Download - Promoting risk mitigation, not migration: a comparative analysis of shadow banking reforms by the FSB, USA and EU

Promoting risk mitigation, not migration: acomparative analysis of shadow bankingreforms by the FSB, USA and EUEdward F. Greene and Elizabeth L. Broomfield*

‘When you light a candle, you also cast a shadow.’

—Ursula K. Le Guin

1. Introduction

The onset of the financial crisis in late 2007–2008 quickly led to the recognition that the

regulatory framework governing banks had significant weaknesses. Over time, greater

Key points

� In the aftermath of the financial crisis, there has been an unfortunate default to bank prudential

regulation for ‘shadow banking’ entities.

� Shadow banking reform efforts have unduly emphasized the identification and regulation of non-bank

entities, instead of a more constructive focus on their activities.

� Efforts to regulate shadow banking, particularly in the USA, too often subject diverse entities to a ‘one

size fits all’ regulatory approach, ignoring the different causes of risk, and further complicating legal

obligations for entities that are often already subject to other complex regulatory regimes.

� Alternatives to prudential regulation, such as non-regulatory and conduct-of-business tools, as well as

improved disclosure requirements, are regrettably absent in the efforts to date of the Financial Stability

Board (FSB), USA and EU.

� While the FSB and EU have initiated their shadow banking reform efforts by first addressing shadow

banking at the macro level, the USA reforms have focused on non-bank systemic entities and activities

and avoided the term and concept of ‘shadow banking’.

� Although the FSB, USA and EU have taken positive steps to address the interconnectivity of regulated

commercial banks and non-bank institutions, international coordination and carefully tailored rules

are key to preventing the movement of risk outside the regulated banks to the more opaque shadow

banking sector.

� Despite US and EU reform efforts, money market mutual funds (MMFs) remain vulnerable and highly

responsive to market shocks. Still, any proposal to strengthen MMF resiliency must target the primary

cause of the 2008 run—first-mover advantage and shareholder incentive to redeem.

*Edward F Greene is Senior Counsel in the New York office of Cleary Gottlieb Steen & Hamilton LLP. Mr Greene served as General

Counsel of the Securities and Exchange Commission from 1981 to 1982 and Director of the Division of Corporation Finance from

1979 to 1981. From 2004 to 2008, Mr Greene served as General Counsel of Citigroup’s Institutional Clients Group. Elizabeth L

Broomfield is an associate in the New York office of Cleary Gottlieb Steen & Hamilton LLP. Ms Broomfield graduated from Yale

University in 2008, where she double majored in Electrical Engineering and Ethics, Politics, and Economics. She completed a JD degree

in 2011 from Columbia Law School, where she was a James Kent Scholar, recipient of the Parker School Certificate in Foreign and

Comparative Law, and law clerk at the Securities and Exchange Commission. She simultaneously completed an LLM in International

Business Law with Distinction from the London School of Economics as part of Columbia Law School’s JD/LLM program.

6 Capital Markets Law Journal, Vol. 8, No. 1

� The Author(s) (2013). Published by Oxford University Press. All rights reserved. For Permissions, please email: [email protected]

doi:10.1093/cmlj/kms065 Accepted 10 December 2012

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scrutiny of the financial sector not only revealed that non-bank financial institutions and

financial activity outside the scope of banking regulation posed significant systemic risk,

but also that they lacked adequate regulatory oversight. As a result, the focus of financial

regulatory reform now encompasses these non-bank financial entities and activities, often

referred to as the ‘shadow banking system’.

Prior to the financial crisis, the shadow banking system was subject to much lighter

government oversight and regulation when compared with the banking sector.1 Although

entities such as money market mutual funds (MMFs), other mutual funds and special

purpose vehicles (SPVs) engaged in activities analogous to traditional bank deposit-

taking and lending, they were not subject to similar prudential regulations; it was believed

that such activities did not pose systemic risk to the financial system. This long-held

assumption proved inaccurate in 2008; vulnerabilities in the shadow banking system led

to asset fire sales, depressed market prices and significant losses on the balance sheets of

multiple bank and non-bank entities, which in turn triggered cascading insolvencies

throughout the financial system. To stem this tide of failures, the Federal Reserve Board

(FRB) was forced to extend its role as lender of last resort, typically only available for

commercial banks and other savings institutions, to some of these shadow banking

entities. Yet despite the extraordinary actions taken by the US government and its

counterparts across the globe, the ripple-effects of the 2008 financial system collapse

continue to this day.

Almost half a decade after the onset of the financial crisis, the efforts of national and

international bodies to address systemic vulnerabilities generated by the shadow banking

system are still in their early stages. The Financial Stability Board (FSB), pursuant to its

mandate from the G20, created five workstreams in 2011 to make recommendations with

respect to the entities and activities involved, and committed to release an annual

assessment of the shadow banking system. The FSB’s initial findings pursuant to these

workstreams have been released periodically throughout 2012. The USA finalized rules

covering the designation of non-bank systemically important financial institutions (non-

bank SIFIs) in mid-2012, although it has not yet designated any non-bank SIFIs and the

proposed rules applicable to these entities have not yet been finalized. The European

Union (EU) released a consultation paper on shadow banking in mid-2012, with

comments already due on 1 June 2012.2

The year 2013 is likely to be a watershed time in the development of shadow banking

oversight and regulation. The FSB has commenced public consultations on its initial

recommendations, together with a quantitative assessment of its proposals. Final

recommendations are scheduled to be released in September 2013. The USA will soon

begin designating its first non-bank SIFIs and will clarify its plans for regulating such

1 See ‘Financial Crisis Inquiry Report’ (January 2011)5http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf4 (‘FCIC

Report’).

2 European Commission, ‘Green Paper Shadow Banking’ (March 2012) 5http://ec.europa.eu/internal_market/bank/docs/sha

dow/green-paper_en.pdf4 (‘EU Green Paper’).

Edward F. Greene and Elizabeth L. Broomfield � Shadow Banking Reforms by the FSB, USA and EU 7

http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf

http://ec.europa.eu/internal_market/bank/docs/shadow/green-paper_en.pdf

http://ec.europa.eu/internal_market/bank/docs/shadow/green-paper_en.pdf

entities in practice. The European Systemic Risk Board (ESRB) is preparing to recom-

mend shadow banking oversight changes in early 2013.3

It is therefore an appropriate time to pause and re-evaluate the steps that have been

taken thus far to address shadow banking at a national and global level. It has been over

two years since the G20 recognized the possibility that ‘regulatory gaps may emerge in the

shadow banking system’ and called upon the FSB to ‘to work in collaboration with other

international standard setting bodies to develop recommendations to strengthen the

regulation and oversight of the shadow banking system’.

We begin by examining the framework established by the FSB to meet its G20

mandate, focusing on the five shadow banking workstreams that have formed the

foundation for the FSB’s research and proposals on shadow banking. We then use this

FSB framework to analyse and compare the high-level strategies of the USA and EU

towards shadow banking.

We find that, particularly in the USA, there has been an undue focus on identifying

entities operating in the non-bank financial sector and a default to bank prudential

regulation for those entities deemed to pose significant risk to the US financial system.

This default to a safety and soundness regulatory approach disregards other options

available for risk mitigation in the shadow banking sector. Moreover, it subjects diverse

entities to a ‘one-size-fits-all’ regulatory approach, ignoring the different causes of risk,

and also further complicating legal obligations for entities that are often already subject to

other complex regulatory regimes. The consequence may be to potentially force risk

migration rather than mitigation. We therefore expand upon the recent Institute of

International Finance (IIF) recommendations to advocate increased analysis of shadow

banking activities, instead of defaulting to an entity-based strategy imposing bank-like

regulation.4 This approach, recently reflected by the FSB in its November 2012 release on

oversight of shadow banking entities (other than MMFs), allows for more effective

identification of the sources of risk, greater uniformity in cross-border application of

proposed reforms and more flexibility in addressing financial innovation.5

We then examine two fiercely debated FSB workstreams: indirect regulation targeting

bank interconnectedness and exposure to the shadow banking system and the proposed

reforms of money market funds in the USA, EU and at the FSB. Both workstreams

demonstrate the importance of tailored solutions that target the activities which create

risk, rather than the application of uniform rules to shadow banking entities that ignore

their unique characteristics, risk profiles and existing regulation.

3 J Brunsden and R Christie, ‘ESRB Aims for EU Shadow Banking Proposals in Early 2013’ Bloomberg (September 2012)

5http://www.bloomberg.com/news/2012-09-12/esrb-aims-for-eu-shadow-banking-proposals-in-early-2013.html4.

4 EF Greene, co-author of this article, is Chair of the IIF Shadow Banking Advisory Group and involved in the creation of the IIF

Report. Institute of International Finance, ‘Shadow Banking: A Forward-Looking Framework for Effective Policy’ (June 2012)

5http://www.iif.com/download.php?id¼aYFmUgfMDbA¼4 (‘IIF Report’).

5 Financial Stability Board, ‘Policy Framework for Strengthening Oversight and Regulation of Shadow Banking Entities’

(November 2012) 5http://www.financialstabilityboard.org/publications/r_121118a.pdf4 (‘FSB Nov 2012 Report on Shadow

Banking Entities’).

8 Capital Markets Law Journal, 2013, Vol. 8, No. 1

http://www.bloomberg.com/news/2012-09-12/esrb-aims-for-eu-shadow-banking-proposals-in-early-2013.html

http://www.iif.com/download.php?id=aYFmUgfMDbA=

http://www.iif.com/download.php?id=aYFmUgfMDbA=

http://www.financialstabilityboard.org/publications/r_121118a.pdf

2. Background on shadow banking

Before analysing approaches to improve oversight of the shadow banking system, it is

essential to examine the origins of the concept as well as its benefits and costs.

Definition

The origin of the term ‘shadow banking’ is widely attributed to economist and investment

manager Paul McCulley, who used it to refer to ‘the whole alphabet soup of levered up

non-bank investment conduits, vehicles, and structures’.6 Shadow banking has since been

redefined and expanded by numerous commentators. Many have found the term

synonymous with ‘market-based finance’ or ‘market-based credit’. Supporters of the

shadow banking system often prefer these terms to ‘shadow banking’, which they view as

pejorative; to operate in the shadows clearly implies inappropriate behaviour. As will be

discussed below, the FSB nevertheless uses the term ‘shadow banking’ and defines it as

‘credit intermediation involving entities and activities outside the regular banking system’.7

Although shadow banking remains an imprecise term, there is a general consensus that

the shadow banking system consists of markets and institutions that engage in credit

intermediation both in conjunction with, and parallel to, regulated banks. Like

conventional banks, shadow banking entities generate credit through maturity trans-

formation (use of short-term funding to finance longer-term assets) and liquidity

transformation (use of liquid instruments to fund more illiquid assets). However,

conventional banks have traditionally engaged in maturity transformation by using their

short-term insured deposits to fund longer-term loans. Shadow banking entities such as

structured investment vehicles (SIVs), hedge funds, dealers and conduits also finance

long-term assets with short-term funding, but through channels other than insured

deposits. These channels include activities involving securitization, securities lending and

repos, all of which facilitate credit intermediation by both banks and non-bank financial

entities. For example, a securities dealer may effectively re-invest a ‘deposit’ of a client by

re-hypothecating the client’s cash or securities to make an investment return for itself.

Short-term funding from asset-backed commercial paper (ABCP), the tri-party repo

system and customer balances in prime brokerage accounts have also been employed to

fund longer-term assets. Although often referred to as a ‘parallel’ system of banking

(which calls to mind a system running alongside, but never touching, the regulated

banks), these activities also increase the linkages between commercial banks; for example,

shadow banking entities, such as broker-dealer subsidiaries of commercial banks, often

6 P McCulley, ‘Teton Reflections: PIMCO Global Central Bank Focus’ PIMCO (September 2007) 5http://www.pimco.com/

EN/Insights/Pages/GCBF%20August-%20September%202007.aspx4.

7 Numerous other definitions of shadow banking exist. Boston College finance professor Ed Kane essentially defines shadow

banks as entities that have persuaded their customers that they will be bailed out if necessary by a government—even though they

are not formally protected by government guarantees. See Edward J. Kane, ‘The Inevitability of Shadowy Banking’ (April 2012)

5http://www.frbatlanta.org/documents/news/conferences/12fmc/12fmc_kane.pdf4. New York University professor Viral Acharya,

even argues that governments themselves are shadow banks, on the basis that ‘by allowing excessive competition, providing

downside guarantees and encouraging risky lending for populist schemes, governments can create periods of intense economic

activity fueled by credit booms’. See Viral V Acharya, ‘Governments as Shadow Banks: The Looming Threat to Financial Stability’

(2012)5http://pages.stern.nyu.edu/�sternfin/vacharya/public_html/Acharya.A3Edit.pdf4.


http://www.pimco.com/ EN/Insights/Pages/GCBF20August-20September202007.aspx

http://www.pimco.com/ EN/Insights/Pages/GCBF20August-20September202007.aspx

http://www.frbatlanta.org/documents/news/conferences/12fmc/12fmc_kane.pdf

http://pages.stern.nyu.edu/sternfin/vacharya/public_html/Acharya.A3Edit.pdf

http://pages.stern.nyu.edu/sternfin/vacharya/public_html/Acharya.A3Edit.pdf

act as prime brokers to hedge funds, while other entities (such as MMFs) provide

liquidity to commercial banks by purchasing their commercial paper.

Similarities between the regulated bank and shadow banking systems are evident in

times of crisis; stressed markets can trigger investor runs on both conventional banks and

shadow banking entities. In traditional banks, investors withdraw their deposits. In the

shadow banking system, investors withdraw from funds such as MMFs and both retail

and wholesale borrowers face increased haircuts on collateral for overnight loans in the

repo market. In both systems, these investor runs can set off a crash because of the

contagion that can result.

While there are numerous analogies between shadow banking and traditional banking,

shadow banking lacks the regulatory backstops that support traditional banks and stem

the risk of runs: deposit insurance and access to central bank funding to ensure liquidity.

While this government support can ease the concerns of wary bank investors and prevent

massive withdrawals, no such backstops currently exist for the shadow banking system,

which has no lender of last resort. The result was instability during the 2008 financial

crisis that eventually forced governments to extend central bank support to these non-

bank entities, in particular MMFs.

In the decade prior to the financial crisis, the size of the shadow banking system grew

exponentially, from $26 trillion in 2002 to $62 trillion in 2007.8 Although the total

declined to $56 trillion in 2008, by 2011 the system reached $67 trillion, surpassing its

pre-recession height. In the USA alone, the shadow banking sector consisted of an

estimated $25 trillion in assets in 2007 and $23 trillion in 2011. In broad terms, the

aggregate size of the shadow banking system in terms of assets is approximately half the

size of the regulated banking system and accounts for roughly 25 per cent of total global

financial intermediation. Although definitional inconsistencies complicate such com-

parative and cumulative studies, it is clear that the shadow banking system is enormous

and a key component of the financial system. Furthermore, shadow banking is expected

to expand even further in light of the new banking capital and activity restrictions

imposed in the wake of the crisis.

History

Though ‘shadow banking’ has only recently entered the popular lexicon, the concept is

almost as old as that of the insured, highly regulated modern banking system. The

unregulated nineteenth-century US banking system was prone to runs due to its use of

short-term deposits to fund longer-term loans.9 Because not enough cash was maintained

to honour all deposit redemptions simultaneously, the mere rumour of instability could

spur runs. To stabilize financial markets, Congress created the Federal Reserve System in

8 Financial Stability Board, ‘Global Shadow Banking Monitoring Report’ (November 2012)5http://www.financialstabilityboard.

org/publications/r_121118c.pdf4 (‘FSB 2012 Monitoring Report’).

9 Runs were common before the Civil War and then occurred in 1873, 1884, 1890, 1893, and 1907. See, eg C Calomiris, ‘Bank

Failures in Theory and History: The Great Depression and Other ‘Contagious’ Events’, National Bureau of Economic Research

(November 2007)5http://homepage.ntu.edu.tw/�nankuang/Bank%20Failures%20in%20Theory%20and%20History.pdf4.


http://www.financialstabilityboard.org/publications/r_121118c.pdf


http://homepage.ntu.edu.tw/nankuang/Bank20Failures20in20Theory20and20History.pdf

http://homepage.ntu.edu.tw/nankuang/Bank20Failures20in20Theory20and20History.pdf

1913, which acted as the lender of last resort to banks. Over time, deposit insurance and

prudential regulation developed to further stabilize regulated banks.

This insured banking system came with a cost—while prudential laws such as interest

rate caps on deposits and capital requirements were designed to make banks safer, these

constraints simultaneously eroded the competitive position of these insured banks.

Through innovation and arbitrage to avoid the applicability of banking laws, a

complicated network of shadow banking funding activities—repo, securities lending,

securitization, purchases and sales of commercial paper—connected money market

funds, investment bank broker–dealers, asset managers and hedge funds to each other

and to the regulated banks. While this new ‘shadow banking system’ was interconnected

with the bank regulatory structure, relatively few restrictions were placed on its collecting

and investing money. Regulated entities such as MMFs and securities firms were more

often subject to laws focused more on investor disclosure and understanding than on

safety and soundness.

Traditional banks were often a part of these non-bank credit intermediation chains.

Banks provided financing for numerous shadow banking entities and simultaneously

received funding from them as well, most notably MMFs. At the same time, commercial

banks moved away from exclusive reliance on conventional, customer-centric banking

models to compete with the expanding shadow banking system. In particular,

securitization and off-balance sheet entities were created which helped obfuscate bank

exposure to the non-bank financial sector, allowing banks to lower their required capital

and increase leverage. The consequent build-up of risk in both regulated banks and the

shadow banking system and their interconnectivity culminated in the 2008 global

financial crisis.

Benefits of shadow banking

Shadow banking is undoubtedly a pejorative term, implying that these actors pose

significant threats to a financial system because they operate outside an effective

supervisory spotlight. However, this negative connotation disregards the important

benefits of the system.

