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Analysis

Towards a new ECB role in shadow banking

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The financial crisis has shown that the financial sector needs wider and more comprehensive financial supervision. The former belief in ‘light touch’ regulation was proved wrong. After more than five years of updated regulation and supervision, for example through Basel III and EMIR, European policy-makers have reached the next stage.

The European Central Bank is expanding the reach and scope of the single supervisory mechanism that grants it the right to monitor all systemically relevant banks in the euro area (and in some other non-member countries).

Another step will be to develop a framework for non-banking financial supervision. The ambition to develop new tools and instruments of regulation aims to test the ability of banks to overcome liquidity crises. It is also designed to integrate the European financial market into a comprehensive framework that will ultimately be a part of the banking union.

As Vítor Constâncio, deputy president of the ECB, outlined at an OMFIF City Lecture on 8 May, this is part of a comprehensive policy on macroprudential supervision and regulation that has far-reaching repurcussions across the financial field.

Stronger supervision

A key part of this approach, as Constancio explained, is stronger supervision of the nonbanking financial market. Indeed, the shadow banking sector has almost doubled in the last decade to about €23.5tn, largely because tighter rules on the banking sector have squeezed major banks out of certain markets, which are now being taken over by non-banking financial entities.

Constâncio explained how shadow banking entities are vital providers of credit to the real economy and can help companies to diversify their funding requirements. However, these entities can take on too much risk and may ‘too big to fail’.

This could have a direct effect on the financial sector and on the wider economy. The ECB is proposing to expand its supervisory framework to shadow banking entities. This would require it to create tools and instruments similar to those found in the banking sector, such as stress tests and capital requirements. Alongside these extra instruments, the ECB wishes to promote a stronger institutional base in the euro area, through implementing a capital market union. The introduction of the SSM is an important first step towards the banking union, which would strengthen the financial capacity of the euro area and would provide businesses with better access to capital.

The SSM, however, covers only part of the EU. Apart from creating a two-speed integration process, this could create the danger of insufficient supervision and failures of banks outside the SSM.

It is difficult to imagine how the ECB can extend its capacity to supervise the entire European financial sector, including the nonbanking area.

Direct insight

The ECB has direct insight into the credit worthiness of and the collateral used by commercial banks. It is in a unique position to monitor banks. This however creates a potential conflict of interest between its role as a market participant and its position as an independent institution controlling monetary policy.

The information the ECB gains from supervising 130 systemically relevant banks can have a major influence on its monetary policy. For example, if the ECB intends to increase interest rates in line with its inflation target, but believes this would negatively affect the financial sector, this might dissuade it from monetary action. This issue also affects Constâncio’s proposal to expand supervision to the non-banking sector, which would would greatly strain the ECB’s resources.

National level

Delegating this responsibility to the national level would probably result in a divergent regulatory framework, negatively impinging on the prospects for genuine banking union.

The best outcome would appear to be increasing still further the SSM’s independence from the ECB, giving it more resources to supervise both the banking and the non-banking sectors. Without doubt, macroprudential supervision of the banking and non-banking sector is an important part of anticipating and preventing future financial crises. It remains uncertain however whether the ECB is the best institution to take the lead on this development, considering both possible conflicts of interest and the strong capacity constraints that at present are all too visible.

The ECB has vital access to market information that can be crucial to its supervisory actions. The challenge for the future lies in using this access in the best possible manner to create a supervisory institution with powers over banking and non-banking activities in the euro area and the wider EU. 

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