May 5, 2013 6:09 am

Brussels to clamp down on ‘shadow banking’

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©EPA

The latest proposals from the European Commission to regulate ‘shadow banks’ have raised concerns that overly heavy-handed regulation could stymie economic growth

The European Commission has signalled a wider clampdown on the continent’s “shadow banking” sector to counter “surreptitious” increases in leverage, illiquidity mismatches and the potential for systemic risk.

As FTfm revealed last week, Brussels is already planning to introduce tighter restrictions on stable value money market funds, which some believe would “kill off” the €490bn industry.

A second leaked draft from the commission suggests it is likely to expand this regulatory push to cover all funds that engage in securities lending or repo transactions.

It is believed the final recommendations will be published in June, alongside the proposals for reform of the money market sector.

Although not as an contentious as Brussels’ broadside against money market funds, the latest proposals have raised concerns that overly heavy-handed regulation could stymie economic growth, given that the growing number of credit funds that loan money directly to companies and infrastructure developers are viewed by regulators as “shadow banks”.

“We want to ensure long-term project financing. You can’t address that and say shadow banking will be regulated into the ground,” said one leading asset management figure. ‘Appropriate’ doesn’t just mean no risks, no failures, it also means growth.

“I think it’s right that shadow banking is looked at so other forms of lending do not fall through the net but, on the wider point, how tightly it is regulated will affect the ability of others to supply long-term credit.”

The document outlines the commission’s desire to review the Ucits framework for funds that engage in securities financing transactions, such as lending securities or engaging in repo deals.

Amid concerns that funds may be impairing their liquidity as a result, it is likely to call for tighter eligibility criteria for the collateral posted to back such trades, as well as stipulating greater diversification of collateral.

Particularly, Brussels said the re-lending of collateral, or reinvestment if the collateral is in the form of cash, generates “dynamic collateral chains” that can contribute to a “surreptitious increase in leverage [that] strengthens the pro-cyclical nature of the financial system, which then becomes vulnerable to bank runs and sudden develeraging”.

The draft said the commission would make a legislative proposal to tackle this issue, without giving details.

Michael Jackson, partner in the asset management team at Matheson Ormsby Prentice, a Dublin law firm, feared this could lead to a wider push to unwind parts of the 2001 Ucits III directive, which allowed mainstream European funds to make greater use of derivatives.

“There are some concerns that there is a trend towards moving back to the Ucits I style of eligible asset,” said Mr Jackson. “I think that would be a mistake and would not serve the interests of investors. There are already stringent liquidity requirements in Ucits.”

Brussels also appears to be calling for banks to engage in fewer transactions with “unregulated” financial counterparties, which includes Ucits and hedge funds.

Neil Hamilton, a partner at international law firm Paul Hastings, said this was “troubling”, given that many funds that support the real economy rely on banks for finance or other support.

The draft appears to confirm that capital buffers and tougher restrictions on eligible assets will be imposed on money market funds, regarded by Brussels as part of the “shadow banking” system.

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