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World leaders to put shadow banks on long leash

Sunday, 25 Aug 2013 | 7:40 PM ET
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World leaders are expected to take a softly-softly approach to regulating the so-called shadow banking sector when they meet in Russia next month to avoid damaging the flow of finance to the global economy.

While governments have cracked down on risk-taking by traditional banks in the wake of the financial crisis, the shadow banking sector, an assortment of financial intermediaries that handle $60 trillion of transactions a year - roughly the same size as the world economy - remains a source of systemic risk for taxpayers.

Such intermediaries, which include hedge funds, money market funds and structured investment vehicles, provide credit to the financial sector, but, unlike banks, have no access to central bank support or safeguards such as deposit insurance and debt guarantees.

(Read more: What the G20 Need to Talk About This Week)

They often rely on short-term funding sources, such as the repurchase or repo market, in which borrowers sell the lender a security as collateral and agree to buy it back later at a set time and price.

At their meeting on Sept. 5-6 the Group of 20 economies (G20) will endorse reforms but stop short of rushing through far-reaching changes because of the role shadow banking activities play in providing liquidity to the still fragile banking sector, according to people familiar with the G20's work.

Banks' use of off-balance-sheet vehicles to repackage and sell on U.S. subprime mortgages kick started the financial crisis in 2007, but such shadow banking activity, known as secularization, is viewed as key to helping wean banks off central bank money and fund themselves.

"There is a fuss about this because the crisis of 2008 was essentially a shadow banking crisis, as most of the lending in the United States and UK was financed through short-term repo," said Alistair Milne, professor of financial economics at Loughborough University.

(Read more: G-20 finance ministers try to avoid market turmoil)

"The shadow banking reform is more about not getting into trouble in the future, so they can take a bit more time," added Milne, a former Bank of England and UK Treasury official.

Regulators pushed through a new regulatory regime for traditional banks - the Basel III framework, which forces them to hold more capital - in record time.

There is growing appreciation at the G20 that unlike action on banks, which targeted the institutions themselves, reform of the more complex shadow banking world should be focused on activities.

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"Just increasing capital won't work in most cases because it's not about entities, but mostly about markets, interlinked transactions and networks," said Andres Portilla, director of regulatory affairs at the Institute of International Finance, a banking and insurance lobby in Washington.

Lobbying has already been intense on the sidelines.

Hedge funds and large money market funds and securities lenders like BlackRock insist they did not play a central role in the crisis. They even object to the term shadow banking, which they consider pejorative, with BlackRock suggesting "market finance" as an alternative.

No "hit list"

The G20 has drawn up a list of top global "systemic" banks and insurers who must hold more capital because their size and complexity could lead to market mayhem if they were to fail.

(Read more: G-20 backs key corporation tax reforms)

Regulators in Britain have already collected data on hedge funds and found so far that none is systemic.

People familiar with the G20 work said the summit won't pursue a "hit list" approach in shadow banking but likely endorse a broad supervisory framework with optional tools to stop the sector undermining financial stability.

Hedge funds and broker-dealers who become excessively leveraged using the repo markets will be a key target.

While top firms will be relieved they won't be singled out, the G20 is likely to brush aside their opposition to a requirement for them to apply a minimum discount - or "haircut" - on the value of collateral they take to cover securities lending and repos.

The aim of this first global rule is to ensure that the collateral taken provides a big enough safety cushion if market valuations plunge.

(Read more: G20 backs fundamental reform of corporate taxation)

The International Securities Lending Association (ISLA) is opposed, saying it could disrupt trading, while BlackRock says mandatory haircuts would likely exacerbate market moves.

The G20 may tread carefully by leaving the door open to refinements through a public consultation and promises to gather more data on possible impact before finalizing the new rule.

IIF's Portilla said the proposal would reignite debate about possible shortages of collateral such as top quality bonds and cash due to the combined effect of all the G20's new rules.

Separately, the European Union will publish a draft law on Sept. 4 to reform money market funds in the 28-country bloc based on work done by G20 regulators, following on from similar steps announced by the United States.

The EU is set to propose capital requirements on some types of money market funds, going further than the United States.

Both sides of the Atlantic have already approved tougher rules on secularization activity, which remains moribund since the crisis, prompting the G20 to shift its focus to how such a key method for funding banks can be revived safely.

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