In brief
Written by Partner Karla Fraser, Managing Associate Nick Church and Associate Gabriela Wilson
Plenty of attention has been lavished on the shadow banking sector ever since its vulnerabilities were brought to the fore in the GFC of 2007. Since then, the Financial Stability Board, a global body working with national regulators across the G20, has been working to develop a policy framework which mitigates its systemic risks while simultaneously preserving its benefits (such as the provision of alternative sources of funding and the creation of competition, innovation and efficiency). In this article, we take a look at international developments in shadow banking and the Financial Stability Board's proposed regulatory response. Against this backdrop, we assess the state of the Australian shadow banking market to make sense of the Reserve Bank of Australia and the Australian Prudential Regulatory Authority's policy proposals so far.
International shadow banking developments
The Financial Stability Board (FSB) defines shadow banking as 'credit intermediation involving entities and activities outside the regular banking system'. The FSB's annual shadow banking monitoring report, which examines trends in 25 jurisdictions (including Australia), shows that movements in shadow banking are largely cyclical.
The FSB is of the view that shadow banking tends to reinforce the peaks and troughs of economic cycles, thereby creating systemic risk which could potentially feedback to the prudentially regulated sector. The FSB has been keen to develop a policy framework that mitigates the spill-over effect between the regulated and unregulated sectors. While it is essential that any such framework be applied across different jurisdictions to reduce the potential for regulatory arbitrage, it must nevertheless be noted that there are large variations in shadow banking trends across different markets. As such, the FSB has sought to give each national regulator the discretion to adopt its recommended policies as they see fit. The focus of the FSB's policy framework is to identify those shadow banking institutions that, in performing bank-like functions, undertake similar risks as traditional banks (such as liquidity and maturity transformation, leverage and imperfect risk transfer) and to bring them within a framework of prudential regulation that mitigates systemic risk and reduces the scope for regulatory arbitrage.
The economic functions served by shadow banking entities, the risks inherent in them and the potential policy tools to mitigate these risks are summarised below.
Management of collective investment vehicles (CIVs). In times of financial stress, CIVs with illiquid portfolios and low-risk investment objectives may face runs as capital shifts to higher quality and more liquid assets. CIVs may also be subject to roll-over risk, especially if invested in long term and more complex financial instruments. Tools that regulate the ability of investments to be redeemed (such as redemption gates, suspension of redemptions and redemption fees) may help reduce the risk of runs. Liquidity requirements and restrictions on the average maturity of portfolio assets could regulate the level of liquidity and maturity transformation undertaken by CIVs.
Loan provision that is dependent on short-term funding. Where shadow bank entities that provide loans are heavily dependent on wholesale funding or short-term bank commitment lines, they engage in maturity transformation and are vulnerable to runs. To guard against these risks, liquidity buffers, leverage limits and capital requirements may be put in place. Concentration limits on particular lenders, sectors or instruments can also help mitigate the risks arising from liquidity and maturity transformation.
Intermediation of market activities. This may include securities brokering services and prime brokerage services to hedge funds. Where shadow bank entities rely on funding that deploys client assets, they undertake an economically similar activity to that of banks' redeployment of deposits into long-term assets (thus engaging in maturity transformation). Liquidity requirements can help ensure that shadow bank entities have sufficient liquid assets to withstand runs and capital buffers can help mitigate the risks of high leverage. Restrictions on the hypothecation of client assets, so that they can only be used to fund long positions or cover short positions (and not to fund the entities' own activities) can help counteract the risks of maturity and liquidity transformation.
Facilitation of credit creation. The provision of credit enhancements may take the form of insurance on financial products or mortgages. Such credit creation can lead to excessive leverage, greater risk taking and inappropriate risk pricing. Liquidity buffers and capital requirements can help withstand runs, satisfy insurance liabilities and absorb losses. Capital requirements also help encourage entities to price their products in direct proportion to the risk they take and thus help reduce leverage.
Securistiation-based credit intermediation. Banks may use the securitisation-based funding provided by non-bank entities for warehousing purposes and to reduce their capital requirements in bank regulation. This form of regulatory arbitrage creates a level of interconnectedness between the prudentially regulated banking sector and the shadow banking sector that can create systemic risks. Where short-term securitisation funding is used to fund long-term and illiquid assets, the risks inherent in liquidity and maturity transformation also become prevalent. These risks can be mitigated by restrictions on liquidity and maturity transformation.
The Australian perspective
Against this international context, the shadow banking sector in Australia is comparatively small. The Australian shadow banking system peaked at slightly less than A$900 billion worth of financial system assets in mid-2007 and has fallen drastically since then to approximately A$500 billion. This is roughly one tenth of the size of the prudentially regulated sector. In the rest of this article, we take a look at the shadow banking entities present in Australia, the risks they pose, and the regulatory responses so far. We then use this review of recent Australian shadow banking history, along with the recently released Financial System Inquiry's (FSI) interim report, as a gauge to determine if more stringent regulation is likely.
Registered Financial Corporations (RCFs)
RCFs, which include finance companies and money market corporations (MMCs), intermediate between lenders and borrowers in much the same way as banks. They therefore fall within the 'intermediation of market activities' function outlined above. Currently, there are approximately 300 RCFs which in aggregate account for a very small and declining portion of total domestic financial system assets.