Additional source of funding and liquidity

As stated by the FSB, entities and activities in the shadow banking system ‘create

additional sources of funding and offer investors alternatives to bank deposits’. This

feature of shadow banking was one reason that expansion of the shadow banking system

was sometimes encouraged by regulators, who viewed the system as a way to expand

access to credit without risk to the insured banks.10 For example, MMFs are key investors

in commercial paper, providing additional financing to both financial institutions and

non-financial companies that rely on short-term debt for funding. Securities lending

10 See eg FCIC Report (n 1) (‘Fed Chairman Greenspan and many other regulators and legislators supported and encouraged this

shift toward deregulated financial markets.’).


provides lenders with an additional source of capital and enables borrowers to obtain

securities at below-market rates, thereby providing market liquidity.

Risk diversification

By creating a mixture of securities with differing risk and maturity characteristics, shadow

banking entities and techniques offer financial institutions and investors more options in

creating diversified portfolios. Securitization in particular can promote greater portfolio

diversification and efficient transfer of risk across products, borrowers and locations. The

shadow banking system also facilitates risk diversification away from the regulated

banking sector, enabling investors to benefit from multiple sources of funding and avoid

overreliance on exposure to a single entity.

Efficient channelling of resources

The specialization and expertise of numerous shadow banking entities helps to facilitate

efficient credit intermediation. MMFs, for example, provide means to invest in products

with slightly higher risk and reward profiles than traditional bank deposits while still

being deemed relatively ‘safe’ because they provide short-term credit for companies.

While investors might be able to recreate an MMF portfolio by investing in similar

low-risk, short-term assets, MMFs benefit significantly from the scale and scope of their

investing, thereby reducing costs for all MMF investors.

Risks of shadow banking

These benefits of shadow banking should not be overstated. Each of the examples

mentioned above was deemed relatively safe before 2008, but the financial crisis exposed

the hidden costs associated with each of the above advantages.11 As noted by Adair

Turner ‘the system can for a period of time appear to promise combinations of lower risk,

higher return, and greater liquidity that cannot objectively in the long term be

sustained’.12

Risk of runs

The crisis demonstrated how these bank-like activities contributed to the risk of runs on

shadow banking entities. Like conventional banks, these entities carry an asset–liability

mismatch that results from engaging in maturity and liquidity transformation. Their

relatively illiquid, long-term assets will therefore not be able to immediately satisfy all

short-term liabilities should massive redemptions occur simultaneously. In times of

market turmoil, traditional banks can address their asset–liability mismatch through

access to central bank funding and government deposit insurance. Shadow banking actors

have no such stabilizing backstops, making them heavily dependent on the constant

provision of short-term funds and, as a result, susceptible to runs.

11 For example, the susceptibility of money market funds to runs, the complexity and uncertainty arising from securities lending

in times of crisis, and the perverse incentives and regulatory arbitrage associated with securitization techniques.

12 Speech by Lord Turner, FSA Chairman at the Cass Business School, (March 2012) 5http://www.fsa.gov.

uk/static/pubs/speeches/0314-at.pdf4.


http://www.fsa.gov.uk/static/pubs/speeches/0314-at.pdf

http://www.fsa.gov.uk/static/pubs/speeches/0314-at.pdf

Linkages between the shadow banking and regulated banking sector

The shadow banking system poses a source of systemic risk, not solely through its

activities outside the regulated banking sector, but through its interaction and intercon-

nectedness with traditional commercial banks. Under times of market stress and

uncertainty, contagion may easily spread from and between the shadow banking and

regulated banking sectors. There are many channels for the transmission of contagion.

Shadow banking entities such as MMFs provide a source of funding for banks while also

borrowing directly, or receiving implicit support, from those same banks. Banks may also

be compelled to provide support for the SPVs and other off-balance-sheet entities they

are perceived to have sponsored in times of market stress either for reputational reasons

or because of funding commitments. Banks also regularly invest in products issued by

shadow banking entities, such as the top tier tranches of securitized products issued by

SIVs, often referred to as ‘super senior’. Fire sales by shadow banking entities can depress

asset prices and weaken bank balance sheets. These examples are only a few of the many

ways the shadow banking system can transmit toxicity from their balance sheets to the

regulated, ‘less risky’ commercial banks.

Opportunities for arbitrage

The interconnectivity of the shadow and regulated banking systems presents

opportunities for arbitrage by the regulated banks. These highly regulated banks can

use the shadow banking sector to take on additional risk to enhance profit and

circumvent prudential regulatory requirements designed to maintain their stability. In

particular, the use of securitization techniques to lower capital charges and comply

with the Basel rules has been well documented. For example, a key driver of the

mortgage-backed securities market was the favourable capital treatment of securitized

loans; under capital rules prior to the crisis, residential mortgage loans generally required

a higher risk weighting than packages of such loans bundled into securities. Use of

off-balance-sheet operations through SPVs, and other entities to which they were linked,

also helped banks to reduce the size of their balance sheets and to limit their mandatory

capital requirements.13 The incentive for regulatory arbitrage has only increased since the

imposition of tighter banking regulations in response to the financial crisis, which include

the higher capital and liquidity standards called for by Basel III, proposed consolidation

requirements for supported SIVs and other sponsored vehicles, and activity restrictions

such as the Volcker Rule.

Leverage

All of the techniques discussed above contributed to the build-up of high, yet

simultaneously disguised, leverage in the financial system. This procyclical build-up

of leverage led to asset bubbles; when confidence in the markets declined, as it did in

13 See eg Acharya and others, ‘Securitization Without Risk Transfer’ (2011) 5http://papers.ssrn.com/sol3/papers.

cfm?abstract_id¼13645254 (finding that 2004 changes in regulatory capital rules led to the rapid expansion of ABCP).


http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1364525



2007–2008, an abrupt deleveraging sparked fire sales, margin calls and increases in

haircuts. This problem is aggravated when both banks and non-banks invest in the same

assets and in each other.

3. ‘Shadow banking’ frameworks

In light of the benefits and risks discussed above, regulators have the unenviable task of

attempting to contain risk posed by the shadow banking sector while maintaining its

beneficial role in the creation and expansion of credit. The shadow banking system is

complex; what follows is therefore a high-level overview of the frameworks created by the

FSB (at the request of the G20) and in the USA and EU to address the risks posed by the

shadow banking sector. While the FSB and EU first sought to study the ‘shadow banking

system’ and to then create proposals for its reform, the USA took a broader view; it did

not focus on ‘shadow banking’ per se, but rather addressed the entirety of the non-bank

financial sector, of which shadow banking is a part.14

FSB

In November 2010, the G20 tasked the FSB, in collaboration with other international

standard setting bodies, to develop recommendations to strengthen the oversight and

regulation of the ‘shadow banking system’.15 In an April 2011 report, the FSB defined

shadow banking as ‘credit intermediation involving entities and activities outside the

regular banking system’.16 After ‘casting the net wide’ with this broad definition, the FSB

clarified that authorities should focus initially on risks created by maturity/liquidity

transformation, flawed credit risk transfer, leverage, or the potential for regulatory

arbitrage. In doing so, the FSB acknowledged that only certain elements of the shadow

banking system require additional oversight and regulation.

After defining its field of inquiry, the FSB released a report in October 2011, ‘Shadow

Banking: Strengthening Oversight and Regulation’ (‘October 2011 report’), that set out

high level principles for addressing shadow banking risk.17 The FSB report emphasized

that the monitoring process should be ‘targeted, proportionate, forward-looking and

adaptable, effective, and should be subject to assessment and review’. To this end,

authorities should have a system-wide oversight framework in place to gain a

comprehensive understanding of activities and entities in the shadow banking system

and of the risks they pose. The monitoring framework should identify and assess the risks

on a regular and continuous basis, with sufficient data collection authority supported by

14 This broader scope by the USA includes, eg financial market utilities such as clearing houses that are not included within FSB

and EU shadow banking initiatives.

15 The FSB publishes most of the shadow banking reports described below at the following website: 5http://www.

financialstabilityboard.org/list/fsb_publications/tid_150/index.htm4.

16 Financial Stability Board, ‘Shadow Banking: Scoping the Issues’ (April 2011) 5http://www.financialstabilityboard.org/pub

lications/r_110412a.pdf4.

17 Financial Stability Board, ‘Shadow Banking: Strengthening Oversight and Regulation’ (October 2011) 5http://www.

financialstabilityboard.org/publications/r_111027a.pdf4 (‘FSB October 2011 Report’).


http://www.financialstabilityboard.org/list/fsb_publications/tid_150/index.htm

http://www.financialstabilityboard.org/list/fsb_publications/tid_150/index.htm





cross-jurisdictional information sharing arrangements. In particular, new rules should be

mindful of opportunities and incentives for regulatory arbitrage.

The FSB’s October 2011 report also announced the creation of five workstreams to

study and recommend policy proposals related to particular aspects of shadow banking it

had identified, two focused on activities and three based on entities: (i) banks’

interactions with shadow banking entities;18 (ii) MMFs;19 (iii) shadow banking entities

other than MMFs; (iv) securitization; and (v) securities lending and repos. These

workstreams are supplemented by annual monitoring exercises of the shadow banking

system by the FSB’s Standing Committee on Assessment of Vulnerabilities (SCAV). Its

2012 exercise covered 25 jurisdictions and the euro area as a whole, encompassing 86 per

cent of global gross domestic product and 90 per cent of global financial system assets.20

The FSB released a progress report on its five workstreams in April 2012 and then an

‘integrated overview of policy recommendations’ in November 2012, with comments on

these recommendations due by 14 January 2013.21

To help it address shadow banking activities, the FSB tasked the International

Organization of Securities Commissions (IOSCO) with the securitization workstream

and created an FSB Task Force (WS5) to examine securities lending and repos. The

IOSCO Task Force on Unregulated Markets and Products, in coordination with the Basel

Committee on Banking Supervision (BCBS), published a ‘Consultation Report on Global

Developments in Securitization Regulation’ in June 2012.22 The consultation report

described the status of securitization in different jurisdictions, including the makeup of

the investors in various securitization markets, approaches to risk retention, transparency

and standardization, and the extent and nature of cross-border activity. On 16 November

2012, IOSCO published its final report entitled, ‘Global Developments in Securitization

Regulation’. The report proposed a series of recommendations to improve incentive

alignment through risk retention requirements and to improve asset-level disclosure

through standardized templates.23

The WS5 Task Force released an interim April 2012 report on the securities lending

and repo markets which included a market overview and study of existing regulations and

the relationship of securities lending and repos to the rest of the shadow banking

18 The FSB has already issued high-level recommendations under this workstream that address capital and consolidation

requirements as well as counterparty exposure limits. Further recommendations pursuant to this workstream are expected in

mid-2013. This workstream will be addressed in greater depth in Section 4.

19 IOSCO, tasked by the FSB with this workstream, issued policy recommendations for MMF reform in October 2012.

Suggestions included limiting the use of constant net asset value, capital buffers, redemption restrictions, liquidity and maturity

portfolio requirements and stress testing. This workstream will be addressed in greater detail in the discussion on MMFs in

Section 5.

20 FSB 2012 Monitoring Report (n 8).

21 Financial Stability Board, ‘An Integrated Overview of Policy Recommendations’ (November 2012) 5http://www.

financialstabilityboard.org/publications/r_121118.pdf4 (‘FSB November 2012 Overview Report’).

22 International Organization of Securities Commissions, ‘Consultation Report on Global Developments in Securitization

Regulation’ (June 2012)5http://www.iosco.org/library/pubdocs/pdf/IOSCOPD382.pdf4.

23 International Organization of Securities Commissions, ‘Global Developments in Securitization Regulation’ (November 2012)

5http://www.iosco.org/library/pubdocs/pdf/IOSCOPD394.pdf4.


http://www.financialstabilityboard.org/publications/r_121118.pdf


http://www.iosco.org/library/pubdocs/pdf/IOSCOPD382.pdf


system.24 In November 2012, the FSB released a consultation containing a recommended

policy framework.25 These recommendations included: more granular data collection,

minimum standards for haircut methodologies and collateral valuation, implementation

of proposed minimum standards for cash collateral reinvestment, principles governing

limitations on re-hypothecation of client assets, and potential changes to the bankruptcy

law treatment of repos. WS5 plans on refining its recommendations over the next year,

taking into account consultation responses and the results of a quantitative impact

analysis, in particular concerning the possibility of numerical floors on haircuts in times

of material procyclicality risk. The FSB has announced it will agree on final

recommendations by September 2013.

The task force on ‘other shadow banking entities’ (WS3) began its work with a data

collection and characterization exercise and, as of the April 2012 report, was ‘working on

a filtered list based on national experiences and risk factors to focus on types of entities

that may need policy responses’.26 In November 2012, the FSB released its proposed

‘Policy Framework for Strengthening Oversight and Regulation of [Other] Shadow

Banking Entities’.27 The policy framework set forth the ‘other shadow banking entities’

identified by the FSB, which included: (i) credit investment funds; (ii) exchange traded

funds (ETFs); (iii) credit hedge funds; (iv) private equity funds; (v) securities broker-

dealers; (vi) securitization entities; (vii) credit insurance providers/financial guarantors;

(viii) finance companies; and (ix) trust companies. After studying these entities in greater

depth, the WS3 ‘observed a high degree of heterogeneity and diversity in business models

and risk profiles not only across the various sectors in the non-bank financial space, but

also within the same sector (or entity-type)’. Cross-border differences in existing

regulatory frameworks and legal names and forms only exacerbated the challenge of

prescribing reforms. Therefore, the FSB rejected an entity-specific focus and instead

proposed assessing risk posed by the shadow banking activities themselves. The economic

functions listed by the FSB which underlie the activities under review included:

management of client cash pools that are susceptible to runs; loan provision dependent

on short-term funding; market intermediation dependent on short-term funding or

secured funding of assets; facilitation of credit creation; and securitization. Over the

upcoming months, WS3 will review feedback from the public consultation and refine its

November 2012 recommendations.

This decision to focus on activities or ‘economic functions’ rather than entities may

have been in response to a paper from the IIF released in June 2012.28 The IIF paper

recommended analysing activities that contribute to shadow banking risk, in part because

24 Financial Stability Board, ‘Securities Lending and Repos: Market Overview and Financial Stability Issues’ (April 2012)

5http://www.financialstabilityboard.org/publications/r_120427.pdf4.

25 Financial Stability Board, ‘Consultative Document: A Policy Framework for Addressing Shadow Banking Risks in Securities

Lending and Repos’ (November 2012)5http://www.financialstabilityboard.org/publications/r_121118b.pdf4.

26 Financial Stability Board, ‘Strengthening the Oversight and Regulation of Shadow Banking: Progress Report to G20 Ministers

and Governors’ (April 2012)5http://www.financialstabilityboard.org/publications/r_120420c.pdf4.

27 FSB Nov 2012 Report on Shadow Banking Entities (n 5).

28 IIF Report (n 4).



http://www.financialstabilityboard.org/publications/r_121118b.pdf


of interconnectivity, rather than simply focusing on the entities engaged in these

activities. The IIF also proposed a framework to help identify and analyse such activities,

similar in concept to the framework proposed by the FSB in WS3 and WS5.

In consultation with IOSCO, the WS3 is also preparing guidelines for identifying non-

bank, non-insurance global SIFIs.29 These new methodologies for identifying non-bank

systemic entities will be finalized over the course of 2013, but the FSB has already stated

that the list will not include financial market infrastructures or insurance companies. The

April 2012 FSB release notes that, unlike the other workstream efforts that focus on

systemic risks posed by bank-like activities, the FSB’s efforts to identify non-bank global

SIFIs are centred on developing methodologies to identify companies whose distress

would have significant effects at the global level.30 This approach matches the framework

created in the USA under the Dodd–Frank Act, which we discuss below.

USA

The identification of systemically important non-bank financial institutions has not

been a top priority in the FSB’s shadow banking initiatives to date. However, such

identification is critical to the US framework. The USA has not adopted a strategic

approach that uses the term or focuses on ‘shadow banking’.31 Rather, the USA has cast a

wider net and has instead sought to identify all non-bank financial entities and activities

that create systemic risk, of which shadow banking is only a part. Its approach therefore

includes, but is not limited to, components of the shadow banking system identified by

the FSB.

As previously noted, the Dodd–Frank Act does not use the term ‘shadow banking’.

Rather, it empowers the Financial Stability Oversight Council (FSOC) to designate non-

bank financial entities and identify non-bank financial activities as systemically

significant. The FSOC’s emphasis to date has been primarily on the process by which

it will identify these non-bank financial entities posing systemic risk, rather than on

identifying activities, where its authority to implement change is limited; FSOC

identification of a risky activity only entails the release of non-binding reform proposals

to other regulators or Congress, whereas designation as a non-bank SIFI entity subjects

29 The FSB and BCBS have already identified an initial group of 29 globally systemically important banking groups pursuant to a

BCBS methodology and have finalized a principles-based, minimum framework for identifying domestic systemically important

banks. In November 2012, the FSB issued an updated list of 28 global systemically important banks. See Financial Stability Board,

‘Update of Group of Global Systemically Important Banks (G-SIBs)’ (November 2012) 5http://www.financialstabilityboard.

org/publications/r_121031ac.pdf4. The International Association of Insurance Supervisors has issued a proposed methodology for

identifying global systemically important insurers. International Association of Insurance Supervisors, ‘Global Systemically

Important Insurers: Proposed Assessment Methodology’ (May 2012) 5http://www.iaisweb.org/view/element_href.

cfm?src¼1/15384.pdf4.

30 The FSB and BCBS have also extended the GSIB framework to domestic systemically important banks (DSIBs), whose failures

may not be significant on a global level, but could have a substantial impact on domestic financial systems. In October 2012, the

BCBS released a DSIB framework containing an assessment methodology to identify DSIBs as well as principles for the

implementation of a higher loss absorbency requirement for these banks. Basel Committee on Banking Supervision, ‘A Framework

for Dealing with Domestic Systemically Important Banks’ (October 2012)5https://www.bis.org/publ/bcbs233.pdf4.

