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Financial regulations 29 Jun 2017

Shadow banking amounts to nearly three times the GDP of the European Union

The digital transformation of financial services is expanding the concept and business of shadow banking — broadly defined as “credit intermediation involving entities and activities (fully or partially) outside the regular banking system”—, according to the Financial Stability Board (FSB), the international body that monitors the stability of the global financial system.

Activities as well established and useful as crowdfunding can be included in this category. The European Systemic Risk Board (ESRB), which is in charge of macro-prudential oversight of the EU financial system and the prevention and mitigation of systemic risk, estimates that the sector represents 38% of the EU financial sector’s total assets, or 272% of the EU’s GDP at the end of 2016.

As it is clear that shadow banking is on the rise, the main challenge lies in shedding light through regulation and adequate supervision to find “the optimal balance between maximizing the benefits and minimizing the adverse consequences from financial instability and regulatory arbitrage,” according to BBVA Research.

The ESRB’s May 2017 EU Shadow Banking report estimated that parallel banking in the European Union amounted to €40 billion at the end of the fourth quarter of 2016. The latest report published by the FSB on shadow banking in the world (Global Shadow Banking Monitoring Report) estimates that parallel banking activity added up to €34 billion last year – a 3.2% annual increase. This represents 13% of the financial system’s total assets and 70% of the GDP in the jurisdictions where it exists.

BBVA Research’s Digital Economy Outlook from January 2017 reported that: “Shadow banking can be a useful tool for helping the banking sector in the provision of credit, especially in Europe, where approximately two-thirds of funding depends on banks”. In this regard, the report underscores that: “Non-banking funding can also contribute to facilitating market liquidity and risk sharing and to fostering competition and innovation through the support of new ideas and projects.”

BBVA Research: Shadow banking can be a useful tool for helping the banking sector in the provision of credit, especially in Europe”

Similarly, FSB Chair Mark Carney says that: “Market-based finance provides important diversification of the funding sources which support the real economy.”

What should be the focus, then? On regulation and supervision. In BBVA Research’s view, “If shadow banking is not appropriately regulated and supervised, it could raise the systemic risk due to its interconnections with different actors in the financial system, especially in the banking sector.” This risk of interconnection among banking institutions and credit institutions is one of the warnings issued by the ESRB. In its opinion, heterogeneous regulation and the lack of information hinder systemic oversight of the risk of these connections and lead to a situation where the rules are not the same for everyone, with some actors having an advantage over others. An extra effort is needed to compile data related to parallel banking, the body indicates.

The letter the FSB Chair sent to the G20 finance ministers and central bank governors prior to their meeting in Germany indicated that after completing the road map of shadow banking, the FSB had not identified new parallel banking risks that require additional regulatory measures on a global scale. However, given that new forms of parallel banking would likely be developed in the future, FSB authorities should maintain and continue investing in an effective and permanent program for oversight, data sharing and analysis to support any judgments on any regulatory response required in the future.

BBVA Research: If shadow banking is not appropriately regulated and supervised, non-banking funding could contribute to raising the systemic risk”

The fact that this alternative banking is based on digital financial services does not help its regulation. In fact, the problems with fraud and the cyberattacks experienced by some P2P platforms should be addressed by regulatory bodies, BBVA Research indicates in its report, “providing a comprehensive framework for the development of these shadow banking activities, and allowing the development of instruments that can contribute to maximizing the advantages of digital shadow banking while minimizing its inconveniences.”ºº

The goal of this regulation would be to guarantee financial stability and promote a uniform framework in which the same risks are regulated in the same manner for all players. This would increase consumer protection. Consumers would be able to take advantage of improved efficiency and access a wider and more competitive range of services.  And financial institutions could strengthen their innovation projects and learn more quickly, BBVA Research concludes.

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