Shadow-Bank Ties to Lenders in Crosshairs of Basel Supervisors

  • Bank oversight committee wants to limit risk from non-banks
  • Industry asked to weigh in by March on proposed policies

Global regulators need to do more to protect banks from being dragged down by money-market mutual funds, asset managers and mortgage finance companies, according to the Basel Committee on Bank Supervision.

So-called shadow banks may pose a risk to regulated lenders even in the absence of a legal obligation because of business ties that encourage lenders to absorb losses on to their own balance sheets. This “step-in” risk could then spill over and trigger another crisis, the Basel committee said on Thursday.

The Basel committee said additional set-asides may be needed to make sure this risk is mitigated. In a consultation paper, the regulator asked for feedback on proposed indicators to identify risk, and on whether supervisors should set quantitative requirements or plan for regulatory consolidation of linked firms.

“The objective is to avoid that unanticipated support provided by banks weakens their situation, possibly to the point of having systemic implications,” the Basel committee said. “This work falls within the G-20 initiative to strengthen the oversight and regulation of the shadow-banking system and mitigate the associated potential systemic risks.”

The draft framework seeks to avoid a repeat of situations such as the U.S. encountered during the financial crisis, when banks took special purpose vehicles back on to their balance sheets and absorbed “conduits” that securitized mortgages and ran into trouble.

‘Financial Distress’

“The supposed credit risk transfer to shadow banking turned out to be inefficacious in certain instances during the crisis,” the regulator said. At times, “banks preferred to support certain shadow banking entities in financial distress, rather than allowing them to fail and facing a loss of reputation, even though they had neither ownership interests in such entities nor any contractual obligations to support them.”

Signs that a bank has strong links to an outside financial firm could include capital ties, sponsorship, provision of financial facilities and decision-making or operational input. The Basel committee also suggests a list of secondary indicators and ways that banks and supervisors could work together to identify risk.

The U.S. and the U.K. already have taken steps to limit step-in risk through the Volcker Rule and ring-fencing regulations, respectively, along with new U.S rules on money-market mutual funds, according to the regulator. The EU has proposed draft regulations covering similar matters, on money market funds and on bank structure reform.

Responses are due by March 17. The full consultation can be read on the web here:

Before it's here, it's on the Bloomberg Terminal.