31 Although the Federal Reserve has issued research reports on ‘shadow banking’ and various efforts are underway to

independently address components of the shadow banking system, including repos, securitization and money market funds, these

advances are not part of an overarching initiative to address shadow banking.


http://www.financialstabilityboard.org/publications/r_121031ac.pdf

http://www.financialstabilityboard.org/publications/r_121031ac.pdf

http://www.iaisweb.org/view/element_href.cfm?src=1/15384.pdf



https://www.bis.org/publ/bcbs233.pdf

the newly designated institution to an extensive and complex banking law regulatory

infrastructure.32

Under Dodd–Frank Act Section 113, the FSOC may designate a non-bank financial

company for enhanced supervision and regulation by the FRB if it determines that

material financial distress at the company—or the nature, scope, size, scale, concentra-

tion, interconnectedness or mix of the activities of the company—could threaten US

financial stability. Under Section 106 of the Dodd–Frank Act, a non-bank financial

company that may be designated systemically significant pursuant to Section 113 includes

any US or foreign company that is ‘predominantly engaged in financial activities’ other

than a bank holding company, a foreign banking organization (FBO) that is treated as a

bank holding company in the USA, and certain other types of entities subject to bank or

bank-like regulation.33 Treasury Secretary and FSOC chairman Timothy Geithner stated

that this power to designate non-bank SIFIs was ‘one of the most important things that

the Dodd–Frank Act did’.

In April 2012, the FSOC approved a final rule with respect to how, through a

three-stage process, it will designate certain non-bank financial companies as systemically

important. While the final rule describes the assessment process at each stage, its

quantitative and qualitative standards serve as guidelines, not absolute or binding limits.

Therefore, the FSOC retains considerable discretion at each stage.

The first stage in the designation process is a quantitative screen of companies with $50

billion or more in assets and one or more of: at least $30 billion in gross notional credit

default swaps referenced to the company; $3.5 billion in derivative exposures (after

accounting for cash collateral and netting agreements); $20 billion of total debt outstanding

(broadly defined); a minimum 15:1 assets to equity leverage ratio; or short-term debt equal

to 10 per cent of total consolidated assets. While these levels will be assessed based on a

global basis for US firms, foreign firms will only be evaluated based upon their US assets

and liabilities. Where necessary, the FSOC may consult with foreign regulators and,

whenever possible, rely on information already being collected by such foreign regulators.

Despite this detailed guidance, these metrics are effectively non-binding; the FSOC can

progress a firm to the next stage even if the thresholds above are not met.

At the second stage, the FSOC will evaluate the firm’s risk profile through a

combination of both quantitative and qualitative metrics. In particular, the FSOC will

32 In addition to non-bank SIFIs, the FSOC has the power to designate financial market utilities (FMUs) as systemically

important pursuant to Title VIII of the Dodd–Frank Act. This regime is distinct from the non-bank SIFI process and looks to

different factors in evaluating systemic importance, including: total monetary value of transactions processed by the FMU,

aggregate counterparty exposure, as well as the relationship, interdependencies or other interactions of the financial market utility

with other such utilities or payment, clearing, or settlement activities and the impact of FMU failure or disruption on the financial

system. The first round of eight FMUs were designated in July 2012. See ‘Financial Stability Oversight Council Makes First

Designations in Effort to Protect Against Future Financial Crises’ (July 2012) 5http://www.treasury.gov/press-center/

press-releases/Pages/tg1645.aspx4. A few weeks later, the Federal Reserve passed a final rule on risk-management standards

governing the operations related to FMU payment, clearing, and settlement activities. See 12 C.F.R. s 234 (2012)5http://www.gpo.

gov/fdsys/pkg/FR-2012-08-02/html/2012-18762.htm4.

33 Although Dodd–Frank Act s 170 authorizes the Federal Reserve Board of Governors to promulgate regulations setting forth

the criteria for categorical exemptions of certain classes of non-bank financial companies from Fed supervision, no such

exemptions have been issued at this time.


http://www.treasury.gov/press-center/press-releases/Pages/tg1645.aspx


http://www.gpo.gov/fdsys/pkg/FR-2012-08-02/html/2012-18762.htm

http://www.gpo.gov/fdsys/pkg/FR-2012-08-02/html/2012-18762.htm

take six broad factors into account: size, substitutability, interconnectedness with other

financial firms, leverage, liquidity risk and maturity mismatch, and existing regulatory

scrutiny. This list is based on the statutory factors in Section 113 of the Dodd–Frank Act

prescribing what the FSOC should consider. Although firms will not receive notice that

they have been moved to the second stage, they may make voluntary submissions to the

FSOC if they believe they may progress to stage three.

Companies selected for the third and final stage will be notified by the FSOC. At the

final stage, firms will have 30 days to submit materials to supplement the FSOC analysis

and contend that they should not be awarded non-bank SIFI status. In addition to further

study of the stage two factors, the final stage focuses on potential contagion ‘transmission

channels’, such as exposure of market participants to the non-bank entity, potential for

market disruption caused by a fire sale of the entity’s assets, or failure of the firm to

supply a critical function or service.

At the end of the final stage, the FSOC will decide whether a company should receive a

proposed non-bank SIFI determination. Designation requires the vote of 2/3 of the

FSOC’s voting members (and the affirmative vote of its chairperson) and a firm would

have 30 days to challenge the decision. The FSOC would then have 30 days to hold a

non-public hearing and an additional 60 days to make a final determination, which

would require another 2/3 vote of the council and the approval of the FSOC chairman.

The FSOC has broad discretion both under the Dodd–Frank Act and its final rule in

the designation of non-bank SIFIs. There is no safe harbour that will protect a non-bank

financial company from potential designation. The qualitative standards described above

often lack clarity and, moreover, serve only as interpretive guidance that does not restrain

the FSOC’s discretion.

The non-bank SIFI label triggers the application of a complicated network of enhanced

regulatory requirements that are comparable to the safety and soundness approach of

bank regulation. The rules are in addition to, and not in lieu of, the existing regulatory

regime already applicable to the non-bank SIFI. In particular, several provisions of the

Dodd–Frank Act are applicable to non-bank SIFIs designated by the FSOC. A few of the

most significant provisions are discussed below.

Sections 165 and 166 of the Dodd–Frank Act require the FRB to establish enhanced

prudential standards and early remediation requirements both for bank holding

companies (BHCs) with total consolidated assets of $50 billion or more (‘covered

BHCs’) and for non-bank SIFIs. A proposed rule implementing these requirements was

released in December 2011.34 The FRB’s proposed rule technically applies the same set of

enhanced prudential standards to covered BHCs and to non-bank SIFIs. However, the

FRB may tailor the application of the enhanced standards to non-bank SIFIs by category

or individually, considering each company’s size, capital structure, risk profile and any

34 The comment period for the Federal Reserve’s enhanced prudential standards proposal closed on 30 April 2012. Nearly 100

comments letters were received. The Federal Reserve is currently reviewing the comments and developing final rules to implement

ss 165 and 166.


other relevant risk-factors deemed appropriate by the FRB. The FRB may also provide an

appropriate transition period for newly designated non-bank SIFIs to comply with the

rules. Otherwise, the proposed rules under Sections 165 and 166 would demand that a

non-bank SIFI meet most requirements, discussed below, within 180 days of designation.

The proposed rule extends the FRB’s capital framework to non-bank SIFIs as if they

were banks. Specifically, a non-bank SIFI must calculate its minimum risk-based capital

and leverage ratios as if it were a bank holding company. These requirements consist of: a

risk-based capital requirement, a leverage requirement, and a market risk capital

requirement for non-bank SIFIs with trading activity of at least $1 billion or equal to 10

per cent of total assets. Non-bank SIFIs must also comply with the FRB’s capital plan

rule, which would call for them to maintain a Tier 1 common risk-based capital ratio of 5

per cent under expected and stressed conditions.35 Subjecting non-bank SIFIs to bank

holding company capital requirements will be a major development for companies that

have not traditionally been subject to such formal capital or leverage requirements, or are

required to comply with different capital requirements more narrowly tailored to their

structure and market role (such as insurance company or broker–dealer capital

requirements). The extension of a framework that has been developed for decades to

cover just depository institutions and their holding companies is therefore a significant

and controversial step.

Section 165(d) of the Dodd–Frank Act requires that each non-bank SIFI provide the

Federal Deposit Insurance Corporation (FDIC) and the FRB with a ‘living will’, setting

forth a plan for its orderly resolution under the US Bankruptcy code. The Orderly

Liquidation Authority, administered by the FDIC, may also be applied to resolve a non-

bank SIFI if its resolution under otherwise applicable insolvency laws would have serious

adverse effects on financial stability in the USA.

Potential non-bank SIFIs naturally want to avoid designation and the consequent

regulatory burden. In comments to the FSOC’s initial proposed rule for SIFI designation,

many commenters representing particular financial industry sectors (eg insurers, asset

managers and MMFs) argued that their particular market segment did not pose a threat

to US financial stability and that major industry actors should therefore not be subject to

a determination.

At the time of this writing, no non-bank SIFIs have been designated. However, analysts

have predicted that the FSOC may designate several insurance companies, including

Prudential, AIG, MetLife and possibly the Hartford. GE Capital has also been mentioned

as a potential candidate. Still, a Treasury spokesperson has confirmed that the FSOC

‘does not intend to publicly announce the name of any non-bank financial company that

is under evaluation before a final determination with respect to such a company’.

The non-bank SIFI framework under the Dodd–Frank Act is based on an extension of

banking law to these designated non-bank entities. This decision to extend the scope of

35 A non-bank SIFI would become subject to the capital plan rule in the calendar year that it was awarded non-bank SIFI status,

provided that the designation occurred more than 180 days before September 30 of that calendar year.


banking law in the USA may have been driven in part by a combination of the regulatory

community’s initial post-crisis focus on banking reform and the counterintuitive manner

in which the USA addressed shadow banking. The Dodd–Frank Act’s framework for non-

bank, systemically significant entities was the first major attempt to regulate shadow

banking in the wake of the financial crisis. The relatively early formation of the Dodd–

Frank Act’s approach to regulating these entities stands in stark contrast to the slower,

more methodical approaches by the FSB and EU. The FSB and the EU have elected to first

study institutions and activities that constitute part of the shadow banking system, and

then consider the best regulatory approach. This decision to first study potential risk and

then create proposals is sensible and intuitive. The US legislature cast a wider net, without

considering the gradations of activity or the roles of entities which might have led to a

more nuanced approach.

The Dodd–Frank Act was also passed when the regulatory community was focused on

improving bank prudential regulation and ‘shadow banking’ had not been identified as a

source of concern by the G20. This focus on improving bank regulation coincided with a

growing, but early assessment that ‘shadow banks’ needed greater regulation. As a result,

the non-bank SIFI framework was premised on the controversial assumption that such

entities (to be identified at a later date) should be subject to prudential bank regulations.

This automatic extension of banking regulations to non-bank SIFIs was perhaps hasty

and unwise, as will be explained in the discussion below.

Although the FSOC focus has thus far been on non-bank financial entities, rather than

activities, it is important to note that the FSOC also has the power under Section 120 of

the Dodd–Frank Act to designate particular activities as posing systemic risk. To do so,

the FSOC must find that ‘the conduct, scope, nature, size, scale, concentration, or

interconnectedness of such activity or practice could create or increase the risk of

significant liquidity, credit, or other problems spreading among bank holding companies

and non-bank financial companies, financial markets of the USA, or low-income,

minority, or underserved communities’. However, unlike Section 113 and the designation

of non-bank financial entities as SIFIs, FSOC identification of a risky activity does not

automatically trigger new prudential constraints on the activity. Instead, the FSOC must

conduct an analysis and provide activity-specific recommendations to the primary federal

regulatory agency or agencies that oversee these activities or to the Congress. The

regulators are free to reject these recommendations, but must explain their failure to

implement them. In November 2012, Section 120 was used to issue proposals for MMF

reform, as will be discussed later in this article.

EU

The EU was slower than the USA and the FSB to address shadow banking. The lag may

have been related to the more limited role of shadow banking in the EU, where

traditional banks dominate the financial system.36 In 2010, EU banks held over 50 per

36 FSB 2012 Monitoring Report (n 8).


cent of total assets held by credit intermediaries, in contrast with the USA, where banks

held approximately 20 per cent.37 Money market funds were also less significant market

players in Europe and fewer banks made use of SPVs to move items off of their balance

sheets. Furthermore, many of Europe’s financial woes, such as the crises in Ireland and

Spain, were primarily caused by poor commercial real-estate lending by conventional

banks.

European financial institutions were nevertheless vulnerable participants in credit

intermediation chains with the US shadow banking system. US shadow banking entities

such as money market funds provided financing for European institutions and

simultaneously served as ‘low-risk’ investments for those same companies. Engaging

in repo and securities lending transactions with US counterparties and purchasing

securitized products also increased exposure to the shadow banking system.

Although shadow banking has played a more limited role in the EU than in the USA,

the issue has grown in importance to the region over time. The FSB has estimated that the

assets of non-bank financial intermediaries in Europe as a percentage of shadow banking

globally have grown sharply from 2005 to 2011, while their share in the USA has

decreased. Effects of the European sovereign debt shock may be further aggravated by

shadow banking entities such as MMFs, which have provided a vital, but unreliable,

source of funding to European banks.38

On 19 March 2012, the European Commission published a ‘Green Paper on Shadow

Banking’ and then convened a conference in April on the topic.39 The Green Paper takes

the view that shadow banking is founded on ‘two intertwined pillars’ of entities and

activities. Shadow banking entities are defined as entities outside the regular banking

system engaged in one of the following activities: accepting deposit-like funding,

performing maturity and/or liquidity transformation, undergoing credit transfer, and

using direct or indirect financial leverage. The Green Paper sets forth a non-exhaustive

list of entities engaged in such activities, including: MMFs, investment funds that provide

credit or are leveraged, securitization vehicles such as ABCP conduits, and other SPVs

that perform liquidity and/or maturity transformation. The ‘second pillar’ includes

activities that could act as important sources of funding for non-bank entities, such as

securities lending and repos and securitization.

The Green Paper states that ‘a specific approach to each kind of entity and/or activity

must be adopted’ and sets forth three potential complementary strategies: indirect

regulation targeting linkages between banks and the shadow banking system; new

regulation created to address shadow banking; and extension or revision of existing

regulation where appropriate. On this last point, the report suggests that EU banking

legislation, which is currently limited to deposit-taking institutions, could possibly be

expanded to cover additional entities and activities. The report explicitly cites the Capital

37 FSB October 2011 Report (n 17).

38 Financial Stability Oversight Council, ‘2011 Annual Report’ (2011) 5http://www.treasury.gov/initiatives/fsoc/Documents/

FSOCAR2011.pdf4 (‘FSOC 2011 Annual Report’).

39 EU Green Paper (n 2).


http://www.treasury.gov/initiatives/fsoc/Documents/FSOCAR2011.pdf

http://www.treasury.gov/initiatives/fsoc/Documents/FSOCAR2011.pdf

Requirements Directive (CRD) IV as one framework that might be expanded to cover

non-bank financial entities and notes that the CRD has already been extended to certain

investment firms under the Markets in Financial Instruments Directive (MiFID).

The EU is currently evaluating the responses to the Green Paper and may initiate

targeted consultations on specific issues in the future. The ESRB, established in December

2010 and tasked with macro-level prudential oversight of the EU financial system, is

planning to recommend shadow banking oversight changes in early 2013.40

Discussion

Analytical scope

The FSB and EU have initiated their shadow banking reform efforts by first addressing

shadow banking at the macrolevel via assessments of financial activity in the shadow

banking system as a whole. This data-gathering exercise allowed the FSB to identify

shadow banking entities and activities that pose systemic threats to financial stability, and

then proceed to issue recommendations based on the character of the risks presented. The

FSB then created workstreams to study specific components of the shadow banking

system. The EU appears to also be adopting a comprehensive strategy for addressing the

shadow banking system along these lines.

In contrast, the USA has not approached shadow banking in a targeted manner or as a

subset of the non-bank financial sector. Although the FRB has issued several reports on

the shadow banking system, these reports are not part of a comprehensive strategy to

address ‘shadow banking.’ The 217-page FSOC 2012 annual report never uses the term

‘shadow banking’, though it does address elements of the shadow banking system, such as

the tri-party repo market and MMFs, as ‘potential emerging threats’.41 Instead, through

the Dodd–Frank Act, shadow banking entities and activities are mainly addressed

through the lens of non-bank SIFIs and activities (identified pursuant to Dodd–Frank Act

Section 120). These categories are broader than just ‘shadow banking’, as they encompass

any financial system components that may pose significant threats to financial stability,

such as financial market utilities (FMUs).

The FSB’s and EU’s narrower approach has the potential to lead to gaps in regulatory

reform efforts. The EU Green Paper and early FSB efforts are grounded in the premise

that shadow banking can be defined and regulators can, and should, create lists of shadow

banking entities that should be subject to greater oversight and regulation. Although the

recent FSB November 2012 reports shift the FSB’s focus to shadow banking activities, the

scope of these reports still do not cover the entire non-bank financial sector. Instead, the

40 The European Commission has also launched a possible ‘framework for the recovery and resolution of non-bank financial

institutions’. The consultation was open from 5 October 2012 until 28 December 2012. This consultation complements the Green

Paper by considering whether a resolution framework is necessary to stem systemic consequences of a non-bank institution’s

failure. However, the consultation primarily focuses on insurance companies and financial market infrastructures. See European

Commission, ‘Consultation on a Possible Recovery and Resolution Framework for Financial Institutions Other Than Banks’,

European Commission Directorate General Internal Market and Services (June 2012) 5http://ec.europa.eu/internal_

market/consultations/2012/nonbanks/consultation-document_en.pdf4.

41 Financial Stability Oversight Council, ‘2012 Annual Report’ (2012) 5http://www.treasury.gov/initiatives/fsoc/Documents/

2012%20Annual%20Report.pdf4.


http://ec.europa.eu/internal_market/consultations/2012/nonbanks/consultation-document_en.pdf

http://ec.europa.eu/internal_market/consultations/2012/nonbanks/consultation-document_en.pdf

http://www.treasury.gov/initiatives/fsoc/Documents/201220Annual20Report.pdf

http://www.treasury.gov/initiatives/fsoc/Documents/201220Annual20Report.pdf

FSB concentrates its efforts on activities that it believes define ‘shadow banking’. It is

therefore possible that the FSB and EU may overlook non-bank financial institutions that

pose systemic risk outside their definition of what the shadow banking system comprises.

