it is all still there.”