How special are they? Targeting systemic risk by regulating shadow banking

Tobias Troger

  • 8.1 Introduction page 185
  • 8.2 The rationale underpinning current regulatory initiatives to cover

non-bank credit intermediation 188

8.3 Legislators’ and supervisors’ ‘formalist’ implementation of the

policy prescriptions 196

8.4 Enhancing prudential regulation’s assertiveness in a normative

approach 199

8.5 Conclusion 202


As a response to a request from the G-20 at the 2010 Seoul Summit, the Financial Stability Board (FSB) appointed a Task Force that should ‘develop recommendations to strengthen the regulation and oversight of the shadow banking system’ (G-20 2010: 10). Eleven such recommendations were presented in a FSB report that also established five work streams to further prepare the ground for an effective implementation of the final suggestions (FSB 2011b: 15-26). The priority areas and the way forward were endorsed at the following G-20 Cannes Summit that assigned the FSB in cooperation with the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) to work out specific and effective policy proposals (G-20 2011: no 30). The latter were published in due course (IOSCO 2012b: 11-18; IOSCO 2012a: 48-51; FSB 2013b; FSB 2013c) and subsequently synthesised in the FSB’s general policy recommendations (FSB 2013a) that were submitted to public consultation (FSB 2013d) and will be implemented under FSB monitoring (FSB 2013a: 7-8). The interlinkages between banks and alternative credit intermediation entities were explored in a final report submitted to the FSB, which led to amendments to the Basel standards regarding large exposure limits (BCBS 2014) and banks’ investment in funds (BCBS 2013).

This quest for global consistency documented by the pivotal role that the transnational standard-setting bodies play in drawing up and implementing enhanced regulation that accounts for critical lessons learned from the financial crisis indicates—inter alia—that integrating the pertinent responses in the world’s most important economies is seen as a high priority. Quite importantly, the underlying global consensus—also corroborated by trend-setting national reactions to perceived deficits in financial regulation—seems to be that rule makers have to close loopholes in the existing frameworks with ever more detailed and complex regulation. It is a strong indicator that both the United States and the European Union in pursuing similar policy objectives (Kumpan 2009: 278-84) promulgated extensive and highly specific sets of rules to remedy precisely those perceived deficits in securitization transactions that were revealed during the financial crisis.1 This broad agreement on the advisable regulatory mode is not called into question where a functional approach to financial regulation is proposed: the envisioned recourse to functionally described objectives of regulation is mainly supposed to facilitate a swifter, more accurate amendment of existing rules by expert bodies whose operations could escape the political quagmire of the legislative process (Schwarcz 2014:

3-4). In fact, the approach only points to an arguably more effective way for achieving the (ever more detailed and complex) prudential rules; that is, it does not deviate from the predominant mindset that underpins financial regulation.

To be sure, more radical departures from the now-prevailing regulatory approach have been championed prior to and through the financial crisis by both regulators (FSA 2007: 6-8; FSA 2008) and academics (Black 2011: 26-32; Black et al. 2007: 200-4). Regardless of the merits of the criticism that these proposals received (Engert 2012: 383-7; Schwarcz 2009a: 175), it is sufficient for the purposes of this chapter to point out that even these alternatives rest upon the notion that a rule-based framework automatically commands a formalist interpretation of its narrow provisions. In this view, rule-based regulatory systems are conceptually inapt to react to innovation by well advised market participants. In order to change the pertinent paradigms in prudential supervision and to switch to alternatives that only impose general standards of conduct and leave discretion to supervisors in dealing with individual cases (Di Lorenzo 2012: 47), law reform is required, not least because resource input has to be shifted from rule making under a standard-based system to [1]

enforcement under a principles-oriented one (Moriss and Henson 2013: 438). Quite similarly, approaches that seek to activate general private law concepts to limit the scope of potentially hazardous financial innovation, for instance the property law principle ofnumerus clausus (Chu 2009-2010: 443; Dana 2010: 97; Dyal-Chand 2011: 1369; Fish 2010: 2030; Janger 2009: 39; Levitin and Wachter 2012: 1255; Note 2012: 1808-21) assume that a change of existing prudential regulation would be needed to implement the alternative concepts. In sum, all the proposals mentioned tacitly share an understanding of jurisprudence, that is, the interpretation and implementation of prudential rules that renders it impossible to make mileage out of the observation that financial regulation can be legitimised by—a few—very fundamental macro-economic considerations and is thus essentially functional.