It is essential that both the FSB and EU consider whether there are institutions that

threaten financial stability, yet are not part of the shadow banking system, such as

clearing houses, CCPs and other FMUs. This potential concern may be less problematic

in the EU, where the Green Paper sets out a much vaguer and broader definition of the

scope of ‘shadow banking’ than the FSB, requiring only one of any of a set of activities to

qualify. In contrast, the FSB only looks to entities and activities that facilitate the

extension of credit, either directly or as a component of a credit intermediation chain.

However, the broader US framework may also contain possible regulatory ‘blind

spots’. While the non-bank SIFI framework under the Dodd–Frank Act is expansive in

theory, as any entity may be labelled systemic, the non-bank SIFI label may be too narrow

in practice. Although the designation process purports to consider characteristics in

addition to size, such as interconnectedness and potential for the transmission of

contagion, it is likely that size will be the paramount factor in the FSOC’s analysis. There

are many reasons for this supposition. First, only the largest financial institutions in their

sector, such as AIG, GE Capital and Prudential, are expected to be included in the initial

round of non-bank SIFI designations, though it is admittedly still early in the FSOC’s

analysis of potential non-bank SIFIs. The burdensome nature of the regulation of non-

bank entities provides further support for this assumption; regulators may rightly be

reluctant to impose this burdensome framework on multiple small entities. Thus, the

framework’s focus on large individual institutions may fail to capture numerous small,

interconnected entities that are ‘systemic as a herd’, collectively posing systemic risk

because of the similarity of their business models and susceptibility to common shocks.

The S&L crisis demonstrated the potential for crises to be triggered by multiple failures of

small independent institutions; on average, each failed entity held less than $500 million

in assets and would almost certainly not qualify as a non-bank SIFI today despite their

collective systemic importance.42

Fortunately, tools now exist to address potential gaps in supervision and regulation by

the USA, EU and at the international level; the post-crisis world recognized the need for

macrolevel oversight of activities and interconnectivity in the financial system and the

FSOC, ESRB and FSB have mandates to assume this crucial oversight responsibility.

Therefore, as the macro-prudential supervisors designated to identify potential risks at a

high level, each body must take special care to address potential blind spots. The FSOC

must ensure that it is not overly focused on large institutions. The ESRB must take steps

to identify entities and activities outside shadow banking that may be missed by shadow

banking reform efforts. The FSB’s SCAV, established to identify and review vulnerabilities

42 During the crisis, the Federal Savings and Loan Insurance Corporation (FSLIC), the thrift industry insurer, closed or otherwise

resolved 296 institutions with total assets of $125 billion. See T Curry and L Shibut, ‘The Cost of the Savings and Loan Crisis: Truth

and Consequences’ FDIC Banking Review (December 2000) 5http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.

pdf4.


http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf

http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf

affecting the global financial system, should also make sure to review risks posed by non-

banks that are not engaged in credit intermediation.

Entities versus activities

All three regimes identify and distinguish between entities and activities within the

shadow banking system. However, the focus differs across the regimes; the Dodd–Frank

Act places greater emphasis on systemic entities, which will be subject to the extensive

non-bank SIFI rules based on bank regulation. Although the FSB initially placed equal

weight on entities and activities, the November 2012 consultation on other shadow

banking entities indicates a potential shift to activity-centric recommendations. The EU

has identified both shadow banking entities and activities, but it is too early in the EU

process to identify a clear focus at this time.

To the extent possible, reforms should target activities, rather than entities. Attempting

to create lists of shadow banking entities that should be subject to greater oversight and

regulation could be a diversion from the real risks posed by the activities themselves.

Shadow banking entities are vulnerable because of the risks created by their credit

intermediation activities, not because of particular legal labels. Entities also carry out a

number of activities, some of which pose greater risks than others. A focus on legal form

over substance could lead to overly burdensome regulation that restricts available credit

but fails to address causes or forms of risk. In contrast, addressing activities allows for a

more targeted approach that addresses the source of risk. Furthermore, different entities

engage in similar activities. Regulation of the entity, rather than the activity, could lead to

disparate treatment of the same activity and encourage regulatory arbitrage.

As noted in the November 2012 FSB consultation on ‘other shadow banking entities’, a

focus on activities allows proposals to be applied across jurisdictions to different entities

engaged in similar ‘economic functions’. This approach can also be applied to innovative

structures that, while new, still engage in the same shadow banking activities that create

and transmit risk. Thus, a focus on activities, rather than entities, is a more flexible,

forward-looking strategy that is more responsive to opportunities for regulatory arbitrage

across jurisdictions and among different legal entities, and can help avoid expensive

regulation at the entity level.

The entity focus in the USA has also helped create an overly general ‘one-size-fits-all’

approach to ‘shadow banks’ despite their diverse characteristics and risks. A single non-

bank SIFI classification, applied to a diverse range of entities created for distinct

purposes, is unlikely to deliver appropriate levels of supervision and regulation. Each

financial industry has its own market role and risk. These industries may pose systemic

risk that warrants greater regulation and supervision, but new laws should reflect the

market position and risk profile of each sector and not subject all systemic entities to the

same sweeping new bank-like regulation.

There is also a large discontinuity created by the non-bank SIFI label; an entity is either

designated and subject to an entirely new and cumbersome regulatory framework, or not

designated and not required to comply with the rules applicable to their larger SIFI


counterparts. A greater understanding of the implications of such regulatory divergence

within industries should be considered going forward. For example, the non-bank SIFI

label could imply that a company is believed to be ‘too big to fail’, thereby benefiting the

non-bank SIFI through more favourable financing terms and greater willingness to

transact with an entity deemed to have implicit government support. This advantage over

smaller competitors could drive industry consolidation and only increase the risks

presented by large non-bank SIFIs.

The FSOC’s ability to designate activities that pose systemic risk is therefore a more

promising means of addressing shadow banking contagion than the structure under the

Dodd–Frank Act of the non-bank SIFI regime. When a systemic activity is identified by

the FSOC, the FSOC will consult with the primary regulator of that activity and propose

recommendations based on the risks it has identified for that systemic activity. The

FSOC, in its capacity as a macrolevel supervisor, is well positioned to identify risks only

noticeable when viewing large segments of the financial market and not focusing on a

particular industry. Thus, this ability to focus on risky activities, and to create

recommendations specific to such activities, is a more nuanced and effective means of

addressing risk arising from the shadow banking system.

Unlike the USA, which passed the Dodd–Frank Act before the FSB began examining

shadow banking, the EU has a greater opportunity to benefit from the recommendations

and reports of the FSB. Although the EU Commission has not been clear regarding how

its mission may parallel or support the FSB, the Green Paper advocates greater

international coordination and acknowledges the pre-eminence of the FSB. As the EU

crafts shadow banking proposals going forward, it should remain cognizant of the

benefits of focusing on an activity-centric approach to regulation and oversight.

Extension of banking law to non-bank entities

The US focus on shadow banking entities through non-bank SIFI designation may

contribute to the mistaken impression that such ‘shadow banks’ should be regulated as

banks, instead of a more refined regulation of the activities generating risk.

As discussed above, the Dodd–Frank Act non-bank SIFI framework was developed

during a rush to regulate ‘shadow banks’ while the legislature and regulators were focused

on improving oversight and regulation of banking entities. The result was a default to the

extension of bank prudential laws to non-bank institutions before the risks and nature of

the shadow banking system had been sufficiently analysed and debated.

This default to bank prudential regulation of non-bank financial entities was

misguided. Banking regulation was developed to address banks and bank holding

companies, yet these rules may be applied to various non-bank entities that may

substantially differ from banks in terms of structural model and risk profile. For example,

insurance companies are large, multimillion dollar businesses that may produce systemic

risks and results. However, these entities are very different from traditional banks. They

do not take deposits like banks, but instead receive regular premium payments from

policies. Insurance companies invest in assets to match the effective duration of their


liabilities, and therefore lack the asset-liability mismatch and liquidity risk that serves as

the fundamental source of instability in the banking system. Nevertheless, designation as

a non-bank SIFI would apply banking prudential rules to these companies.

The US extension of banking law to non-bank SIFIs may also unnecessarily complicate

an already fragmented and, in the authors’ view, incoherent regulatory landscape. Many

of the potential non-bank SIFIs are already governed through a complex regulatory

structure. Rather than modify elements of these existing legal frameworks, the Dodd–

Frank Act layers a new non-bank SIFI regime on top of current laws. This blunt approach

increases complexity and the costs of compliance, risks imposing overlapping or

conflicting requirements and complicates further reform efforts. These non-bank SIFIs

will also be overseen by yet another regulator; non-bank SIFIs are automatically subject to

the oversight of the FRB, even if other regulators already watch over the entity, have

greater industry experience, and therefore may be better suited to the task. The FRB has

virtually no experience regulating entities that are not banks or BHCs. More regulators

does not necessarily mean greater oversight; turf wars and coordination failures can lead

to even more gaps. The USA should consider allowing for oversight of select non-bank

SIFIs to remain with their primary regulators, with recommendations by the FSOC as to

how the regulatory structure in place could be enhanced.

Rather than simply extending banking law to cover other financial institutions, new

rules should be created to address the structure and market position of particular

industries. Although tailoring of the bank-like requirements to non-bank SIFIs is

contemplated by the FRB, it is unclear what such tailoring might involve. Given the

number of insurance companies that might be designated, special care will hopefully be

taken to adopt rules that suit the characteristics of the insurance industry. This process

calls into question why banking rules should be applied to insurance companies, instead

of a modification of existing insurance company laws to account for the additional risk

posed by large insurers.

A better approach can be seen in the capital requirements governing European

investment funds, which are extensively regulated in the EU by the Undertakings for

Collective Investment in Transferable Securities (UCITS) Directive and the Alternative

Investment Fund Managers Directive (AIFMD). Like the Basel rules, these directives

address liquidity management and leverage, but are more carefully targeted to address

issues specific to funds. For example, the AIFMD, which will be implemented in the EU

on 22 July 2013, will impose capital requirements crafted specifically for funds based on

an alternative investment fund’s assets under management.43 These narrower reforms

appropriately reflect the differences between banks and funds.

Unfortunately, the EU regime also contemplates the extension of prudential banking

laws to non-bank entities. Current prudential regulation has already been extended to

43 Managers must hold at least E125,000 and an additional 0.02 per cent of any AUM (including leveraged assets) above

E250,000 with a total cap of E10 million. AIFs such as UK investment trusts that are internally managed must retain assets of

E300,000. See Duncan and others, ‘Alternative Regulation: The Directive on Alternative Investment Fund Managers’ (2011) 6

CMLJ5http://cmlj.oxfordjournals.org/content/6/3/326.full.pdf?keytype¼ref&ijkey¼f4qaMU47YGmq6Wu4.


http://cmlj.oxfordjournals.org/content/6/3/326.full.pdf?keytype=ref&ijkey=f4qaMU47YGmq6Wu



certain investment firms under the MiFID, which cross-refers to the CRD, thereby

imposing bank capital requirements on entities within the scope of the MiFID. Further

extension of banking law to non-bank entities is explicitly mentioned in the EU

consultation on shadow banking as well as by a November 2012 European Parliament

resolution.44 For the reasons outlined above, a default to bank prudential requirements

for non-bank entities should be adopted only if other, less invasive options are believed to

be inadequate.

Alternatives to prudential regulation

Alternatives to prudential regulation are unfortunately absent in the efforts to date of the

USA, EU and FSB. There are numerous tools available for risk mitigation that may be less

invasive, relatively simple to implement and cause less market disruption. Steps to

address shadow banking should be limited and follow rigorous cost–benefit analyses of

potential steps, making use of all options available to both the regulators and industry.

While the extension of bank prudential regulation is one alternative, there are several

other possibilities that may be more cost-effective and well-calibrated to the risks at issue.

An IIF Paper released in June 2012 suggests several useful non-regulatory and

conduct-of-business tools that can be used instead of, or in conjunction with, legal

reform. Non-regulatory measures to address shadow banking entities and activities

include improved disclosure of risks to investors and the public, improved risk

governance in shadow banking entities or in bank linkages to shadow banking, and the

creation and adoption of industry-wide standards for shadow banking entities. Several

conduct-of-business tools should also be considered, such as effective disclosure,

ensuring the separation of certain activities within the same company, and prevention of

conflicts of interest.

The decision regarding which specific set of measures should be deployed must be

made on a case-by-case basis, with an understanding of the advantages and costs as well

as the extent to which the entity or activity is already regulated. As suggested by the IIF,

less burdensome approaches should be considered first, before turning to more invasive

requirements. Proposals should also complement existing regulation, making use of

existing frameworks when possible. While prudential bank-like rules may be called for in

limited circumstances, a blunt default to bank law might undermine the benefits of

shadow banking, promote arbitrage and increase ‘Maginot line risk’, or the illusion of

safety through the use of rules that are not difficult to circumvent.

4. Bank exposure to shadow banking

One alternative to extending bank regulation to reduce risks in the shadow banking

sector is exemplified by the FSB workstream (WS1) which focuses on the inter-

connectivity of regulated commercial banks and non-bank institutions and investors. As

stated by Adair Turner, ‘shadow banking has to be understood as involving both in some

44 ‘Shadow Banking: Balance Benefits and Risks, Say MEPs’ (November 2012) 5http://www.europarl.europa.

eu/news/en/pressroom/content/20121116IPR55709/html/Shadow-banking-balance-benefits-and-risks-say-MEPs4.


http://www.europarl.europa.eu/news/en/pressroom/content/20121116IPR55709/html/Shadow-banking-balance-benefits-and-risks-say-MEPs

http://www.europarl.europa.eu/news/en/pressroom/content/20121116IPR55709/html/Shadow-banking-balance-benefits-and-risks-say-MEPs

cases new forms of non-bank interaction between the financial system and the real

economy, and as entailing far more complex links within the financial system itself,

including between banks and non-bank institutions’.45 Unlike the direct supervision and

regulation of shadow banking discussed above, this indirect approach entails reform of

banking law to reduce the risk of shadow banking to traditional banks. Therefore, these

rules call for changes in bank behaviour, rather than action by shadow banking

institutions.

FSB

The FSB has delegated WS1 to the BCBS and published an initial integrated set of policy

recommendations for public consultation in November 2012 that included input from

the BCBS. Thus far, the FSB has issued high-level recommendations concerning:

consolidation rules for prudential purposes, improved disclosure and tighter restrictions

on bank sponsorship of non-consolidated entities, risk-based capital requirements for

banks’ exposures to shadow banking entities and limits on the size and nature of a bank’s

exposures to shadow banking entities.

The BCBS is currently examining consolidation rules for prudential purposes across

jurisdictions. In particular, the BCBS is considering the extent to which non-bank entities

sponsored by banks are, or should, be consolidated for accounting purposes. Before the

financial crisis, SPVs, conduits and other structures were regularly formed specifically to

keep their debt off of bank balance sheets. These off-balance sheet entities enabled banks

to limit their required capital because of the belief that these entities isolated risky

activities from their bank sponsors. These thinly capitalized, opaque vehicles were

therefore useful tools that distorted bank balance sheets by hiding potential liabilities

while simultaneously avoiding prudential rules designed to mitigate the risk of such

items. In practice, these entities were able to benefit from sponsor reputation and implicit

support, as many investors believed that sponsors would financially support these

companies to avoid the reputational risk of harming investors they had encouraged to

invest in these vehicles and which had typically acquired their assets from the banks

themselves. This balance sheet management promoted uncertainty about the real

exposures of such institutions, which became clear when assets and liabilities of these

SPVs were repatriated back onto sponsor balance sheets. The FSB has therefore

recommended that any consolidation rules ensure that sponsored entities be reflected on

bank balance sheets and be included in meeting prudential regulatory requirements (such

as capital and leverage ratios).

The FSB has also recommended that restrictions be placed on bank sponsorship of

non-consolidated entities through greater scrutiny of implicit support and reputational

risk. In particular, the November 2012 FSB release stated that the BCBS’s work on

reputational risk and implicit support should address bank sponsorship of MMFs.

During the financial crisis, banks felt compelled because of reputational risk to exceed

45 Speech by Lord Turner (n 12).


their contractual obligations and provide liquidity support to SIVs, MMFs and other

sponsored entities. For example, some banks purchased the ABCP issued by their own

sponsored entities to preserve market liquidity for their debt and, in theory, maintain

market confidence in the bank. Banks were also concerned about maintaining customer

relationships. However, such steps also weakened bank balance sheets and their capital

positions. Thus, reputational risk and implicit support are mutually reinforcing

problems; the possibility that negative views of the bank could impede its ability to

create or maintain business relationships and funding can lead to implicit support, which

in turn can undercut a bank’s financial condition and reinforce negative market views.

In recognition of this problem, the BCBS incorporated guidance in its July 2009 release

(Basel II.5) calling for ‘appropriate policies in place to identify sources of reputational

risk when entering new markets, products or lines of activities’. Banks should also

consider reputational risk and implicit support in stress testing through scenarios that

evaluate the effects of off-balance sheet exposures on bank credit, market, and liquidity

risk profiles. The July 2009 release also suggests comparing on-balance sheet exposure to

the maximum exposure held off-balance sheet. The BCBS is reviewing global

implementation of the Basel II.5 market risk framework and evaluating the results of

its recent survey on Pillar 2 (supervisory) treatment of implicit support.46 The November

2012 FSB report stated that the BCBS has also enhanced the internal capital adequacy

assessment process for banks under Pillar 2 for securitization risk, reputational risk and

implicit support.47 In addition, the BCBS task force is examining divergences in

consolidation practices across jurisdictions with the aim of developing additional

guidance to help promote international consistency.

The BCBS task force is also addressing risk-based capital requirements governing

banks’ exposures to shadow banking entities. The workstream will pay particular

attention to investments in funds, considering whether to examine underlying assets and

leverage, as well as short-term liquidity facilities whose risks might not be adequately

captured by the Basel rules. Although work in this area is ongoing, the November 2012

FSB consultation made clear that the BCBS has chosen not to make further policy

changes to the capital requirements covering bank short-term liquidity facilities to

shadow banking entities that are outside the scope of the Basel III securitization

framework (eg MMFs). The BCBS was concerned that any changes could have adverse

effects and were potentially unnecessary in light of new reforms such as the liquidity

coverage ratio.

