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BackOn 4 September, the Commission published a draft proposal concerning a regulation of so-called Money Market Funds and a communication on further regulatory provisions for shadow banks. Even though regulating this sector is without a doubt a step in the right direction but the proposals fail to meet the requirements of a stable financial system that serves society.
Money Market Funds and shadow banks at the heart of the crisis
Shadow banking refers to types of credit intermediation, which are outside the banking system and therefore not subject to the same regulations. Money Market Funds in particular, which have now become the subject of a new regulation, represent a special form of shadow banking. They invest in short-term bonds (with a maturity of maximal one year) and provide companies and banks with the opportunity of depositing large sums of money at short notice. Insofar, they are similar to bank deposits. These funds guarantee investors that their deposits will not lose in value and that the money invested can be paid back at any time. However, in the end this is no more than an illusion, because just like any other funds, Money Market Funds may also lose in value.
In respect of the still prevailing financial crisis, the shadow banking system has played a disastrous role in parts. Prior to the outbreak of the crisis, Money Market Funds had massively invested in so-called “Asset Backed Securities” (i.e. securitised mortgages). Panic broke out when the first funds went bust, which gripped the whole system. Shadow banking also provided banks with the opportunity to hide bonds from their balance sheets, which meant they were able to avoid capital requirement provisions.
Five years after the crisis and in spite of initiated reforms of the financial markets, shadow banking still forms a large part of the financial market. According to the European Commission, shadow banks had a volume of 51 billion EUR in 2011, which is equivalent to ca. 25-30 % of the entire financial system and about half of the banking assets. As the name shadow banking suggests, reliable figures, however, do not exist. Money Market Funds, in particular, are also a significant factor; they hold about 22 % of all short-term bonds.
Regulation – how far should it go?
The most recent proposal of the Commission for regulating Money Market Funds follows a Green Paper on shadow banking in 2012 and a subsequent public consultation. The content of the proposed regulation confirms fears that lobbyists of the financial sector have succeeded in watering down the regulation.
Both the European Systemic Risk Board (ESRB), which had been set up in response to the crisis and the Financial Stability Board (FSB), which exists within the scope of the G20, had demanded a complete ban of Money Market Funds, which guarantee their customers the full value of their deposits. Even the German and the French Government supported this demand. Nevertheless, the proposal of the Commission does not even mention it. Money Market Funds only need to fulfil additional provisions to enable them to pay out as large a part of their funds as possible and to have a capital buffer of 3 % on their books. The latter is way lower than the capital requirement provisions for banks, as implemented by Basel III Regulations; and wouldn’t be sufficient in the case of a sudden withdrawal of funds. Apart from that, Money Market Funds are granted a generous transition period of three years to develop their capital buffer. The fact, that a draft proposal, which had been made available to the public in March, did not contain any transition periods, gives reason to suspect that the financial sector has engaged in massive lobbying. National interests also seem to have prevailed. In particular Ireland and Luxemburg with their relaxed tax provisions play host to most of the European Money Market Funds.
What now?
In addition to the proposal on regulating Money Market Funds, the Commission also published a communication, which deals with the future of regulating shadow banking and must also be seen in the context of the forthcoming G20 summit, which will also address this matter. Most of the measures proposed move towards greater transparency and monitoring. This goes in the right direction; however, the dangers are not only once again watering down tactics, but very little energy is used to stamp out some of the practices completely.
Much of what is going on in the shadow banking system is of a highly speculative and high risk nature. The Commission argues, as do the market participants, that the existence of a shadow banking system would promote innovation on financial markets and represent an additional source of financing in times, when banks were very reluctant to lend. However, one seems to have forgotten that in particular the “innovations” of the financial sector greatly contributed to the financial crisis, for example spreading the risk by securitising loans throughout the world. Of course, Europe’s economy needs access to financing options, but it would be reasonable if the banks showed more aversion to risk-taking if they want to break the circle of boom and bust. After all, the lack of regulations means that in particular shadow banks are strongly acting in a pro-cyclical manner and as a result aggravate the crisis to the same extent as they stimulate boom. Prior to the outbreak of the crisis, shadow banks significantly contributed to the fact that households in the United States, but, for example, also in Spain or Great Britain were able to take out more and more new loans - as they were securitised, in special-purpose vehicles, outsourced as part of the shadow banking system and sold on.
