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How to Reduce the Risks Lurking in Shadow Banking: C.D. Howe Institute

September 5, 2012

TORONTO, Sept. 5, 2012 /CNW/ – Financial regulators should turn their
attention to the potential threats to financial stability lurking in
the shadow banking system, according to a report released today by the
C.D. Howe Institute. In “Combatting the Dangers Lurking in the Shadows:
The Macroprudential Regulation of Shadow Banking,” David Longworth,
former deputy governor of the Bank of Canada, argues greater regulation
of the financial entities in the sector is required to mitigate the
risks of another run on the shadow banking system exacerbating
financial instability, as occurred in the 2008/2009 financial crisis.

Regulatory work, Longworth notes, has recently shifted to some extent to
the shadow banking sector, which broadly refers to the system of credit
intermediation outside the regular banking system, and consists of
finance companies, commercial paper issuance, money market funds, the
securitization process, and repurchase (“repo”) markets for the
short-term financing of securities. This system has greatly risen in
importance over the past 20 years.

Prior to the recent financial crisis, many of the system’s short-term
liabilities were seen as nearly risk-free (“AAA”) assets, but some
proved not to be so. Not only did the shadow banking system contract
considerably during the financial crisis in both the United States and
Canada, but so did the system’s provision of financing to regulated
banks, which exacerbated their liquidity difficulties.

Longworth makes the case that some shadow banking entities ought to be
regulated as banks or in a similar fashion to banks (for example, with
capital and liquidity requirements) while in other cases regulation
should cover banks’ relationships with them, their procyclical
behaviour in certain markets (such as those for repos), or the ratings
process for securitized products.

Taken together, says Longworth, the implementation of these policies
should help reduce systemic risk and the probability of future periods
of financial stress, for a stronger and more stable financial system.

For the report go to: http://www.cdhowe.org/combatting-the-dangers-lurking-in-the-shadows-the-macroprudential-regulation-of-shadow-banking/18791

SOURCE C.D. Howe Institute


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