Vol 12 (2015) - Issue 5

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Policy, or Practicality? An Analysis of Shadow Banking Reforms in the EU – Part Two

Introduction
Post-financial crisis, the concept of 'shadow banking' and its associated risks have come under intense regulatory and public scrutiny. The need for a fresh look at resultant attempts at reform therefore cannot – and should not – be understated. Part One of this article sought to impart the reader with a better understanding of the fundamental scope, nature, and background underlying this dynamic sector, with a particular focus on the European region as evidenced through recent regulatory work (both proposed and existing) issued by the European Commission (EC).
Part Two will attempt a fresh analysis of reforms, and will, in itself, consist of two stages. Firstly, it will examine the Commission’s underlying general rationale for seeking shadow banking reform, exploring in particular the notion of 'risk' associated with maturity/liquidity mismatches and the build-up of leverage. Next, it will turn to the question of whether the reforms have been successful in dealing with concerns in a targeted, proportionate way.
While acknowledging that progress has been made, three main arguments will be advanced to show that in many instances, regulatory efforts have been fundamentally misguided. Firstly, this article will highlight areas in which existing regulations already impose onerous – and, arguably sufficient – burdens upon shadow banking entities, and will purport to show that any further extensions would be resultantly unnecessary. Secondly, it will question the conventional assumption that shadow banking entities necessarily pose the same 'risks' borne by traditional banks, arguing in particular that the idea that funds should be regulated in a similar fashion to banks is a 'one-size-fits-all' approach which fundamentally misses the point of regulation. Finally, it will purport to show how, on a macro scale, efforts at reform have been overly concerned with cracking down on said 'risks' at all costs. This narrow approach crucially misses the broader importance of shadow banking to the overall financial market and effectively discounts their essential role in funding market activity. Much of the funding which currently underpins the shadow banking regime stems from the same sources currently driving traditional banking activity; that regulators have failed to consider the full implications of this is, as will be demonstrated, but another example of their naivety. Unfortunately, it appears that regulatory responses overall have been driven by a response to policy rather than actual practicality; this, in turn, has ultimately produced surprising contradictions at the policy level.

A. Rationale for reform and the nature of 'risk'
As a starting point for analysis, it will be necessary to look to the Commission’s rationale for reform, exploring in particular the concept of 'risk' said to be inherent in shadow banking activities.
The Commission’s underlying rationale for regulatory overhaul was hinted at in its 2013 Communication, in which it postulated that:
'... the overarching aim, as reaffirmed on several occasions by the G20, is to eliminate all the dark corners in the financial sector and extend regulation and oversight to all systemically important financial institutions, instruments, and markets.'