“Shadow Banking” Regulation: New Areas of Focus and Possible Implications for Asset Managers

The so-called “shadow banking” sector has received significant attention from both U.S. and international regulatory bodies in the years since the onset of the recent financial crisis. Regulators appear increasingly concerned about systemic risk posed by the shadow banking sector, and these concerns appear to extend to segments of the asset management industry.

In this Alert, we provide background regarding the shadow banking system and some of the proposals to subject it to stronger regulation. In light of the diverse and complex nature of the shadow banking sector, the regulatory proposals under discussion would establish a variety of tools to address risks from shadow banking, rather than a single set of regulations. Participants in that sector, including asset managers, should be prepared for even more proposals from regulators intended to address those concerns.

The “Shadow Banking” Sector

As explained by the Financial Stability Board (the “FSB”) in its recently published Strengthening Oversight and Regulation of Shadow Banking: An Overview of Policy Recommendations (the “FSB Policy Framework”), “the ‘shadow banking system’ can broadly be described as ‘credit intermediation involving entities and activities (fully or partially) outside the regular banking system’ or non-bank credit intermediation in short.” The shadow banking system is said to create assets that are thought to be safe, short-term, and liquid, similar to insured deposits of banks, but that may not behave like or have the same protections or support as insured deposits in times of stress. Financial activities which take place in the shadow banking sector include investments in money market funds, securitizations, and securities financing transactions, such as securities lending and repurchase agreement transactions.

A recent report from the Office of Financial Research (the “OFR”) on Asset Management and Financial Stability (the “OFR Report”) acknowledges that asset management activities differ in important ways from banking activities, but argues that some types of asset management activities are similar to those provided by banks and other nonbank financial companies, and increasingly cut across the financial system in many ways.¹ In the minds of regulators, certain activities of asset management firms, such as their involvement in money market funds, repurchase agreement transactions and securities lending activities, are thought to connect asset management firms to the shadow banking sector.

Risks Presented by Shadow Banking

Regulators have cautioned that much of the shadow banking system is subject to little or no oversight from financial regulators. However, regulators note that, like banks, participants in the shadow banking system can be vulnerable to “runs” in the event of a crisis of investor confidence. The effect of such a run can be further amplified through contagion to other areas of the financial system. According to regulators, risks in the shadow banking sector were compounded during the financial crisis by the fact that shadow banking assets were widely viewed as free from risk.

Risks Highlighted in the OFR Report

The OFR Report highlights four factors that could make the asset management industry vulnerable to financial shocks:

• “reaching for yield” and herding behaviors;
• redemption risk in collective investment vehicles;
• leverage, which can amplify asset price movements and increase the potential for “fire sales”; and
• firms as sources of risk (i.e., the possibility that failure of a large asset management firm could be a source of systemic risk, depending on its size, complexity, and degree of interaction among its activities).

The OFR Report further explains that asset management firms could transmit risks across the financial sector through two primary channels: (1) exposure of creditors, counterparties, investors, or other market participants; and (2) disruptions to financial markets caused by fire sales. Through these channels, risks can be transmitted into both the regulated financial sector and into the shadow banking sector.

The OFR Report states that regulation of asset managers often focuses on limiting conflicts of interest between asset managers and their clients, but observes that such regulation does not always address collective action problems and other broader behavioral issues that can contribute to asset price bubbles or other market cycles. The SEC requested public comments on the OFR Report, possibly signaling its intention to focus on risks created by asset management firms’ involvement in the shadow banking sector.

Proposals to Regulate the Shadow Banking System

We discuss below the general policy approaches presented by international and U.S. financial regulators to address risks in the shadow banking system, as well as more specific regulatory measures. Most of these measures have yet to be adopted on the national level, but it seems likely that regulators will seek to take some form of action to address risks in the shadow banking sector given regulators’ concern about the sector’s contribution to the financial crisis.