Further information:
Press release of the Commission
Communication of the Commission
Draft proposal of the Commission
Shadow banking refers to types of credit intermediation, which are outside the banking system and therefore not subject to the same regulations. Money Market Funds in particular, which have now become the subject of a new regulation, represent a special form of shadow banking. They invest in short-term bonds (with a maturity of maximal one year) and provide companies and banks with the opportunity of depositing large sums of money at short notice. Insofar, they are similar to bank deposits. These funds guarantee investors that their deposits will not lose in value and that the money invested can be paid back at any time. However, in the end this is no more than an illusion, because just like any other funds, Money Market Funds may also lose in value.
In respect of the still prevailing financial crisis, the shadow banking system has played a disastrous role in parts. Prior to the outbreak of the crisis, Money Market Funds had massively invested in so-called “Asset Backed Securities” (i.e. securitised mortgages). Panic broke out when the first funds went bust, which gripped the whole system. Shadow banking also provided banks with the opportunity to hide bonds from their balance sheets, which meant they were able to avoid capital requirement provisions.
Five years after the crisis and in spite of initiated reforms of the financial markets, shadow banking still forms a large part of the financial market. According to the European Commission, shadow banks had a volume of 51 billion EUR in 2011, which is equivalent to ca. 25-30 % of the entire financial system and about half of the banking assets. As the name shadow banking suggests, reliable figures, however, do not exist. Money Market Funds, in particular, are also a significant factor; they hold about 22 % of all short-term bonds.
Regulation – how far should it go?
The most recent proposal of the Commission for regulating Money Market Funds follows a Green Paper on shadow banking in 2012 and a subsequent public consultation. The content of the proposed regulation confirms fears that lobbyists of the financial sector have succeeded in watering down the regulation.
Both the European Systemic Risk Board (ESRB), which had been set up in response to the crisis and the Financial Stability Board (FSB), which exists within the scope of the G20, had demanded a complete ban of Money Market Funds, which guarantee their customers the full value of their deposits. Even the German and the French Government supported this demand. Nevertheless, the proposal of the Commission does not even mention it. Money Market Funds only need to fulfil additional provisions to enable them to pay out as large a part of their funds as possible and to have a capital buffer of 3 % on their books. The latter is way lower than the capital requirement provisions for banks, as implemented by Basel III Regulations; and wouldn’t be sufficient in the case of a sudden withdrawal of funds. Apart from that, Money Market Funds are granted a generous transition period of three years to develop their capital buffer. The fact, that a draft proposal, which had been made available to the public in March, did not contain any transition periods, gives reason to suspect that the financial sector has engaged in massive lobbying. National interests also seem to have prevailed. In particular Ireland and Luxemburg with their relaxed tax provisions play host to most of the European Money Market Funds.
What now?
In addition to the proposal on regulating Money Market Funds, the Commission also published a communication, which deals with the future of regulating shadow banking and must also be seen in the context of the forthcoming G20 summit, which will also address this matter. Most of the measures proposed move towards greater transparency and monitoring. This goes in the right direction; however, the dangers are not only once again watering down tactics, but very little energy is used to stamp out some of the practices completely.
Much of what is going on in the shadow banking system is of a highly speculative and high risk nature. The Commission argues, as do the market participants, that the existence of a shadow banking system would promote innovation on financial markets and represent an additional source of financing in times, when banks were very reluctant to lend. However, one seems to have forgotten that in particular the “innovations” of the financial sector greatly contributed to the financial crisis, for example spreading the risk by securitising loans throughout the world. Of course, Europe’s economy needs access to financing options, but it would be reasonable if the banks showed more aversion to risk-taking if they want to break the circle of boom and bust. After all, the lack of regulations means that in particular shadow banks are strongly acting in a pro-cyclical manner and as a result aggravate the crisis to the same extent as they stimulate boom. Prior to the outbreak of the crisis, shadow banks significantly contributed to the fact that households in the United States, but, for example, also in Spain or Great Britain were able to take out more and more new loans - as they were securitised, in special-purpose vehicles, outsourced as part of the shadow banking system and sold on.
Further information:
Press release of the Commission
Communication of the Commission
Draft proposal of the Commission