MMCs obtain a large part of their funding from short-term wholesale markets (repos) and related parties. The source of funding for finance companies varies but some make use of wholesale funding. In many cases, funding sources are highly concentrated. In theory therefore, these RCFs are, much like banks, subject to runs and other risks associated with liquidity and maturity transformation. Reliance on related parties and concentration on certain sectors or lenders have the potential to magnify cyclical effects, thereby creating greater volatility. Nevertheless, RCFs are deemed by the Reserve Bank Australia (RBA) to pose little threat to economic stability due to their small size and limited credit and funding links to the prudentially regulated sector.
The failure in late 2012 of Banksia Securities Limited, an Australian retail debenture issuer and property lender, has focused attention on the financial positions of retail debenture issuers. However, given that retail debenture issuers account for a very small component of the Australian financial system, the regulatory focus has been on investor protection (with the Australian Securities and Investments Commission (ASIC) calling for minimum capital and liquidity requirements and increased monitoring obligations) rather financial stability.
Investment funds
Investment funds include money market funds (MMFs) and hedge funds and fall within the 'management of collective investment vehicles' and 'intermediation of market activities' functions outlined above. Together, MMFs and hedge funds accounted for approximately 6 per cent of financial system assets as of September 2011. Most investment funds are equity funds and are therefore not considered to be part of the shadow banking sector. MMFs, at ½ per cent of financial system assets, are uncommon in Australia and thus deemed too small to pose any systemic risk. While they engage in credit intermediation, they do not engage in maturity transformation. Moreover, as Luci Ellis, the head of financial stability at the RBA has pointed out, Australian MMFs are not, like their US counterparts, subject to runs. 'If you become illiquid, you have to freeze under the Corporations Act' she told the Thomson Reuters 2nd Australian Regulatory Summit. 'The [Australian] system worked [during the GFC] because you couldn't get a run going… because the Act says you can't offer instant liquidity if you are not a deposit[-taking entity].' For this reason, Australian investment funds do not pose the same systemic risks inherent in other CIVs.
Securitisation Vehicles
Securitisation, which falls under the 'securitisation-based credit intermediation' category, above, has been the main driver behind the shadow banking sector in the lead up to the GFC. Residential mortgage backed securities (RMBS) grew at a quick pace throughout the 1990s and into the 2000s and was supported structurally by lower inflation and interest rates which in turn led to lower debt servicing costs. The rate of growth fell during the GFC but subsequently picked up in 2013. RMBS are closely linked to authorised deposit-taking institutions (ADIs), as securitisation has been an essential source of funding for housing credit. However, this interconnectedness has not posed the same systemic risks as it did overseas, as the underlying assets of RMBS tend to be high-quality, prime mortgages. Moreover, few securitisations by Australian entities involve anywhere near the same degree of structural complexity as their overseas counterparts. Liquidity and maturity transformation is therefore more muted.
In May 2014, the Australian Prudential Regulatory Authority (APRA) released a discussion paper proposing that capital relief for securitisation vehicles engaged in warehouse funding be limited to 12 months. In a surprising move, APRA stated that it intended this reform to apply to both ADI and shadow banking securitisation vehicles. This is the most recent imposition of regulation on the shadow banking sector and appears to be an anomaly against the RBA and APRA's general reluctance to interfere in a relatively small sector of the Australian financial system. It should be noted, however, that warehousing arrangements are an exception to the general premise of traditional securitisations, namely, that the term of funding matches the term of the underlying asset. Moreover, ADI and non-ADI warehouse funding providers alike may not be able to control when a term securitisation is possible in the market. This makes them susceptible to rollover risks where a term issue does not occur prior to the expiry of the warehouse and can lead to capital leakage. The risks posed by maturity transformation and capital leakage, together the interconnection between shadow-bank securitisation vehicles and ADIs, seem to have tipped the scales in the favour of limited regulation. Indeed, the interconnectedness between shadow banking securitisation vehicles and ADIs may increase in the near future – the interim report canvassed the idea of allowing RMBS to be treated as a high quality liquid asset for the purpose of ADIs' liquidity coverage ratio. This should increase the appetite of ADIs for RMBS.
The future of regulation
Against this backdrop, it is possible to glean some indication of the future of shadow banking regulation in Australia. In their submission to the FSI, a number of banks made it clear that they considered regulation of shadow banks to be a structural priority. However, the actions of the RBA and APRA so far seem to imply that the size, characteristics and structure of the shadow banking sector in Australia do not generally warrant heavy regulation, if any at all. The absence of substantive discussion about the shadow banking sector in its interim report seems to suggest that the FSI is of the same view. The Inquiry did, however, acknowledge that the sector was a significant, albeit small, source of systemic risk that needs to be closely monitored. It also sought views on the prospect of bringing certain designated shadow banking entities within the purview of APRA's oversight in limited circumstances.
On balance, significant regulation of shadow banks is unlikely. Monitoring frameworks aimed at addressing the lack of transparency and relevant data in the shadow banking sector are more likely prospects. To the extent that regulation is recommended in FSI's final report, it is likely to be bespoke and targeted at the particular subset of the shadow banking sector thought to pose risks (for example, limited regulation of securitisation vehicles). In any event, it is improbable that shadow banking regulation in Australia will be as stringent as in foreign jurisdictions where shadow banking represents a much greater market share.