The BCBS is also expected to issue recommendations concerning the size and nature of

bank exposure to shadow banking entities and activities. In particular, it is assessing

whether the potential large exposure regime captures exposures to all entities, including

shadow banking entities, why certain shadow banking exposures are excluded from the

46 Basel Committee on Banking Supervision, ‘Enhancements to the Basel II Framework’ (July 2009) 5http://www.bis.

org/publ/bcbs157.pdf4.

47 FSB November 2012 Overview Report (n 21).


http://www.bis.org/publ/bcbs157.pdf

http://www.bis.org/publ/bcbs157.pdf

large exposure regime, and any concentration risk measurement and management

implications.48

The BCBS is aiming to develop reform proposals on interactions between banks and

shadow banking entities by mid-2013.

USA

The USA has also taken several steps to indirectly regulate shadow banking through

improved banking regulation and oversight. Like the FSB, the USA has approached

indirect regulation of shadow banking by improving accounting rules covering balance

sheet consolidation, applying stricter regulatory treatment to bank implicit support of

shadow banking institutions, increasing the risk-weighting of exposure to shadow

banking entities and activities, and limiting the size and nature of bank exposure to the

shadow banking system.

Accounting reform addressing consolidation was introduced in June 2009 by the

Financial Accounting Standards Board (FASB) through the adoption of Financial

Accounting Standards (FAS) 166 and FAS 167. These rules forced certain conduits and

securitized assets that posed risks to banks, such as ABCP, on to bank balance sheets.

Specifically, FAS 166 altered the criteria allowing such entities to be kept off consolidated

financial statements by eliminating the concept of a ‘qualifying special-purpose entity’

(QSPE), and altering the requirements for derecognizing financial assets. Following this

change, former QSPEs will be treated like all other variable interest entities (VIEs), a

broad accounting term covering thinly capitalized entities deemed to be controlled by an

entity for reasons other than majority voting rights. VIEs, including former QSPEs, are

eligible for balance sheet consolidation under Interpretation 46(R), as revised by FAS 167.

FAS 167 addresses the determination of whether a company is a VIE’s ‘primary

beneficiary’ and therefore required to consolidate a VIE, taking into account an entity’s

purpose, structure and the company’s actual control over significant entity activities. FAS

166 also requires increased disclosures about a transferor’s continuing involvement with

transferred financial assets.49

By driving most SPVs and conduits on to bank balance sheets, loans and securities

such as ABCP will be included in calculating required risk-based capital, leverage ratios

and loan loss reserves.50 Due to Dodd–Frank Act Section 331, which links FDIC

assessments to the size of consolidated assets, formerly off-balance sheet entities will also

48 A large exposure regime is meant to limit banks’ risk exposure to any single entity. Though the current Basel framework does

contain explicit limits on large exposures, in mid-2011 the Basel Committee created a group to review potential limits. However, a

consultation on large exposure limitations has not yet been released. The BCBS is also currently reviewing large exposure regimes

that have been implemented on a national level.

49 ‘FASB Issues Statements 166 and 167 Pertaining to Securitizations and Special Purpose Entities’, News Release 12 June 2009

5http://www.fasb.org/cs/ContentServer?c¼FASBContent_C&pagename¼FASB/FASBContent_C/NewsPage&cid¼11761562408344;

‘Briefing Document: FASB Statement 166 and 167’ (June 2009) 5http://www.fasb.org/cs/ContentServer?c¼FASBContent_C&page

name¼FASB%2FFASBContent_C%2FNewsPage&cid¼11761556334834.

50 US banking agencies clarified in September 2009 that depository institutions would have to hold regulatory capital against

consolidated securitization transactions and ABCP conduits. See Adrian and Ashcraft, ‘Shadow Banking Regulation’, Federal

Reserve Bank of New York Staff Reports, Staff Report No. 559 (April 2012) 5http://www.newyorkfed.org/research/

staff_reports/sr559.pdf4.


http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB/FASBContent_C/NewsPage&cid=1176156240834




http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB2FFASBContent_C2FNewsPage&cid=1176155633483





http://www.newyorkfed.org/research/staff_reports/sr559.pdf


increase FDIC assessments. New updates to capital rules, including a final rule on market

risk and new proposed capital rules released by federal bank regulators on June 2012

implementing Basel III, include improved methodologies for determining risk-weighting

for residential mortgages, securitization, exposures and counterparty credit risk.

For non-consolidated entities, Section 165(k) of the Dodd–Frank Act generally

requires the inclusion of certain off-balance sheet activities in calculating capital

requirements for banks and non-bank SIFIs. The Dodd–Frank Act clarifies that such

off-balance-sheet activities cover existing liabilities that may move on-balance sheet upon

the occurrence of some future event. This definition covers standby letters of credit,

repurchase agreements, interest rate swaps, credit swaps, and commodities, forward and

securities contracts. Therefore, even if such activities are not consolidated onto the

balance sheet of bank or bank holding companies covered by the 165 proposed rule, they

should be included in computing required capital.

The USA has also proposed new limitations on counterparty exposure between bank

and non-bank entities. The Section 165 Proposed Rule prohibits a BHC or a designated

non-bank SIFI with more than $500 billion in total consolidated assets from having an

aggregate net exposure (including loans, deposits, credit lines, derivatives) in excess of 10

per cent of the BHC’s or non-bank SIFI’s consolidated capital and surplus to (i) a BHC or

FBO with more than $500 billion in total consolidated assets or (ii) a non-bank SIFI of any

size. Currently, there are only 7 BHCs and approximately 38 FBOs with assets greater than

$500 billion. Covered BHCs and non-bank SIFIs may also not maintain an aggregate net

credit exposure to an unaffiliated counterparty, together with its subsidiaries, that exceeds

25 per cent of the covered BHC or non-bank SIFI’s consolidated capital stock and surplus.

It is interesting to note that a subset of non-bank SIFIs may be subject to harsher

requirements than BHCs and FBOs, as limitations apply to a non-bank SIFI of any size but

BHCs are only covered if they meet specific total consolidated asset thresholds. Therefore,

any non-bank SIFIs with assets less than $500 billion will have more limits imposed with

respect to aggregate net exposure than large BHCs or FBOs of the same size.

The USA is in the process of implementing structural reform of banks to insulate

so-called ‘safe’ deposit-taking activities from ‘risky’ trading activities. Section 619 of the

Dodd–Frank Act established the controversial ‘Volcker Rule’, which addresses bank

exposure to certain shadow banking entities by limiting bank ownership of hedge funds

and other private investment funds. The Volcker Rule also currently limits bank

sponsorship of such entities, which includes financing or lending schemes between banks

and funds sponsored or controlled by the bank. Reforms to the derivatives market, such

as central clearing of swaps, will also reduce bank exposure to hedge funds and other

institutions engaged in proprietary trading.

EU

The EU Green Paper also lists several forms of bank exposure to shadow banking entities

that require further research and analysis. The list clearly reflects the mandate of the FSB


workstream, looking at: (i) whether the current large exposure regime properly addresses

all shadow banking exposures, individually as well as globally; (ii) how to account

effectively for leverage in shadow banking entities such as investment funds, including

whether to extend the ‘look-through approach’ currently used by some banks; (iii)

whether to apply the CRD II treatment of liquidity lines and credit exposures for

securitization vehicles to all other shadow banking entities and (iv) a review of EU

member state supervisory treatment of implicit support.

The EU has also already taken several steps to address the links between banks and

shadow banks. Like the FASB, the International Accounting Standards Board (IASB) has

also addressed accounting treatment of SPVs. In May 2011, the IASB issued IFRS 10

addressing standards for consolidation, and IFRS 12, which calls for disclosure of bank

unconsolidated participations in ‘structured entities’ like securitization vehicles or

asset-backed financing. IFRS 10, which becomes effective for annual periods beginning on

or after 1 January 2013, requires an ‘investor’ in an entity to consider ‘all facts and

circumstances’ when determining whether consolidation is required, including SPV

function and structure. Consolidation is required if an entity is exposed to variable

returns due to its relationship with the SPV and can also affect those returns through its

influence over the SPV.51 The European Commission is analysing these new standards on

consolidation. In November 2011, the European Commission endorsed an amendment

to the International Financial Reporting Standards (IFRS) to improve the disclosure

requirements relating to the transfer of financial assets (related to IFRS 7).

Through ‘CRD III’, EU states have adopted stronger capital requirements that

incorporated the BCBS July 2009 recommendations. Since December 2011, banks have

been required to hold more capital to cover complex securitizations and

re-securitizations. This Directive also called for the competent authorities in each

Member State to consider reputational risks due to complicated securitization structures

or products in their Pillar 2 risk assessments. The European Commission’s CRD IV

proposal amending the Directive calls for additional liquidity facilities for products or

services linked to a bank’s reputational risk, including SPVs.

The EU large exposure regime was also revised post-crisis, with changes coming into

force after 31 December 2010. CRD II, an earlier iteration of CRD IV, contained new

rules for the large exposure regime designed to address risks arising from entity

interconnectedness and through securitizations. Specifically, the amendments address:

(i) exposure to interconnected entities, in particular when control issues or economic

dependence should cause entities to be considered a ‘single risk’ and grouped together,

and (ii) treatment of exposures to the underlying assets in investment schemes (such as

securitizations or collective investment undertakings) and prescribing, where possible,

51 See Ernst & Young, ‘IASB issues three new standards: Consolidated Financial Statements, Joint Arrangements, and Disclosure

of Interests in Other Entities’ (May 2011) 5http://www.ey.com/Publication/vwLUAssets/IFRS_Developments_Issue_1/$FILE/

IFRS_Developments_Issue_1_GL_IFRS.pdf4.


http://www.ey.com/Publication/vwLUAssets/IFRS_Developments_Issue_1/FILE/IFRS_Developments_Issue_1_GL_IFRS.pdf

http://www.ey.com/Publication/vwLUAssets/IFRS_Developments_Issue_1/FILE/IFRS_Developments_Issue_1_GL_IFRS.pdf

look-through treatment of investment schemes that will take into account risk posed by

the assets owned by the investment entity as well as the entity itself.

Numerous EU Member States have proposed laws akin to the Volcker Rule, requiring

some form of separation between commercial banking entities and other investment and

trading activities. Of individual country proposals, the Independent Commission on

Banking’s (ICB) ‘Vickers Rule’ is probably the most widely cited and debated. This

proposal, issued by the ICB in a white paper in late 2011, advocates the implementation

of firewalls around Britain’s retail banks. This proposal would entail insulating retail and

small and medium enterprise deposits within a ring-fenced subsidiary that could survive

independently of the rest of the financial institution. The ring-fenced entity would have

to independently meet enhanced capital and liquidity requirements and face limitations

on its exposures to other entities within the same group.52

The EU’s Liikanen Commission is also attempting to reduce risk to commercial banks

through structural reform. The Liikanen Commission, modeled after the UK’s ICB, was

established in February 2012 and issued a report on banking reform in October 2012.

Among its many recommendations, the report proposed separating risky trading

activities from banks’ deposit-taking function and placing trading business in separate

subsidiaries. Specifically, if a bank’s trading assets exceed E100 billion or 15–25 per cent

of its total assets, its trading activities should be transferred to an independently

capitalized subsidiary that would pose less risk to the retail banking operations of the

bank. As under the ICB Report, the independent subsidiary could remain within the same

organization as the retail banking operations, so long as these activities are conducted in

separate subsidiaries.53

While the Liikanen Report is still being debated at a conceptual level and has not yet

been transposed into legislation, the Vickers proposal has been incorporated in the UK

October 2012 Government Draft Bill on Banking Reform.54 However, the Bill is still in

draft form. Furthermore, it provides for the Treasury to set the scope of ring-fencing

policy (the ‘location’ of the ring-fence) through secondary legislation. Thus, a

determination of which activities may be undertaken within ring-fenced banks, and

which are to be prohibited, and to whom ring-fencing applies, are all matters that have

not yet been determined.

Discussion

Increased regulation of bank connectivity to the shadow banking system is one of the

many alternatives to bank prudential regulation for non-bank entities that should

continue to be explored. Several constructive steps have been taken to increase

transparency and understanding of the relationship between banks and shadow banking

52 ‘Independent Commission on Banking Final Report’ (September 2011)5http://www.hm-treasury.gov.uk/d/ICB-Final-Report.

pdf4.

53 ‘High-level Expert Group on Reforming the Structure of the EU Banking Sector’ (October 2012) 5http://ec.europa.

eu/internal_market/bank/docs/high-level_expert_group/report_en.pdf4.

54 ‘Sound Banking: Delivering Reform’ HM Treasury (October 2012)5http://www.hm-treasury.gov.uk/d/icb_banking_reform_

bill.pdf4.


http://www.hm-treasury.gov.uk/d/ICB-Final-Report.pdf

http://www.hm-treasury.gov.uk/d/ICB-Final-Report.pdf

http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/report_en.pdf

http://ec.europa.eu/internal_market/bank/docs/high-level_expert_group/report_en.pdf

http://www.hm-treasury.gov.uk/d/icb_banking_reform_bill.pdf

http://www.hm-treasury.gov.uk/d/icb_banking_reform_bill.pdf

entities. Accounting reforms have been improved to reduce opportunities for banks to

utilize shadow banking entities to artificially manipulate the size of their balance sheets

and conceal risk from regulators and investors. Greater risk-weighting of bank exposures

to shadow banking activities is also a constructive step. The intricacies of capital and

consolidation rules are complex and beyond the scope of this article, but both areas

should continue to be analysed and developed.

Although the measures discussed above have helped to increase transparency and to

discourage certain risky activities by banks, it is important to acknowledge the limitations

of this approach. Overemphasis on bank regulation may force risk outside the regulated

banks to the more opaque shadow banking sector. Lack of international coordination in

these new reforms can also lead to an uneven playing field and promote arbitrage. These

concerns are explored further below.

Potential growth of shadow banking

While steps to limit bank exposure to shadow banking are a necessary and potentially

useful means of stemming the spread of contagion, restrictive measures may drive

systemic risk outside regulated banks. New capital and consolidation rules will

significantly reduce the appeal of practices adopted to evade such requirements. As

banks therefore reduce their involvement in certain practices and activities, demand no

longer met by large banks may be met by an expanded shadow banking sector. Structural

changes will also drive more risky activities to the shadow banking sector. For example, as

banks eliminate proprietary trading and decrease their market-making role to comply

with the Volcker rule, other shadow banking institutions such as hedge funds will likely

expand to meet the surplus demand.

The counterparty credit limits under the Dodd–Frank Act are another example of how

new reforms may contribute to the growth of shadow banking and increase in systemic

risk. These proposed limits may direct more business to non-US SIFIs not subject to the

limitations.55 Ironically, these limits therefore encourage greater exposure to these non-

bank, non-SIFI entities that are not subject to heightened prudential requirements and

are potentially smaller and more vulnerable than their SIFI counterparts.

The migration of risky activities to the shadow banking sector could itself be a source

of systemic risk by greatly increasing the size of the shadow banking system. Despite new

reforms, shadow banking will be inherently more vulnerable than the government-backed

banks. Although steps are being taken to limit bank exposure to shadow banking, the

systems will remain substantially interconnected; banks will continue to receive financing

from, and be a source of funding for, the shadow banking sector. Therefore, any

limitations must be well calibrated so as to limit bank exposure without promoting

significant growth of the shadow banking system.

55 See ‘SIFI Standards: Single Counterparty Exposure Limits’ PwC (April 2012)5http://www.pwc.com/us/en/financial-services/

regulatory-services/publications/dodd-frank-closer-look.jhtml#pub384 (finding that constraining lending between large US SIFIs

may create the need to divert business to non-US SIFIs). This example also highlights the potential discontinuity caused by the

non-bank SIFI designation.


http://www.pwc.com/us/en/financial-services/regulatory-services/publications/dodd-frank-closer-look.jhtml#pub38

http://www.pwc.com/us/en/financial-services/regulatory-services/publications/dodd-frank-closer-look.jhtml#pub38

Although this growth of the shadow banking sector due to increased bank regulation is

unavoidable, certain proposals are more conducive to distortion and arbitrage. It is

therefore essential that proposals take a macrolevel view and not overly emphasize

institution-specific analyses. For example, the Vickers and Liikanen proposals both

contemplate the idea of a ‘safer’ bank by separating banks from ‘risky’ trading activities

through ring-fencing. However, Vickers calls for higher capital standards for the

ring-fenced ‘safe’ bank. Thus, if banks choose to keep certain activities within the

government-backed ring-fenced entity, they will then be required to hold capital against

such activities at a higher level than conducted in the non-ring fenced entity. In contrast,

the Liikanen proposal suggests that the ‘risky’ activities simply be removed from the retail

bank, yet allowed to remain within the same holding company. While both proposals

advocate a structural separation of retail and trading activities, the Vickers approach

forces those activities to meet higher capital requirements and disclosure obligations if in

the retail bank.

It is essential that the nature and extent of shadow banking expansion be weighed

against any potential advantages of new reforms. Governments must recognize the

potential for reforms that may be appealing in theory to promote risk migration, not

mitigation.

International consistency

Reform efforts targeting bank interaction with non-banks are relatively uniform at a high

level. The FSB, USA and EU have followed similar steps from a macro perspective:

revision of accounting rules, analysis of implicit and explicit support of shadow banking

institutions and practices, revised capital rules and limitations on the size and nature of

bank exposure to the shadow banking system through counterparty credit limits and

structural reform. Still, implementation details vary among jurisdictions.

Harmonization or some measure of uniformity is essential to the effectiveness of these

measures, especially between the international IFRS and US Generally Accepted

Accounting Principles (GAAP). Capital requirements are based on financial reporting

and it is therefore essential that we have equivalence to maintain a level playing field.

Without some measure of international uniformity, banks will be able to turn to the

international stage to evade national restrictions. Such steps would undermine

national reforms, decrease transparency and increase risk. Joint efforts by the IASB

and FASB to promote consistency between GAAP and IFRS are especially key in this

regard. IASB–FASB convergence projects have already identified consolidation of SPVs

and enhanced disclosures as key priorities. However, significant differences remain

between the two systems and should continue to be addressed.