General Policy Approaches

The possible policy approaches to address regulators’ concerns about the shadow banking sector can be grouped into four general areas:

• Data collection, monitoring and analysis. Regulators believe that efforts to monitor and understand activities in the shadow banking sector would be enhanced through improved transparency in the shadow banking sector.
• Regulatory policies and measures. Regulators are developing policies and tools designed to strengthen oversight and regulation of the shadow banking system.
• International standardization and cooperation. For example, the FSB is developing proposals to standardize regulatory standards for non-centrally cleared securities financing transactions, including minimum standards for methodologies to calculate haircuts and numerical haircut floors.
• Supervisory measures. Regulators may also work through supervisory channels to push for changes to industry practices in areas of the shadow banking sector.

Specific Areas of Focus and Proposals

In the FSB Policy Framework, the FSB identified five specific areas in which it believes policies are needed to mitigate the potential systemic risks associated with shadow banking. The FSB is undertaking various studies and making recommendations to address these areas, in coordination with the International Organization of Securities Commissions (“IOSCO”) and the Basel Committee on Banking Supervision (“BCBS”).

As discussed below, certain of these areas have been addressed by regulatory initiatives in the United States. Federal Reserve Governor Tarullo has highlighted certain steps taken by regulators to address these concerns in speeches and Congressional testimony regarding the shadow banking sector. As suggested by its request for comments on the OFR Report, the SEC may also be considering steps to address some of the involvement of the asset management sector in some of these areas.

Mitigate the spill-over effect between the regular banking system and the shadow banking system

Although non-bank financial intermediation provides a valuable alternative to banks in providing credit to support economic activity, the FSB is concerned that the financial crisis revealed that in some cases the regular banking system was exposed to risks in the shadow banking system.

The BCBS is developing proposals to address these concerns that would:

• ensure that all bank activities, including interaction with the shadow banking system, are appropriately captured in prudential regimes;
• limit banks’ large exposures to single counterparties (including to shadow banking entities); and
• introduce risk-sensitive capital requirements for banks’ investments in the equity of funds.²

In the United States, some of these concerns about exposure of the regular banking system to the shadow banking sector may be addressed through rules which implement aspects of the Dodd-Frank Act, such as the Federal Reserve’s proposed rules for Enhanced Prudential Standards and Early Remediation Requirements for bank holding companies with $50 billion or more in consolidated assets (“Large BHCs”) and nonbank financial companies subject to supervision by the Federal Reserve Board (“non-bank SIFIs”).

Reduce the susceptibility of money market funds to “runs”

As stated by the FSB, money market funds provide a deposit-like instrument to investors, especially when they are redeemable at short notice and at par. As such, the FSB argues that money market funds are susceptible to contagious investor runs, as shown by the run on institutional prime money market funds after the Reserve Primary Fund did not provide support for losses in September 2008.

The FSB has endorsed policy recommendations developed by IOSCO that provide the basis for common standards of regulations and management of money market funds across jurisdictions. These recommendations include a requirement that money market funds that offer stable or constant net asset value (“NAV”) to their investors should be converted into floating NAV funds where workable. Where such conversion is not workable, the FSB recommends that safeguards be introduced that are functionally equivalent to the capital, liquidity, and other prudential requirements on banks that protect against runs their deposits.

In the United States, regulation of money market funds has been the focus of significant policy debate. The SEC’s most recent proposal regarding money market fund regulation, published in June 2013, includes two key alternative changes along with a number of other reforms.

• The first alternative would require a non-government institutional money market fund to round to the nearest 1/100th of a penny (“basis point round”) its market-based NAV (e.g., to $1.0004 or $0.9997). This alternative would effectively require these funds to float their NAVs.
• The second alternative would require a non-government money market fund whose “weekly liquid assets” fall below 15% of the fund’s total assets to impose a liquidity fee of 2% on all future redemptions.³

Assess and align the incentives associated with securitization

The FSB believes that complex structuring of some securitizations before the financial crisis created incentives to weaken lending standards and generated an undetected build-up of leverage.

