Hedge Funds Are Shadow Banks in Need of Regulation, Bafin Says

Bafin's Head of Banking Supervision Raimund Roeseler
Bafin's head of banking supervision Raimund Roeseler said, “We probably won’t be able to fix every loophole, but we’ll get a good chunk - and make dodging rules more tedious and expensive.” Photographer: Arne Dedert/AFP/Getty Images

Hedge funds act as shadow banks and should be added to the list of organizations in need of regulation, according to Raimund Roeseler, head of banking supervision at Germany’s financial regulator Bafin.

Shadow-banking definitions by the Financial Stability Board and the Basel Committee are too narrow, Roeseler said. Bafin is working on its own proposals to regulate the sector and will provide them for the discussion at the FSB, he said.

“We probably won’t be able to fix every loophole, but we’ll get a good chunk -- and make dodging rules more tedious and expensive,” Roeseler, 50, said in an interview at his Bonn-based office last week. “Anything already calling itself a hedge fund should be covered, that’s for sure.”

So-called shadow banking that takes place outside the scope of regulators is being targeted by financial watchdogs on concern that it may be used to evade a global clampdown on excessive risk-taking. Financial rules have become more stringent since the 2008 collapse of Lehman Brothers Holdings Inc. led to a global credit crunch and lender bailouts.

The FSB, which brings together regulators, Group of 20 central bankers and finance ministry officials, established a list of shadow-banking activities that may warrant tougher oversight and said it will seek agreement on the rules by the end of 2012. The list doesn’t name hedge funds, while leaving open the possibility that they could be regulated.

Offshore financial transactions should also be reviewed when discussing shadow-banking regulations, Roeseler said. Authorities should know why money is deposited offshore and what kinds of activities lenders have there, he said.

‘Bug Them More’

“I’ve already talked to banks about those issues,” said Roeseler. “And I am planning to bug them even more.”

Bafin has set up a working group to review the need for additional rules for derivatives, including credit-default swaps. It is considering who should be allowed to sell CDS and whether purchase of the instruments should be restricted to those who actually need default protection, said Roeseler.

Despite some improvements “within the last few years, the CDS market still isn’t transparent and at times sends signals that aren’t supported by the numbers of trades actually done,” he said.

Since Lehman’s collapse, global regulators have approved new rules known as Basel III, more than tripling how much core capital lenders must hold to at least 7 percent of assets, weighted for risk. European Union governments and lawmakers are debating how to meet a January deadline to implement the rules set out in 2010 by the Basel Committee on Banking Supervision. Roeseler, who is a member of that group, said he is worried about whether the deadline will be met.

Flexibility Package

The crucial issue in the negotiations over how to implement Basel III in Europe is the flexibility package, which determines how much freedom national regulators should have to go beyond minimum EU capital rules, said Roeseler. The EU should opt for a level playing field, imposing the same capital rules everywhere, he said.

“What we want to avoid is stigmatizing banks which for good reason don’t need more capital just because other countries want more capital due to specific risk their banks have,” said Roeseler.

Finance ministers are set to discuss the rules again at a meeting in Brussels tomorrow.

German banks that lend to local economies dominated by medium-sized companies are seeking to loosen standards for risk weighting of these loans. Roeseler said easements can be granted only if evidence justifies it. A European Banking Authority group is looking into the matter.

Looking at Evidence

“Sometimes I have the impression there are market participants who want easements regardless what empirical evidence tells us,” said Roeseler. “Why should I privilege a business area without such a justification?”

“The current crises were caused by subprime and government bonds,” Roeseler said. “Who tells us that we won’t get a crisis caused by loans to medium-sized companies?”

EU governments have clashed over plans agreed on by the Basel committee to impose a so-called leverage ratio on banks that would limit the extent to which they can finance their activities through debt.

The measure, published in 2010 as part of Basel III, would force banks to hold Tier 1 capital equivalent to 3 percent of their total assets. That would prevent lenders from accumulating assets worth more than 33 times their reserves.

3 Percent

“I don’t think a 3 percent ratio is too much,” said Roeseler. Regulators “should be allowed to ask for 30 million euros ($38.8 million) of capital from a bank that has a balance sheet with 1 billion euros of assets.”

The measure is needed to stop banks from evading other capital rules requiring lenders to base the amount of reserves they must hold against the riskiness of their activities, according to the Basel committee.

The committee is also debating draft liquidity rules. The issue is on the agenda for when the Basel group meets in June in Stockholm, Roeseler said.

The group is considering how to expand the range of assets that qualify as highly liquid so lenders can count them toward their requirements, amid concerns that the current list is too narrowly focused on government debt.

“There is a broad spectrum of positions on what should count as liquid assets -- starting from government bonds to assets accepted by central banks as collateral,” said Roeseler.

30-Day Squeeze

The aim of the liquid-assets measure is to ensure that lenders hold enough easy-to-sell assets to survive a 30-day credit squeeze. That requirement is set to take effect in 2015.

Governments and lawmakers in the European Parliament are working on a list of assets for the EBA to consider. One version under discussion includes oil and equities, as well as covered bonds and other securities backed by retail mortgages.

“Because the situation is so diverse in the various countries, we are doing an observation period now,” said Roeseler. “We, for example, have a huge government bond market; others don’t. We use covered bonds a lot; others rely on ABS structures.”

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