The multiple structural changes which would be required to comply with the Volcker,

Vickers and Liikanen proposals are further evidence of the vital need for international

coordination in this area. As discussed above, banks under the Vickers approach would

be required to isolate and hold more capital in their retail banks, as this ‘traditional’

banking unit receives government support and would be rescued in a crisis. In contrast,


Liikanen calls for isolating ‘risky’ proprietary trading and significant derivatives

businesses. These proposals already independently present significant potential for

arbitrage. Ambiguous and controversial definitions (such as the definition of ‘proprietary

trading’) have been a significant obstacle to Volcker Rule implementation in the USA.

Different regimes requiring ring-fencing of different types of assets could be costly, yet

ineffective due to loopholes and arbitrage. If all three proposals are implemented,

international banks will be subject to duplicative, burdensome requirements. This

potential for overlap and arbitrage has been acknowledged in the debates surrounding all

three proposals.56 It is therefore disconcerting that the UK has determined to progress the

ICB reforms just as debate on the EU Liikanen reforms is beginning. The determination

to continue with the implementation of these rules before greater consensus is achieved

(or at the very least, attempted) should be reconsidered.

Identifying and rectifying differences among jurisdictions is extremely important. The

FSB, ESRB and FSOC must remain cognizant of the potential for arbitrage and the

increase in systemic risk due to these disparities in national regulations and initiatives.

The FSB’s November 2012 ‘Global Shadow Banking Monitoring Report’ is promising in

this regard; the paper contains a section on bank and non-bank interconnectedness and

offers recommendations to improve data quality and consistency in reporting and

monitoring. The FSOC and ESRB should consider the FSB’s data monitoring reports and

suggestions in their own analyses.

5. MMF reform

MMFs are the archetypal shadow banking entity and therefore offer an excellent

opportunity for examining various regulatory approaches to shadow banking. MMFs

exhibit an ultra-safe, deposit-like appearance that masks their inherent structural

instability. MMFs are also arguably the most ‘bank-like’ shadow banking entities;

investments in them developed to be almost interchangeable with true bank deposits and

they engaged in maturity and liquidity transformation, free from the legal safeguards that

prevent runs on traditional banks. The question of implicit support by sponsors of MMFs

and other investment vehicles also remains an important source of risk, as support is at

the same time expected by investors but not guaranteed by the sponsor or its affiliate

(since an explicit commitment could require the sponsor to consolidate supported entity

financials on its balance sheet). Uncertainty about the availability of sponsor support may

thus amplify the likelihood of runs.

This section will therefore explore the response at the FSB, USA, and EU to the risks

posed by MMFs.

56 For example, in the UK, the Parliamentary Commission on Banking Standards has often noted the difficulty in determining

how to craft the ring-fence.


Background

MMFs developed in the USA in response to the FRB’s interest rate caps on savings

deposits in commercial banks required under the Glass–Steagall Act. Money market

funds offered investors greater yields than these traditional deposits, especially during the

high inflation and high interest rates of the 1970s. Even though this interest rate cap has

disappeared, MMFs have grown to hold over $4.7 trillion in assets under management

globally as of the third quarter of 2011.57 Assets under management in MMFs totalled

approximately $2.7 trillion in the USA and $1.5 trillion in Europe, which together

comprise approximately 90 per cent of the global MMF industry.58 At the end of 2011,

MMFs owned over 40 per cent of US dollar-denominated financial commercial paper

outstanding and about one-third of dollar-denominated negotiable certificates of

deposit.59

The vast majority (80 per cent) of money market funds maintain a constant net asset

value (CNAV), a legal fiction that allows the funds to report a $1 net asset value (NAV)

per share even as their portfolio securities fluctuate in value.60 NAV is, by definition, the

total value of all the securities in a money market fund’s portfolio, less any liabilities,

divided by the number of fund shares outstanding. However, CNAV funds make use of

various accounting techniques that the Securities and Exchange Commission (SEC)-

approved that allow them to consistently report a NAV of $1 despite daily changes in the

value of its assets.61 Because the values of securities fluctuate, funds that report a CNAV

therefore do not accurately reflect the true value of the fund’s investments if they had to

be liquidated in a time of stress or market uncertainty. When an investor withdraws from

a fund, its return is based on this reported CNAV. MMFs are required to monitor the

deviation between this artificial CNAV and its ‘true’ or ‘shadow’ NAV using current

market prices. If there is a difference of more than half of one per cent, the fund must

lower its NAV below $1, an event colloquially known as ‘breaking the buck’.

CNAV funds therefore contain an inherent incentive to redeem if there is concern

about safety. Investors who are the first to redeem have assets distributed based on the $1

CNAV regardless of the actual value of the underlying portfolio. These first movers

transfer losses to investors who leave their assets in the fund and risk the potential drop in

NAV if the 0.5 per cent threshold is reached. Furthermore, MMFs meet redemptions by

selling their most liquid securities first. Thus, remaining investors are left with a pool of

57 International Organization of Securities Commissions, ‘Money Market Fund Systemic Risk Analysis and Reform Options:

Consultation Report’ (April 2012)5http://www.iosco.org/library/pubdocs/pdf/IOSCOPD379.pdf4(‘IOSCO MMF Consultation’).

58 ibid.

59 PE McCabe and others, ‘The Minimum Balance at Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market

Funds’ Federal Reserve Bank of New York Staff Reports (July 2012)5http://www.newyorkfed.org/research/staff_reports/sr564.pdf4.

60 International Organization of Securities Commissions, ‘Policy Recommendations for Money Market Funds’ (October 2012)

5http://www.iosco.org/library/pubdocs/pdf/IOSCOPD392.pdf4 (‘IOSCO MMF October 2012 Report’).

61 MMFs were given permission by the SEC in 1983 to use both the penny rounding method of pricing and the amortized cost

method of valuation to maintain a CNAV. Amortized cost method of valuation permits MMFs to calculate their current NAV by

valuing all portfolio securities and assets at their acquisition costs (with minor adjustments for amortization) rather than at current

market value, even if market prices are available. SEC Rule 2a-7(a)(2). Penny rounding allows an MMF to round the NAV per share

to the nearest one cent on a share value of one dollar. SEC Rule 2a-7(a)(20).





less liquid securities to meet their redemptions. In times of market uncertainty, this

structural benefit for early redeemers exposes funds to a risk of runs. This instability is

exacerbated by the fact that institutional investors comprise a large percentage of the

MMF investor base; these investors typically exhibit extreme risk aversion and are more

likely than other investors to preemptively redeem in response to market uncertainty.

Moreover, unlike commercial banks, MMFs are not required to hold capital reserves and

do not have access to central bank funding or deposit insurance.

For decades, MMFs have been viewed as safe alternatives to deposits despite this

fundamental instability. From 1970 to 2007 only a handful of funds ‘broke the buck’,

promoting the mistaken belief that such funds were risk-free alternatives to bank

deposits.62 Most MMFs have even let investors write an unlimited number of checks

against their accounts each month, though each check must be for a minimum amount

(typically of $500).

Despite their risk-free appearance, recent studies have shown that, for years, MMFs

have relied on discretionary sponsor capital support to preserve their CNAVs. According

to one source, over 200 funds were beneficiaries of some form of sponsor support in

Europe and in the USA from 1980 to 2009.63 One Moody’s report finds that, without

direct intervention and support by sponsors, 146 funds would have broken the buck

between 1980 and mid-2007.64

The financial crisis exposed the truly precarious condition of MMFs. While money

market funds did not cause the financial crisis, the 2008 run demonstrated their potential

for amplifying and spreading contagion. Almost immediately following Lehman’s

bankruptcy filing on 15 September 2008, Reserve Primary, a $62-billion money market

fund, ‘broke the buck’ due to its exposure to $785 million of Lehman commercial

paper.65 This watershed incident quickly dispelled the myth of safety surrounding the

funds. Investors withdrew more than $200 billion in two days66 and in total withdrew

approximately $300 billion from prime MMFs (MMFs which principally invest in

non-government securities), the equivalent of 14 per cent of the assets held in those

funds.67

62 There is disagreement concerning the precise number of MMFs that broke the buck prior to the 2008 financial crisis, ranging

from one to three. See eg D Larrabee, ‘Is a Floating NAV the Fix Money Market Funds Need?’ (2012)5http://blogs.cfainstitute.

org/investor/2012/03/14/is-a-floating-nav-the-fix-money-market-funds-need/ (stating that ‘Only twice in their 40-year history have

money market funds broken the buck.’); D Brewster and J Chung, ‘Fear of money Market Funds Breaking the Buck’ Financial

Times (September 2008) 5http://www.ft.com/intl/cms/s/0/696e3dc0-84e4-11dd-b148-0000779fd18c.html#axzz1PBgup83O4(‘Only once before has a money market fund seen its net asset value fall below $1 a share.’); ‘Money Markets Are Not Risk

Free’ US Wealth Group (July 2012) 5http://www.uswealthgroup.com/uncategorized/money-markets-are-not-risk-free/ (‘Up until

2008, only three funds broke the buck in their 37 year history’).

63 Moody’s Investors Service, ‘Sponsor Support Key to Money Market Funds’ (August 2010) 5http://www.alston.

com/files/docs/Moody’s_Report.pdf (‘Moody’s Report’).

64 ibid.

65 ‘Reserve Primary Fund Founder Fails to End SEC Fraud Case’ Reuters (March 2012) 5http://www.reuters.

com/article/2012/03/29/reserve-sec-idUSL2E8ETAM1201203294.

66 ‘Breaking the Buck: Taxpayers Should Not Have to Bail Out Money-market Investors’ Chicago Tribune (September 2012)

5http://articles.chicagotribune.com/2012-09-04/news/ct-edit-money-20120904_1_money-market-funds-reserve-primary-fund-

money-market-investors4.

67 IOSCO MMF Consultation (n 57).


http://blogs.cfainstitute.org/investor/2012/03/14/is-a-floating-nav-the-fix-money-market-funds-need/

http://blogs.cfainstitute.org/investor/2012/03/14/is-a-floating-nav-the-fix-money-market-funds-need/

http://www.ft.com/intl/cms/s/0/696e3dc0-84e4-11dd-b148-0000779fd18c.html#axzz1PBgup83O

http://www.uswealthgroup.com/uncategorized/money-markets-are-not-risk-free/

http://www.alston.com/files/docs/Moody's_Report.pdf (Moodys Report

http://www.alston.com/files/docs/Moody's_Report.pdf (Moodys Report

http://www.reuters.com/article/2012/03/29/reserve-sec-idUSL2E8ETAM120120329

http://www.reuters.com/article/2012/03/29/reserve-sec-idUSL2E8ETAM120120329

http://articles.chicagotribune.com/2012-09-04/news/ct-edit-money-20120904_1_money-market-funds-reserve-primary-fund-money-market-investors

http://articles.chicagotribune.com/2012-09-04/news/ct-edit-money-20120904_1_money-market-funds-reserve-primary-fund-money-market-investors

MMFs met redemption demands by selling securities into stressed markets, thereby

depressing the values of those securities and weakening the balance sheets of other MMFs

invested in similar assets, leading to a self-perpetuating cascade of MMF redemptions and

deterioration. In response, MMFs significantly reduced their purchases of commercial

paper, certificates of deposits and other short-term instruments and stopped rolling over

existing positions, opting for cash to meet redemption demands. The abrupt drop in

purchases of commercial paper eliminated a vital funding source for many companies,

such as GE, which were not able to issue new short-term debt.

The US government and private-sector sponsors intervened to staunch the flood

of redemptions. A study by the Boston Fed found sponsors provided a combined total of

over $4.4 billion to 78 funds between 2007 and 2011. According to that same study, 21 of

the funds would have broken the buck without such support.68 Moody’s found that 36

MMFs in the USA and 26 in Europe were bailed out by their sponsor or parent company

during the financial crisis, costing at least $12.1 billion, with one sponsor alone supplying

$2.9 billion in support.69

On 19 September 2008, only four days after the Lehman filing, the US Treasury

announced a temporary guarantee programme for assets in MMFs that had not yet

broken the buck.70 Each MMF had to choose to participate in the programme by 8

October 2008 and pay a fee to do so. In return, the programme would insure shareholders

for losses incurred following 19 September 2008. Treasury’s creation of the programme

was intended to enhance market confidence and alleviate investors’ concerns about the

ability of MMFs to absorb a loss.

On 19 September, the FRB opened the Federal Reserve’s Asset-Backed Commercial

Paper Money Market Mutual Fund Liquidity Facility (AMLF). The AMLF, administered

by the Boston Fed, was a lending facility that provided non-recourse funding to US

banks, BHCs and branches of foreign banks to finance purchases of collateralized debt at

face value from MMFs to promote market liquidity and help funds meet redemptions.

The AMLF began operating on 22 September 2008, and, at its peak on 1 October 2008,

the programme held $152 billion in commercial paper.71

These programmes were successfully able to staunch the wave of redemptions and

restore calm in the MMF sector. As a result, the Treasury program was allowed to expire

in September 2009 and the AMLF was closed on 1 February 2010.72 Nevertheless, these

destabilizing MMF runs in 2008 led to calls for reform of the industry at both the national

and international level.

68 ‘The Stability of Prime Money Market Mutual Funds: Sponsor Support from 2007 to 2011’, Federal Reserve Bank of Boston,

Working Paper RPA 12-3 (August 2012)5http://www.bos.frb.org/bankinfo/qau/wp/2012/qau1203.pdf4.

69 Moody’s Report (n 63).

70 See ‘Frequently Asked Questions About Treasury’s Temporary Guarantee Program for Money Market Funds’, Treasury

Department Press Center (September 2009)5http://www.treasury.gov/press-center/press-releases/Pages/hp1163.aspx4.

71 See ‘Asset Backed Commercial Paper (ABCP) Money Market Mutual Fund (MMMF) Liquidity Facility (AMLF or ‘‘the

Facility’’)’ (February 2010)5http://www.frbdiscountwindow.org/mmmf.cfm?hdrID¼144.

72 ‘Treasury Announces Expiration of Guarantee Program for Money Market Funds’, Treasury Department Press Center

(September 2009)5http://www.treasury.gov/press-center/press-releases/Pages/tg293.aspx4.


http://www.bos.frb.org/bankinfo/qau/wp/2012/qau1203.pdf

http://www.treasury.gov/press-center/press-releases/Pages/hp1163.aspx

http://www.frbdiscountwindow.org/mmmf.cfm?hdrID=14

http://www.frbdiscountwindow.org/mmmf.cfm?hdrID=14


FSB

In October 2011, the FSB tasked IOSCO with reviewing potential regulatory reforms of

MMFs to mitigate their susceptibility to runs and other systemic risks, and to develop

policy recommendations by July 2012. IOSCO then delegated this task to its Standing

Committee on Investment Management (SC5). IOSCO published its consultation on 27

April 2012 based in part on high-level meetings with industry representatives and

findings from a mapping exercise conducted in June 2011 to assess and compare existing

regulatory frameworks for MMFs among IOSCO members.73 The paper included a

historical discussion on MMF development, including the 2008 run, and solicited

feedback concerning several policy options by the close of the consultation period on 27

June 2012.

Following review of a total of 41 contributions from 12 countries, IOSCO published its

final report in October 2012.74 IOSCO plans to review reform implementation and

potentially revise these recommendations within two years, taking into account new

market or legal developments. The major report recommendations are discussed below.

Explicit functional definition of MMFs

The IOSCO report recognizes that any definition of MMFs would likely vary among

jurisdictions. However, as a starting point, the report suggests that MMFs be defined as

‘investment funds that seek to preserve capital and provide daily liquidity, while offering

returns in line with money market rates’. This functional definition will therefore capture

all funds that present the same risks as MMFs. The report advises regulators to monitor

closely the development and use of investment vehicles similar to MMFs to avoid

regulatory arbitrage. For entities that are similar to MMFs but not collective investment

schemes (eg structured vehicles, private funds or unregulated cash pools), regulators

should ‘assess the need to extend the perimeter of regulation to such products and to

impose requirements which are consistent with the recommendations described [in the

report] taking into consideration the nature and risks of these products’.

Restrictions on MMF portfolio quality

The report calls for strict controls on the types of assets MMFs may hold. Specifically,

funds should only invest in high-quality, low-duration instruments with clear limits on

the average weighted term to maturity and the weighted average life of the portfolio,

though such limits need not be identical for all funds. The report also calls for limiting

purchases from a single investor through concentration limits and diversification ratios.75

MMFs should also be required to hold a minimum amount of liquid assets to strengthen

their ability to face redemptions and prevent fire sales.

73 IOSCO MMF Consultation (n 57).

74 IOSCO MMF October 2012 Report (n 60).

75 It is important to distinguish between concentration limits on MMF investments in a particular debtor as opposed to

concentration limits on the MMF investor base, restricting overreliance on a particular investor. IOSCO supports the former, but

does not recommend the latter.


‘Exceptional’ redemption restrictions

MMFs should have tools to prevent large redemptions when facing exceptional market

conditions and substantial redemption pressures. These techniques might include

temporary suspensions, gates and/or redemptions-in-kind.76 These tools could be

imposed by the fund or required by a regulator. Funds should establish safeguards to

reduce the likelihood of large redemptions from a single investor by potentially limiting

investment from a single investor, though the report does not advocate specific

concentration limits. The potential use of such techniques should be disclosed to

investors prior to investing in the fund. Although provocative ideas, the report does not

elaborate further on these proposals.

Reduced reliance on credit ratings

In keeping with the FSB’s 2010 ‘Principles for Reducing Reliance on CRA Ratings’,

IOSCO suggests measures to mitigate potential negative effects of overreliance on credit

ratings by MMFs.77 The report warns against ‘mechanistic reliance on external ratings’,

which can lead to herding and asset fire sales. To further mitigate against such ‘cliff

effects’, funds should be afforded a reasonable time to respond to portfolio asset

downgrades to address a temporary failure to meet credit rating agency standards. The

report calls for strengthening the obligations of the responsible entities regarding internal

credit risk assessment practices. Rating agencies should also make clear the current rating

methodologies employed for MMF ratings.