IOSCO, which has taken a lead role in coordinating efforts to implement reforms to address complex securitization, issued a report in November 2012 that took stock of the implementation of reforms, especially those related to risk retention requirements, and measures to enhance transparency and standardization of securitization products. The report also set forth policy recommendations to facilitate convergent implementation of reforms across jurisdictions.⁴

We have discussed measures which U.S. regulators believe will address risks from securitization markets in prior Bingham Alerts, including “Potential Effects on the CLO Market of Proposed Risk Retention Rules" (Sept. 12, 2013) and “A Guide to the Re-Proposed Credit Risk Retention Rules for Securitizations" (Sept. 6, 2013).

Dampen financial stability risks and pro-cyclical incentives associated with securities financing transactions such as repos and securities lending that may exacerbate funding strains in times of market stress

The FSB noted that securities financing transactions may be used by non-banks to conduct “bank-like” activities entailing leverage and mismatches between long-term lending and short-term borrowing. The FSB observed that, during the financial crisis, these markets shrank dramatically as losses materialized on the securities underpinning these transactions, thereby generating fire sales of assets.

In the FSB Policy Framework, the FSB provided recommendations for addressing financial stability risks in this area, including enhanced transparency, regulation of securities financing, and improvements to market structure. These measures would include minimum standards on cash collateral reinvestment, requirements for re-hypothecation, minimum regulatory standards for collateral valuation and management, and policy recommendations related to structural aspects of securities financing markets (e.g., central clearing and changes in the bankruptcy law treatment of securities financing transactions). The FSB Policy Framework also provides consultative proposals on minimum standards for methodologies to calculate haircuts on non-centrally cleared securities transactions, and a framework of numerical haircut floors for such transactions.⁵ This week, the FSB launched the second stage of its qualitative impact study of the proposed regulatory framework for securities financing transactions, which will assess the impact of haircut proposals on a broad range of firms.

In the United States, Federal Reserve Governor Tarullo has stated that a major source of unaddressed risk stems from the large volume of short-term securities financing transactions in the financial system, including repos, reverse repos, and securities borrowing and lending transactions. Noting that existing bank and broker-dealer regulatory regimes have not been designed to materially mitigate these risks, he called for continued attention to potential vulnerabilities, both in the United State and abroad. Governor Tarullo also has advocated for improved transparency in securities financing transactions, noting that financial regulators currently can only monitor such transactions indirectly.⁶

The OFR Report identifies concerns regarding securities financing transactions involving asset managers. In the OFR’s view:

• Inadequate risk management relating to reinvestment of cash collateral for asset management securities lending programs can create contagion and amplify financial stability shocks.
• Cash collateral reinvestment practices are not generally subject to comprehensive, targeted regulation and are not necessarily transparent to regulators or clients whose securities are lent, while the connections among cash collateral investment in the securities lending markets, redemption risk, and short-term funding markets are not well understood and difficult to measure due to a lack of comprehensive data.
• In addition to borrowing, asset managers obtain leverage for their funds and accounts through derivatives (futures, options and swaps), securities lending, and repurchase agreements, which can subject borrowers to margin calls and liquidity constraints that increase the risk of fire sales.
• Monitoring the reinvestment of cash collateral from securities lending is important for financial stability purposes, but such monitoring is limited by a lack of data.

It is not yet clear how the SEC and other regulators would address these issues through regulatory measures.

Assess and mitigate systemic risk posed by other shadow banking entities and activities

The FSB has developed a high-level policy framework for adoption by national authorities to detect, assess, and apply policy measures to the sources of financial stability risks from shadow banking in the non-bank financial sector. The policy framework focuses on economic functions rather than legal forms.

