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(Feng Yu/iStockphoto)
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It’s time to act on shadow banking Add to ...

The recent financial crisis started five years ago last month. In Canada, it began in the asset-backed commercial paper market, one part of the so-called shadow banking system. That system consists of the institutions and activities outside the regular banking system that help provide credit to the economy. It includes the overall commercial paper market, the process of securitization, money market funds, repurchase agreements (repos) for the short-term financing of securities, and finance companies.

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Runs on the shadow banking system worsened the financial crisis -- especially in the United States -- prompting calls for better regulation of the global system. Problems that contributed to this run include lack of transparency for some shadow banking products, as well as unstable structures and funding models. So far, little has changed. It is time to act.

Regulation of shadow banking should focus on the risks posed to the financial system as a whole, or systemic risks. In each major area of shadow banking in Canada, there is one key regulatory step that needs to be taken in Canada to reduce the extent of instability in the next financial cycle.

To reduce the probability of a serious run on asset-backed commercial paper, transparency should be regulated along the lines of the stalled April 2011 proposal from the Canadian Securities Administrators -- the team of provincial and territorial securities regulators -- on prospectus disclosure requirements.

To reduce the probability of securitization drying up overnight, as it did in the last crisis, a number of related measures are needed to reduce underlying risks and to improve the transparency and understanding of the underlying assets. Originators and informed third-party institutions should hold key parts of the tranches of a securitization before a securitization can go ahead -- this will create incentives that will reduce risks for other investors. More information needs to be provided in prospectuses and on a continuing basis to increase transparency. And credit-rating agencies should be required, as part of their code of conduct, to use different scales for asset-backed securities than they use for corporate and sovereign bonds; investors should not treat corporate bonds and securitized assets as similar.

To reduce the probability of a serious run on money market funds and the probability of capital support from a sponsor -- banks for example -- greatly affecting its other credit activities, money market funds should have to choose to be one of three types. First, they could choose to just hold government treasury bills. Second, they could choose to have a variable unit price, like other mutual funds. Third, they could choose to have their capital, liquidity, and asset composition regulated - much like a bank -- and continue to have a constant unit price, always trading at par.

To reduce the amplitude of the repurchase (repo) credit cycle, the minimum amount of collateral (typically called a haircut) should be regulated. As well, regulators should have the option of raising that minimum haircut in boom times. The riskier the asset, particularly with respect to securitized assets, and the greater the boom, the higher the minimum should be.

To reduce the probability of a credit crunch in a part of the loan market presently largely serviced by finance companies, the federal government should ask the Office of the Superintendent of Financial Institutions or the Bank of Canada to determine whether there are some types of finance companies that should be regulated as banks.

Most shadow banking institutions and activities have historically been regulated provincially, especially activities that are part of securities markets, while the federal government can regulate the involvement of banks in these activities. However, the Supreme Court of Canada decision on a proposed Canadian Securities Act appears to indicate that the federal government can pass legislation where there is a national “need to prevent and respond to systemic risk” in the securities area.

The provincial securities commissions should take the lead on asset-backed commercial paper, money market funds, and securitization. But the Canadian Securities Administrators have been extremely slow in making progress on these matters. If they do not act soon, the federal government may need to act legislatively, to deal with systemic risk, by taking the actions listed above.

Taken together, 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.

David Longworth, former Deputy Governor at the Bank of Canada and Research Fellow at the C.D. Howe Institute, is author of a recent paper titled “Combatting the Dangers Lurking in the Shadows: The Macroprudential Regulation of Shadow Banking.”

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