Limitation on the CNAV

The report prescribes restricting, though not completely eliminating, the use of CNAV by

MMFs. The report calls for MMFs to adopt a floating NAV and use fair value accounting

for portfolio securities ‘where such a move is workable’. The report claimed that adoption

of a floating NAV would reduce the first mover advantage caused by the discontinuity in

MMF pricing created by the 0.5 per cent threshold. The report also stated its belief that a

floating NAV would help dispel the perception that MMFs are risk-free by highlighting

the difference between MMFs and traditional bank deposits. Furthermore, if investors

grow familiar with small NAV fluctuations, IOSCO believed they will be less likely to

redeem at the first indication of losses. Finally, the loss transfer to remaining investors

caused by redemptions at a misleadingly high $1 NAV would also decrease with a variable

NAV (VNAV).

To mitigate market disruption caused by a shift from constant to floating NAV,

IOSCO recommends a transition period. A gradual transition would be especially

important for investors with investment restrictions or guidelines that proscribe investing

in floating NAV funds. A transition period would also be useful in addressing operational

changes, such as IT and back-office systems. Floating NAV funds would need to recognize

76 A gate partially limits the ability of an investor to redeem all of its investments from a fund, whereas most temporary

suspension provisions proscribe redemptions completely.

77 Financial Stability Board, ‘Principles for Reducing Reliance on CRA Ratings’ (October 2010)5http://www.financialstability-

board.org/publications/r_101027.pdf4.




gains and losses and therefore face additional accounting burdens. A floating NAV might

also increase cost of tax compliance, as all share sales would be tax-reportable events.

Regulators might consider steps to ease or delay compliance burdens related to these new

obligations.

The report allows for limited use of a CNAV and amortized cost accounting, but only

when paired with additional safeguards to enforce CNAV fund resilience. The report

recommends that funds maintaining a CNAV be subject to additional restrictions. Under

the IOSCO proposal, amortized cost valuation for any MMF securities could only be used

when unlikely to lead to mispricing. Because the amortized cost method is likely to be less

accurate with holdings of longer duration, the report suggests that it not be used for

assets with a residual maturity of greater than 90 days. Regulators should consider a

transition period when introducing such a maturity limit. Corrective action procedures

should also be in place when the deviation between the CNAV and shadow NAV passes a

specified threshold.

In addition to restrictions on the use of amortized cost accounting, funds offering a

CNAV should implement additional safeguards to slow redemptions and lessen the first

mover advantage. Several proposals are mentioned in the report, including NAV buffers

by accumulating returns ‘or by any other mechanism’, explicit sponsor commitment, and

restrictions on redemptions. Such restrictions may include liquidity fees or fund

holdbacks on a percentage of a shareholder’s redemption.

Other recommendations

The report also calls for improved disclosure to investors of potential MMF risks, MMF

policies and procedures to know their investors, stress testing, and further examination

and reform of the framework governing MMF use of repos.

USA

In response to the crisis, the SEC adopted amendments to Rule 2a-7 of the 1940

Investment Company Act, the regulation governing money market funds. These January

2010 amendments were designed to improve the liquidity and quality of MMF portfolios.

The new reforms addressed eligible investments by MMFs, reducing maturities,

improving credit standards and mandating new liquidity requirements. Funds must,

for the first time, undergo stress tests to assess the fund’s ability to maintain a stable NAV

during times of market turmoil, including interest rate changes, higher redemptions and

changes in portfolio credit quality. The new provisions also call for regular reporting of

the ‘shadow NAV’ to the public.

The SEC also adopted new Rule 22e-3, which allows MMFs to suspend redemptions

and payment of redemption proceeds if the fund’s board determines that the difference

between the CNAV and ‘shadow’ NAV will cause ‘material dilution and other unfair

results’ and the board has agreed to liquidate the fund. Notification to the SEC is also

required.


To reduce moral hazard, laws have limited the government’s ability to backstop money

market fund runs in the future. The AMLF programme cannot legally be reinstated

(at least, in its previous form); the programme was funded by the Treasury Department

using the Exchange Stabilization Fund, but Congress has specifically prohibited the use of

this fund again to guarantee MMF shares.78

These reforms addressed fund liquidity and portfolio quality, but failed to remove

investors’ first mover advantage and the resulting susceptibility of MMFs to runs. To

address this omission, the SEC has considered two major reforms: elimination of the

ability to maintain a CNAV and/or require MMFs to hold cash reserves to meet

unexpectedly high redemption demands.

Despite widespread agreement in the USA that further MMF reform is necessary, the

majority of SEC commissioners has been reluctant to move forward on these two

proposals. Indications of this reluctance were evident in the spring of 2012, when the

majority of SEC commissioners responded negatively to the IOSCO interim report on

MMF reform. On 11 May 2012, Commissioners Luis Aguilar, Troy Paredes and Daniel

Gallagher (a bipartisan majority of the Commission) issued a statement that the report

did not represent the SEC’s views, and were critical that the SEC, in its capacity as a

member of IOSCO, did not do more to have the report withdrawn for reconsideration.

The Commissioners did not indicate why they disagreed with the recommendations in

the IOSCO report.79 The statement was a rebuke to Chairman Mary Schapiro, who as the

SEC representative to IOSCO had endorsed many of the changes included in the report.

This reaction also calls into question how the SEC, traditionally a key and influential

member of IOSCO, should interact with IOSCO and what internal steps should be taken

before its representative agrees to any report or recommendation that IOSCO issues.

Chairman Schapiro intended to hold a vote on 29 August 2012 that would have

released these proposals for public comment. At the time, there was widespread

agreement that changes to MMFs were necessary and that such reforms should be led by

the SEC as the primary functional regulator of MMFs.80

However, Chairman Schapiro abandoned the effort shortly before the intended vote

when it became evident that she could not obtain the requisite support of a majority of

the Commissioners. She then stated, in light of her weakened position, that she would

78 See Emergency Economic Stabilization Act of 2008, Public Law 110-343, 122 Stat 3765 s 131 (‘The Secretary is prohibited from

using the Exchange Stabilization Fund for the establishment of any future guaranty programs for the United States money market

mutual fund industry.’).

79 ‘Statement concerning publication by IOSCO on 27 April 2012 of the ‘Consultation Report of the IOSCO Standing

Committee 5 on Money Market Funds: Money Market Fund Systemic Risk Analysis and Reform Options’ (May 2012)

5http://www.sec.gov/news/speech/2012/spch051112laatapdmg.pdf4.

80 SEC Chairman Mary Schapiro recognized a need ‘to pursue more fundamental changes to the structure of money market

funds to further protect them from the risk of runs’. Chairman Mary Schapiro, ‘Speech by SEC Chairman: Statement on Money

Market Funds Before the Open Commission Meeting’ (January 2010) 5http://www.sec.gov/news/speech/2010/spch012710mls-

mmf.htm4. The President’s Working Group on Financial Markets ‘agree[d] with the SEC that more should be done to address

MMFs’ susceptibility to runs’. ‘Report of the President’s Working Group on Financial Markets: Money Market Fund Reform

Options’ (October 2010)5http://www.sec.gov/rules/other/2010/ic-29497.pdf4.


http://www.sec.gov/news/speech/2012/spch051112laatapdmg.pdf

http://www.sec.gov/news/speech/2010/spch012710mls-mmf.htm

http://www.sec.gov/news/speech/2010/spch012710mls-mmf.htm

http://www.sec.gov/rules/other/2010/ic-29497.pdf

cease attempts to implement MMF changes through the SEC, and instead support MMF

reform initiatives recommended by other regulators, in particular, the FSOC.

On 27 September 2012, Treasury Secretary Geithner directed the FSOC to immediately

begin drafting a formal recommendation to the SEC on MMF reform. On 13 November

2012, the FSOC released these recommendations pursuant to its Section 120 authority

under the Dodd–Frank Act for public comment.81 As stated above, Section 120

authorizes the FSOC to issue ‘recommendations to the primary financial regulatory

agencies to apply new or heightened standards and safeguards, for a financial activity or

practice conducted by bank holding companies or non-bank financial companies under

their respective jurisdictions’.

The FSOC offered three potential reform alternatives. The first, simple approach is the

mandatory move to a floating NAV. The second option allows MMFs to maintain a

CNAV, but also employ an NAV buffer and ‘minimum balance at risk’ (MBR). The NAV

buffer would be built over time and would be a tailored amount of assets of up to 1 per

cent to absorb daily MMF portfolio volatility. The MBR would require that 3 per cent of a

shareholder’s highest account value in excess of $100,000 during the previous 30 days

(the MBR) be subject to a delay before redemption is allowed. This MBR would then be

subordinated to other investor claims if the MMF suffers losses above the NAV buffer.

Put differently, losses would first be met with the MBRs of shareholders who have

recently redeemed, thereby creating a disincentive to redeem early. The last option

presented by the FSOC was a CNAV combined with a higher 3 per cent NAV buffer and

measures other than the MBR. Such additional measures could include further reforms to

portfolio diversification and liquidity requirements and improved disclosure obligations.

The SEC is not required to adopt any of the FSOC recommendations made after public

comment has been considered. Instead, the agency may, not later than 90 days after the

date of the recommendation, explain in writing why any of the recommendations will not

be adopted. The FSOC is required to report any recommendations and the ensuing

implementation or rejection to Congress. Comments were due on the FSOC’s

recommendations by 18 January 2013.

EU

Money market funds are also significant actors in the EU market, but their role is more

limited than in the USA. As stated above, at their peak, assets under management totalled

approximately $1.5 trillion in Europe, little over 50 per cent that of the size of the US

market. At the end of 2011, this number had fallen to about $1 trillion. However, while

small when compared with MMFs in the USA and other European financial institutions,

MMFs are a substantial component of the asset management industry in Europe;

according to European Central Bank data, MMFs comprise approximately 14 per cent of

the total assets under management of all euro area investment funds. In France,

81 In the interim, the industry proposed a compromise that called for a redemption fee during times of crisis (but not capital

buffers or a floating NAV). See N Popper, ‘Mutual Fund Leaders Aim to End Jam Over Rules’ NY Times (October 2012)

5http://www.nytimes.com/2012/10/27/business/money-market-fund-industry-looks-for-deal-with-regulators.html?_r¼04.


http://www.nytimes.com/2012/10/27/business/money-market-fund-industry-looks-for-deal-with-regulators.html?_r=0

http://www.nytimes.com/2012/10/27/business/money-market-fund-industry-looks-for-deal-with-regulators.html?_r=0

Luxembourg and Ireland, where almost all EU MMFs are domiciled, their role is even

more important. In Luxembourg and Ireland, MMFs respectively account for 27 per cent

and 22 per cent of the balance sheets of financial institutions (not including national

central banks). In France, 30 per cent of the total assets under management of investment

funds are held by MMFs.

Unlike in the USA, some European MMFs report a VNAV to investors. According to

current estimates in a report by the European Commission, 60 per cent of the MMFs in

Europe follow a VNAV model whereas 40 per cent follow the CNAV model, but

European CNAV funds are typically much larger than European NAV funds.82

In spite of the smaller and more diverse EU MMF sector, European MMFs experienced

significant redemptions beginning in the third-quarter of 2007, particularly in France,

Germany and Luxembourg. Between 15 and 20 European funds suspended redemptions

for a brief period of time and four were eventually closed. As in the USA, the run was

stemmed by sponsor support and government aid. In particular, Luxembourg and

Germany, two of the countries experiencing the greatest number of redemptions, offered

statements of support and liquidity assistance.83

While the EU run on MMFs was therefore more contained and less substantial than

the massive redemptions witnessed in the USA, the size and interconnectedness of such

funds has nevertheless prompted reform efforts at the EU level. Money market funds in

the EU are governed by the UCITS Directive, an EU Directive adopted in 1985 and

designed to harmonize regulation of funds investing in ‘transferable securities’

throughout the EU. UCITS funds are required to invest in the eligible liquid instruments

listed in Article 50 of the UCITS Directive, including transferable securities, money

market instruments, units of collective investment schemes, bank deposits and financial

derivative instruments. The UCITS also contains requirements for leverage, counterparty

risk and diversification. Authorization as a UCITS enables funds, including MMFs, to be

sold across the EU to both wholesale and retail investors.

The UCITS Directive is a broad framework that encompasses a variety of funds, but

does not prescribe rules specific to MMFs.84 In May 2010, the Committee of European

Securities Regulators (CESR, predecessor to the European Securities and Markets

Authority, or ESMA) published non-binding guidelines to establish common standards

for MMFs and address some of the problems identified during the financial crisis.85 These

standards came into force in July 2011, affording a six-month transitional period for

existing funds. The non-binding guidelines helped to harmonize definitions of MMFs

82 European Commission, ‘Undertakings for Collective Investment in Transferable Securities (UCITS)’, (July 2012)5http://ec.

europa.eu/internal_market/consultations/docs/2012/ucits/ucits_consultation_en.pdf4 (‘UCITS Consultation’).

83 Steve Johnson, ‘No let up for money market funds’ Financial Times (October 2012) 5http://www.ft.

com/intl/cms/s/0/c53753ba-1867-11e2-80af-00144feabdc0.html#axzz2AojlYMIx4.

84 European Fund and Asset Management Association (EFAMA) data implies that, at the end of 2011, MMFs accounted for

about 19 per cent of all UCITS. See European Systemic Risk Board Occasional Paper Series, Money Market Funds in Europe and

Financial Stability (June 2012) 5http://www.esrb.europa.eu/pub/pdf/occasional/20120622_occasional_paper.pdf4 (‘ESRB MMF

Paper’).

85 Committee of European Securities Regulators, ‘CESR’s Guidelines on a Common Definition of European Money Market

Funds’ (May 2012)5http://www.esma.europa.eu/system/files/10_049.pdf.


http://ec.europa.eu/internal_market/consultations/docs/2012/ucits/ucits_consultation_en.pdf

http://ec.europa.eu/internal_market/consultations/docs/2012/ucits/ucits_consultation_en.pdf

http://www.ft.com/intl/cms/s/0/c53753ba-1867-11e2-80af-00144feabdc0.html#axzz2AojlYMIx

http://www.ft.com/intl/cms/s/0/c53753ba-1867-11e2-80af-00144feabdc0.html#axzz2AojlYMIx

http://www.esrb.europa.eu/pub/pdf/occasional/20120622_occasional_paper.pdf

http://www.esma.europa.eu/system/files/10_049.pdf

across the EU and created stricter standards in terms of portfolio quality and maturity,

risk management, disclosure and the use of CNAV. In contrast to US law, the guidance

distinguished between short-term MMFs (STMMF), which can either have constant or

floating NAV, and longer-term MMFs which are required to have a floating NAV. Most

US MMFs are similar to CNAV STMMFs.

In July 2012, the European Commission launched a consultation on a framework for

investment funds, including among its objectives clarification of ‘the interaction between

the debate on shadow banking and the role of investment funds’.86 The consultation in

part focuses on MMFs, including floating NAV calculation methodologies, the systemic

risk posed by MMFs, and the role of MMFs in the securities lending and repo markets.

The consultation also calls into question the MMF regulatory framework, seeking

feedback on whether MMF risk should be managed under the UCITS Directive, AIFMD,

both, or through a separate law centred on MMFs. The consultation requests feedback on

proposals similar to those considered by the IOSCO report and the SEC: capital buffers,

redemption restrictions, restriction or even phase-out of CNAV, and liquidity constraints

in addition to those already imposed by the ESMA guidelines. The consultation also

considers the role of credit ratings in MMF investments, including MMF reliance on

credit ratings in portfolio management and whether MMFs themselves should be rated.

The consultation also expressed concern that portfolio quality constraints based on credit

ratings would force MMFs to sell downgraded assets to comply with such requirements.

EU officials have repeatedly confirmed their commitment to MMF reform, while

condemning the US failure to put forward significant proposals.87 The priority of MMF

reform is evidenced by the ESRB’s first ‘occasional paper’, which is dedicated to MMFs.88

The ESRB paper did not prescribe specific policy proposals, but instead listed ‘avenues for

further exploration’, including: eliminating the CNAV, capital buffers, redemption gates

and increased capital requirements for MMF sponsors. The report also considered

reforms already implemented in the USA by the SEC but not yet applied in Europe, such

as detailed liquidity management rules (including a minimum share of highly liquid

assets, as in the 2010 SEC 2a-7 amendments) and reinforcing management responsibility

to understand their investor base. The paper also calls for further investigation of issues

related to sponsor support, resolution frameworks and further understanding of the use

of ratings by MMFs. Since the release of the paper in June 2012, the ESRB is reported to

be considering a ban on parent or sponsor support of MMFs.89

86 UCITS Consultation (n 82).

87 D Ricketts, ‘Brussels Sticks to Money Market Reform’ Financial Times (September 2012) 5http://www.ft.

com/intl/cms/s/0/3db98b22-0941-11e2-a5e3-00144feabdc0.html#axzz2AojlYMIx44 (quoting Emil Paulis, head of the European

Fund and Asset Management Association, stating that ‘We are very disappointed that, in the USA, money market funds have not

yet been successfully regulated by the SEC . . . . We regret what is happening there and we do not intend to follow that route.’)