The Policy framework consists of three elements:

• Identification of the potential sources of shadow banking risks in non-bank financial entities with reference to five economic functions: (1) management of collective investment vehicles with features that make them susceptible to runs; (2) loan provision that is dependent on short-term funding; (3) intermediation of market activities that is dependent on short-term funding or on secured funding of client assets; (4) facilitation of credit creation (e.g., through credit insurance); and (5) securitization-based credit intermediation and funding of financial entities.
• Adoption of overarching principles for oversight of non-bank financial entities that are identified as posing a threat to financial stability from shadow banking, and a policy toolkit for each economic function based on the non-bank financial entities concerned, the structure of the markets in which they operate, and the degree of financial risks posed by such entities in their jurisdictions.
• Information-sharing among regulatory authorities across jurisdictions, including sharing of information regarding non-banking financial entities involved in each of the five identified economic functions and policy tools adopted to address risks.

Steps for Further Action

In the FSB Policy Framework, the FSB identified the following steps for further action:

• Development and refinement of recommendations on banks’ interactions with shadow banking entities, including finalization of the supervisory framework for large exposures and capital treatment of banks’ investments in equity of funds and back-up lines to funds.

• Refining proposed minimum standards on haircut practices in securities financing transactions.

• Continued review of securitization markets, in collaboration with IOSCO and other standard-setting bodies, to address regulatory impediments in order to foster the resumption order securitization markets.

• Developing standards and processes for data collection and aggregation at the global level on securities financing markets.

• Developing an information-sharing process for the high-level policy framework for other shadow banking entities and activities.
• Activating policy frameworks through the adoption of an implementation timetable, taking into account market conditions as well as the need for regulatory authorities and market participants to adjust their systems and controls.
• Monitoring the implementation of policy recommendations.

In the United States, Federal Reserve Governor Tarullo has urged regulators to continue to seek the policy consensus that must precede the creation of a comprehensive response to risks in the shadow banking system. At the same time, he has continued to advocate for short-term reforms in three of the areas discussed above - greater transparency, money market fund regulatory reform, and enhancement of the tri-party repurchase agreement framework. In the medium term, Governor Tarullo has stressed that a broader reform agenda will need to address the fact that there is little constraint on the use of leverage in some key types of shadow banking transactions. Governor Tarullo has suggested that one way to address these issues is through proposals for haircut and margin requirements that would be uniformly applied across a range of markets, including OTC derivatives, repurchase agreements, and securities lending.

In addition, as explained above, the SEC requested public comments on the OFR Study, possibly signaling its intention to focus on risks created by asset management firms’ involvement in the shadow banking sector.

¹ As an example, the OFR Report describes funds that can be close substitutes for money-like liabilities created by banks. The OFR Report states that the diversity of asset management activities and the vulnerabilities they may create, either separately or in combination, has attracted attention to the potential implications of these activities for financial stability.

² During the rest of 2013 and 2014, the BCBS intends to finalize its proposed regulatory framework for banks’ large exposures, finalize its proposed capital treatment for banks’ investments in the equity of funds, review the capital treatment of back-up lines to funds, and complete work on the scope of prudential consolidation.

³ For a detailed discussion of the SEC’s proposal, see “SEC Proposes Money Market Fund Reform” (June 11, 2013).

⁴ In 2014, IOSCO plans to undertake a peer review to assess the implementation of incentive approaches in its member jurisdictions, the results of which will be reported to the FSB.

⁵ The FSB expects to complete its work on these proposed recommendations by the spring of 2014.

⁶ One area that Governor Tarullo has repeatedly highlighted as an area of concern is the tri-party repo market. Governor Tarullo has noted that an industry-led taskforce established in 2009 orchestrated the implementation of some important improvements to the settlement process, including pushing the daily “unwind” of repo trades to later in the day, developing new tools for better intraday collateral management, and implementing an improved confirmation process. The Federal Reserve has also pressed for further action not only by the clearing banks which manage the settlement process, but also by the dealer affiliates of bank holding companies which are the clearing banks’ largest customers for tri-party repo transactions.