This chapter argues that at least some of the financial stability concerns associated with shadow banking could also be addressed by an approach to financial regulation that imports its functional foundations more vigorously into the interpretation and implementation of existing rules. It thus encourages a more normative construction of available rules that potentially limits both the scope for regulatory arbitrage[2] and the need for ever more rapid updates and an increasing complexity of the regulatory framework. By tying the regulatory treatment of financial innovation closely to existing prudential rules and their underlying policy rationales, the proposed approach potentially ends the socially wasteful[3] race between hare and tortoise that signifies the relation between regulators and a highly dynamic industry. It thus responds to the key regulatory challenge posed by the rapidly changing institutional structure of contemporary finance (Anabtawi and Schwarcz 2013: 85; Kaal 2013). In doing so, it does not generally hamper market participants’ efficient discoveries.

To make the key argument, section 8.2 of the essay traces the close connection between the rationales underpinning the current regulatory initiatives geared to alternative credit intermediation as well as traditional prudential banking regulation. It does so by looking at the definition of shadow banking that informs these advances and the regulatory challenges that follow from this understanding. The latter are then related to in grosso modo equivalent policy goals that motivate traditional prudential bank regulation. The analysis supports the view that existing regulation—at least in its substance—attempts to address the key concerns that reverberate in the debate on new rules to adequately cover shadow banking. Section 8.3 illustrates the problems of an overly formalist implementation of the policy goals that warrant regulatory intervention in banking. It shows that much of the potential for regulatory arbitrage is created by a specific understanding of financial regulation that arguably commands a narrow reading of existing rules. Section 8.4 discusses the merits, challenges and drawbacks of an alternative approach that integrates normative considerations more momentously into the application of prudential rules. The gist of such a normatively charged approach to supervision is its more aggressive stance vis-a-vis innovations that are mainly driven by an appetite for regulatory arbitrage. In doing so, one pivotal virtue of the proposed concept can be seen in its potential not to hamper efficient financial innovation. Instead, it only weeds out rent-seeking circumventions of existing rules and standards. Section 8.5 concludes.

  • [1] Cf. Dodd-Frank Wall Street Reform and Consumer Protection Act [hereinafter: Dodd-Frank-Act],Pub. L. No. 111-203, §§ 941-6, 124 Stat. 1375, 1890-8 (2010); Directive 2009/111/EC of theEuropean Parliament and of the Council amending Directives 2006/48/EC, 2006/49/EC and 2007/64/EC as regards banks affiliated to central institutions, certain own funds, items, large exposures,supervisory arrangements and crisis management, 2009 O.J. (L 302) 97; Directive 2010/76/EU ofthe European Parliament and of the Council amending Directives 2006/48/EC and 2006/49/EC asregards capital requirements for the trading book and for re-securitisations and the supervisoryreview of remuneration policies, 2010 O.J. (L 329) 3.
  • [2] The term is typically used to characterise a socially undesirable, race-to-the-bottom-like outcomein financial regulation if the addressees are free to choose between a set of diverging institutionalframeworks (Licht 1998: 567,636; Tafara and Peterson 2007: 52).
  • [3] One of the key disservices that a quest for regulatory arbitrage opportunities renders to society isthat it engages talent in a largely non-productive endeavour and thus misallocates a resource thatis among the most valuable to society. Analyses show that the allocation of a given set ofentrepreneurs between socially productive and unproductive activities depends on relative payoffs offered by society (Baumol 1990: 893) and that occupational choice between growth-fostering and redistributive activities depends on compensation contracts (Murphy et al. 1991:503). The financial industry employs an increasing share of high-quality human resources.Empirical data shows an increase of 16% (male) and 11% (female) among those U.S. elitecollege graduates (‘Harvard & Beyond’) between 1970 and 1990 who entered positions infinance and management and held them fifteen years later (Goldin and Katz 2008: 363, 366).That corresponds with findings according to which deregulation is correlated with skill intensity,job complexity and wage levels across time, space and subsectors of the US financial industry(Philippon and Reshef 2012: 1551). In this spirit, then chairman of the UK Financial ServicesAuthority (FSA) Lord Turner alluded to the financial sector domiciled in the City of London as‘swollen’ ‘beyond socially reasonable size’ andpositedthat it engages inagood deal of ‘sociallyuseless’ activities (Parker 2009).
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