88 ESRB MMF Paper (n 84).

89 S Johnson, ‘Plan to Ban Money Fund Bailouts’ Financial Times (October 2012) 5http://www.ft.com/intl/cms/s/0/53f2b402-

1915-11e2-af4e-00144feabdc0.html#axzz2Fp1PKwlo4.


http://www.ft.com/intl/cms/s/0/3db98b22-0941-11e2-a5e3-00144feabdc0.html#axzz2AojlYMIx4

http://www.ft.com/intl/cms/s/0/3db98b22-0941-11e2-a5e3-00144feabdc0.html#axzz2AojlYMIx4

http://www.ft.com/intl/cms/s/0/53f2b402-1915-11e2-af4e-00144feabdc0.html#axzz2Fp1PKwlo

http://www.ft.com/intl/cms/s/0/53f2b402-1915-11e2-af4e-00144feabdc0.html#axzz2Fp1PKwlo

Discussion

The need for further reform

Money market funds remain a major source of systemic risk and instability. Despite US

and EU reform efforts, MMFs remain vulnerable and highly responsive to market

shocks.90

In 2011, after the ESMA guidelines and revisions to Rules 2a-7 and 22e in the USA,

MMFs faced a ‘slow-motion’ or ‘quiet’ run due to concern about their exposure to

European sovereign debt. MMFs now offer no yield to new investors, as interest rates on

short-term French and German government debt have become negative and the

European Central Bank cut the interest rate on deposits in mid-2012.91 Several

companies, including JP Morgan, Goldman Sachs and BlackRock, have closed their funds

to new money.92 Money market funds had outflows of $28.4 billion over the third quarter

of 2012, the biggest outflow since June.93

The current low interest rate environment has caused analysts to question the utility of

MMFs, as they have struggled to find assets of sufficiently low-risk, short duration and

high-yield. Some argue that the ‘money market fund model is essentially broken’94 and

MMFs are ‘merely a vestige of obsolete bank regulation’, as the interest rate cap that led

to their development is no longer in effect.95 If MMFs are truly unnecessary actors

superseded by new market innovations and opportunities, then reforms that may make

MMFs less attractive to investors do not present a significant problem.

However, these arguments ignore the key role that MMFs continue to play in the

short-term debt market. Overly burdensome regulations that would substantially limit

investments in MMFs would shrink the market for the short-term debt of major financial

institutions and companies. As the US economy struggles through sluggish growth,

regulators should avoid unnecessarily restricting credit precisely when it is difficult to

raise.

Reliance on sponsor support alone is an inadequate solution. As stated in a Federal

Reserve 2010 report, ‘despite the apparent importance of sponsor support for MMFs, the

practice is discretionary, unregulated, and opaque, and it is probably most unreliable

when systemic risks are most salient’. Thus, acceptance of the status quo disregards

90 In some cases, the 2010 SEC reforms may have introduced new risk to the system by increasing demand for short-term debt,

which can be particularly volatile in times of market stress. The rule has also increased demand for repos by requiring taxable

MMFs to hold at least 10 per cent of their assets in daily liquid instruments, which includes overnight repos. ‘Fitch: Money Market

Funds Focus on Repo Counterparty Credit’ (September 2010) 5http://in.reuters.com/article/2012/09/24/idINWNA599720

1209244.

91 A Makan, ‘Money Market Funds Look to Pass on Losses’ (September 2012) 5http://www.ft.com/intl/cms/s/0/af5c0160-

f68b-11e1-9dff-00144feabdc0.html#axzz2AojlYMIx4.

92 D Kopecki and C Stein, ‘JPMorgan, Goldman Shut Europe Money Funds After ECB Cut’ Bloomberg (July 2012)5http://www.

bloomberg.com/news/2012-07-06/jpmorgan-shuts-europe-money-market-funds-on-ecb-rate-cut.html4.

93 S Forgione, ‘Investors Take Stock Risk While Exiting Money Market Funds: EPFR’ Reuters (November 2012)5http://www.

reuters.com/article/2012/11/02/us-investing-fundflows-epfr-idUSBRE8A117W201211024.

94 T Alloway, ‘Sympathy for the Money Market Funds’ Financial Times (August 2009) 5http://ftalphaville.ft.

com/2009/08/25/68501/sympathy-for-the-money-market-funds/4.

95 TK Brown, ‘The S.E.C. Needs To Get A Handle On Money Market Funds’ (September 2012) 5http://www.istockanalyst.

com/finance/story/6030010/the-s-e-c-needs-to-get-a-handle-on-money-market-funds4.


http://in.reuters.com/article/2012/09/24/idINWNA599720120924

http://in.reuters.com/article/2012/09/24/idINWNA599720120924

http://www.ft.com/intl/cms/s/0/af5c0160-f68b-11e1-9dff-00144feabdc0.html#axzz2AojlYMIx

http://www.ft.com/intl/cms/s/0/af5c0160-f68b-11e1-9dff-00144feabdc0.html#axzz2AojlYMIx

http://www.bloomberg.com/news/2012-07-06/jpmorgan-shuts-europe-money-market-funds-on-ecb-rate-cut.html

http://www.bloomberg.com/news/2012-07-06/jpmorgan-shuts-europe-money-market-funds-on-ecb-rate-cut.html

http://www.reuters.com/article/2012/11/02/us-investing-fundflows-epfr-idUSBRE8A117W20121102

http://www.reuters.com/article/2012/11/02/us-investing-fundflows-epfr-idUSBRE8A117W20121102

http://ftalphaville.ft.com/2009/08/25/68501/sympathy-for-the-money-market-funds/

http://ftalphaville.ft.com/2009/08/25/68501/sympathy-for-the-money-market-funds/

http://www.istockanalyst.com/finance/story/6030010/the-s-e-c-needs-to-get-a-handle-on-money-market-funds

http://www.istockanalyst.com/finance/story/6030010/the-s-e-c-needs-to-get-a-handle-on-money-market-funds

the continuing interconnectedness of MMFs and the rest of the financial system as well as

the harm caused by MMF instability in 2008. That 2008 run led to a collapse in the

commercial paper market and, as a result, froze short-term funding for businesses.

The market may be even more interconnected and vulnerable today. Many regulators

and commentators have described MMFs as a potential multiplier of a European

sovereign debt shock.96 Several factors have led to increasing consolidation in the

industry in both the USA and EU.97 Fewer but larger MMFs will lead to a greater

concentration of liquidity and contagion risk both at the fund and sponsor levels.98 Thus,

the interconnectedness of MMFs and consequent ability to spread contagion are clear

grounds for further industry and regulatory reform.

Reform proposals

Given the continuing role of MMFs in financial markets, and the inadequacy of the 2010

reforms, additional steps are needed to address the systemic risk posed by MMFs. MMF

reforms in the FSB, USA and EU have operated on surprisingly similar timelines and, for

now, are contemplating comparable policy options. Both the USA and EU initially

addressed the composition of fund portfolios, and are now considering capital buffers, a

mandatory floating NAV, redemption restrictions and some form of subordinated

minimum balance at risk.

Each proposal offers advantages and disadvantages. However, any proposal to

strengthen MMF resiliency should address the primary cause of the 2008 run;

shareholders have an incentive to run due to the higher share price for early redeemers.99

Capital buffers and elimination of the CNAV only touch on this first-mover advantage.

Loss absorbency buffers may not assuage investor fears, especially if a low buffer may

easily be drained.

The mandatory floating NAV also fails to eliminate the first-mover advantage. Those

in favour of forcing a shift to a floating NAV argue that the discontinuity by $1 CNAV

funds ‘breaking the buck’ and sudden drop in NAV encourages investors to redeem to

take advantage of the $1 NAV. It is true that withdrawing shareholders would no longer

benefit from the discontinuity at the $1 CNAV level, and instead be forced to redeem at a

lower NAV that more accurately reflected current losses. However, even though the

floating NAV would decrease any loss transfer to remaining shareholders, early redeemers

would still benefit from the sale of more liquid assets and a higher NAV. There is also

scepticism that the CNAV contributed to runs during the financial crisis; recent studies

have found that sponsor support and yield in the period prior to the Lehman bankruptcy

96 See ‘2011 Annual Report’ (n 38) (describing MMFs as an important conduit through which ‘amplification of a [European

sovereign debt] shock could happen’).

97 See Johnson (n 89). Among these, sponsor support is believed by many to promote concentration in the MMF industry by

serving as a barrier to entry for funds that lack wealthy owners with the ability to bail out their funds if necessary.

98 In the USA, the top 20 firms accounted for approximately 78 per cent of MMF assets, in contrast to about 92 per cent in 2010.

See ESRB MMF Paper (n 84).

99 See ‘Run Risk in Money Market Funds’, HSBC Global Asset Management (November 2011), (where a study of Rule 2a-7

prime funds and European VNAV funds posits that run risk is correlated to currency, rather than a pricing mechanism).


(which can be understood as a proxy for portfolio risk) were more significant

determinants of fund vulnerability during the 2008 crisis.100

There are also many potential problems with the shift to a floating NAV. If the

transition is not carefully managed, investors could preemptively withdraw from the

funds to take advantage of the $1 CNAV before the changeover. Some investors would

have to withdraw pursuant to their internal guidelines that might effectively prohibit

investing in a floating NAV MMF. A quick decrease in investor demand for MMFs could

disrupt short-term financing to financial institutions, local governments and non-

financial companies. Thus, those who want to maintain the CNAV often argue that

shifting to a floating NAV would cause CNAV funds to lose the tax and accounting

benefits that are part of their appeal, while gaining little benefit in return.

There is one important advantage to the floating NAV; it would help to dispel the

impression that MMF funds are equivalent to bank deposits. Even though VNAV funds

typically only experience small fluctuations in NAV, those small changes would still serve

as reminders that the funds are not risk-free. Regulators must decide if the greater

transparency of the floating NAV is worth the additional cost of the floating NAV to

MMFs (from potential withdrawal of investors) and to MMF investors (who would no

longer benefit from the tax and accounting simplicity of the CNAV and, in some cases, be

prohibited from investing in MMFs due to internal investment guidelines). Advocates of

a mandatory floating NAV should base their arguments on this increased transparency, as

the extent to which a CNAV might affect potential runs is unclear.

The MBR is the only reform proposal that directly addresses first-mover advantage.

The MBR does so by creating a first-mover disadvantage, penalizing early redeemers by

forcing them to take losses first before remaining shareholders. Critics have argued that

the MBR will just incentivize investors to redeem even earlier to avoid the 30-day MBR

loss subordination window. However, this criticism ignores the fact that the Lehman

bankruptcy and subsequent collapse of Reserve Primary happened within a few days. In

the days preceding the 2008 run, investors would not have had time to preemptively

withdraw hoping to avoid the 30-day holdback period.

One measure that is surprisingly absent in the MMF reform debate concerns

favourable treatment of debtholders in the resolution of a systemically significant

financial institution. Regulators in the EU and USA are currently developing plans for a

‘top down’ resolution of a failing firm that would wipe out existing equity and

write-down debt to recapitalize the entity. Resolution authorities are now contemplating

a potential exclusion of short-term liabilities from the scope of this write-down, thereby

granting short-term debtholders preferential treatment and potentially shielding them

from substantial losses. This more favourable treatment of short-term debt might help to

sustain confidence in MMFs should a large financial institution fail. Investors might

100 See JN Gordon and CM Gandia, ‘Money Market Funds Run Risk: Will Floating Net Asset Value Fix the Problem?’, The

Center for Law and Economic Studies Columbia University School of Law Working Paper No 426 (September 2012)

5http://papers.ssrn.com/sol3/papers.cfm?abstract_id¼21349954.




therefore be less likely to redeem, as the market would recognize that MMFs would be less

likely to sustain heavy losses on their debt in the failed entity. While this step alone is

insufficient to address the risks posed by MMFs, it should be considered further in both

the MMF reform debate and in resolution planning by US and EU authorities.

While the need for MMF reform is clear, regulators must also take care not to drive

investments from highly-regulated, transparent MMFs to more lightly regulated, opaque

entities, a concern recently expressed by Commissioner Aguilar in response to a

November 2012 report from the SEC on MMFs.101 This migration would decrease

transparency and hinder efforts by authorities to monitor systemic risk. While this

possibility has also been discussed by Secretary Geithner and the FSOC, the SEC staff has

recently concluded that any asset migration would go to bank products and US

Treasuries. Despite this disagreement on the nature of any potential arbitrage, careful

cost–benefit analyses of any proposed changes, as well as an understanding of their overall

market impact beyond the MMF sector, is clearly important when moving forward on

MMF reform.

MMFs also illustrate the interesting way the FSOC entity and activity designation

processes interact and the flaw with the FSOC non-bank SIFI process discussed above. If a

complex of MMFs are conferred non-bank SIFI status, they will become subject to the

oversight of the FRB despite the SEC’s relevant expertise after decades of regulation and

oversight of the industry. Furthermore, even with the FRB’s ability to tailor the

application of existing banking regulation to specific non-bank SIFIs, such rules were not

designed for MMFs and it is unclear how they would affect individual funds and the

industry as a whole. Furthermore, it is doubtful that a single or subset of MMFs would be

designated, given their small size and the concerns about industry discontinuity discussed

above. The FSOC might also struggle to identify any one individual MMF as systemic; as

stated above, the FSOC non-bank SIFI analysis overemphasizes size and may fail to

account for risk arising from numerous interconnected entities that are ‘systemic as a

herd’.

Thus, the FSOC has turned to its power to identify and prescribe recommendations for

systemic activities to regulate MMF entities. The FSOC’s Section 120 authority therefore

appears to be the more promising avenue for addressing shadow banking entities and

activities going forward. Unlike Section 113, which subjects entities to banking regulation

under the oversight of the FRB, Section 120 entails consultation with the primary

regulators associated with the activity. Section 120 recommendations also ‘may include

prescribing the conduct of the activity or practice in specific ways (such as by limiting its

scope, or applying particular capital or risk management requirements to the conduct of

the activity) or prohibiting the activity or practice’. This section affords the FSOC, in

conjunction with the primary regulator, more flexibility in addressing risky practices.

101 See ‘Statement on Money Market Funds as to Recent Developments by Commissioner Luis A. Aguilar’ (December 2012)

5http://www.sec.gov/news/speech/2012/spch120512laa.htm4 (‘Many do not realize that due to the 2010 Amendments, money

market funds have become one of the most transparent financial instruments for both regulators and investors.’).


http://www.sec.gov/news/speech/2012/spch120512laa.htm

The MMF reform process has also demonstrated the FSOC’s value in breaking through

regulatory gridlock. FSOC action has kept the MMF reform debate alive in spite of the

SEC’s inability to pass meaningful reform. At the same time, the non-binding nature of

FSOC recommendations and FSOC release of proposals for comment ensures that the

FSOC cannot simply override the primary regulator. Rather, its responsibility is to

highlight areas of risk, foster debate on appropriate reform and encourage regulatory

action.

The FSOC’s November 2012 decision to revitalize the MMF reform debate in the USA

is especially important in light of the EU’s clear willingness to take unilateral action on

MMF reform.102 If stricter rules are not implemented in both the USA and EU, and at

roughly the same time, there is enormous potential for arbitrage. Absent US MMF

reform, stricter European rules could simply lead to more investments in US MMFs. The

pernicious result would be a shrinking EU MMF sector and growth of the still precarious

MMF industry in the USA.

6. Conclusion

Though ‘shadow banking’ in its current form has only recently come to the forefront of

the regulatory and policy debate, bank-like actors outside the regulated banking system

are not new. Rather, they are a natural and potentially beneficial consequence of

regulation. Nevertheless, the regulatory community has too readily defaulted to

prudential bank regulation for ‘shadow banks’. Simultaneously, there is a drive to limit

the exposure of commercial banks from entities and activities that do not engage in

‘traditional’ banking activities.

Underlying these endeavours is an outdated, dichotomous view of the financial world;

entities and activities either behave as banks and should be subject to banking laws (and

in the USA, overseen by a banking regulator), or are non-bank institutions and should be

separated from traditional banks. In an increasingly complex financial system, such a

view is outdated. The world is not comprised of solely banks and non-banks. The shadow

banking system is not uniform, but entities now exist with bank-like features. We must

therefore look beyond legal labels and target the activities that generate risk.

The FSB’s November 2012 WS3 Consultation is a promising step, addressing

‘economic functions’ rather than the entities themselves. Targeting these activities that

create risk should be more forward-looking and flexible than a less nuanced attempt to

regulate entities, which is more likely to produce distortions and promote arbitrage. The

fact that FSOC designation may only apply to a few, unique large institutions may be a

recognition of the cumbersome and ill-fitting nature of the regime. More promising is the

FSOC’s ability to designate systemic activities, which provides for a more nuanced

approach to shadow banking practices. The FSOC November 2012 decision to reform

102 See P Amery, ‘The Net is Closing in on Money Market Funds’ Financial Times (May 2012) 5http://www.ft.

com/intl/cms/s/0/7e7dd572-944e-11e1-bb0d-00144feab49a.html#axzz2Fp1PKwlo4 (quoting Lord Turner that the UK should, if

necessary, move unilaterally on MMF reform).


http://www.ft.com/intl/cms/s/0/7e7dd572-944e-11e1-bb0d-00144feab49a.html#axzz2Fp1PKwlo

http://www.ft.com/intl/cms/s/0/7e7dd572-944e-11e1-bb0d-00144feab49a.html#axzz2Fp1PKwlo

MMFs through its flexible authority to address systemic activities, rather than its power

to identify non-bank SIFIs, supports this contention. It is essential to consider the nature

and market role of such entities, such as MMFs, rather than an inelegant and potentially

counterproductive extension of existing banking law.

This attempt to extend banking law calls into question the very nature and scope of

banking regulation—should it just be for ‘banks’? Banking regulations have evolved over

decades to address a certain type of financial institution; if these rules are extended

beyond traditional commercial banks and savings institutions, how will that affect

banking regulation going forward? Moreover, shadow banking institutions developed due

to government regulation of the banking sector, leading to a migration of certain risky

activities beyond these regulated banks. If the scope of banking regulation is expanded,

these activities will again move beyond the scope of regulation. Although such arbitrage

is, to a degree, unavoidable, this possibility underscores the need for a more tailored

approach that will restrain risk without incentivizing the movement of risk beyond the

regulatory and supervisory spotlight.

In his nineteenth-century seminal treatise on banking, Walter Bagehot states that

credit intermediation outside traditional banks is an ‘inevitable part of the system of

banking which history has given us, and which we have only to make the best of, since we

cannot alter it’.103 To a degree, Bagehot is correct. Non-bank credit intermediation is an

entrenched component of our financial system. Demand for credit and incentives to

innovate new means of credit intermediation will only grow as the market recovers.

However, through nuanced, balanced policies that attempt to preserve the benefits of

shadow banking while targeting specific activities, we can alter the distribution and

character of risk among bank and non-bank entities. If done carefully, with thorough

utilization of the numerous tools at the disposal of both government and industry, we can

create a financial system that is both diverse and resilient.

103 W Bagehot, ‘Lombard Street: A Description of the Money Market’ (1877).


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