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Reducing the risks of shadow banking - 04/09/2013

Euro notes © EU

The EU presses ahead with plans to regulate the shadow banking system that helped spawn the credit crunch.

Most of the regulatory requirements imposed on the financial sector since the economic slump of 2008 have been focused on the mainstream banking system. But the shadow banking sector – which includes hedge funds, private equity and securitisation – engages in activities similar to banks and yet has traditionally been supervised more lightly and does not have access to central bank support or safeguards such as deposit insurance and debt guarantees.

While the shadow banking sector helps to provide financial liquidity to the banking sector, it has also created instability in the global financial system in recent years. This instability contributed to the collapse of Lehman Brothers in 2008 and helped to freeze global credit markets during the financial crisis.

Remedying the causes of financial instability

Globally, the total amount of shadow banking assets has more than doubled to over €50 trillion over the last decade and now accounts for almost a third of the global financial system. In Europe, shadow banking is worth over €23 trillion.

The sheer size of the shadow banking system and its close links to the regulated financial sector make it a potential source of systemic risk for states, governments and taxpayers, as any weakness could trigger a wave of contagion that would affect the regulated financial sector.

Capital requirements

The EU’s proposed reforms call for certain types of money market funds to hold a cash buffer equivalent to 3% of their assets in order to reduce the risk of the sort of runs on funds that occurred during the financial crisis.

The EU also proposes setting daily and weekly liquidity levels for money market funds as well as measures to help anticipate large redemptions and reduce overreliance on third-party credit ratings.

The EU is working in tandem with the G20 to reduce the risks of shadow banking. The recommendations of the G20’s Financial Stability Board are expected to be endorsed by G20 Leaders in St Petersburg on 5-6 September 2013.

More on shadow banking

Commission’s roadmap for tackling the risks inherent in shadow banking

Communication on shadow banking: frequently asked questions

New rules for Money Market Funds proposed – Frequently Asked Questions

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