FSB-Iosco tweaks systemic shadow bank definition after criticism

Initial proposals for identifying systemic ‘non-bank non-insurers’ ran into criticism last year, with asset managers complaining rules put too much emphasis on size
The FSB is housed in the BIS tower in Basel

International standard setters have adjusted proposals for assessing the systemic importance of shadow banks, after initial plans came under fire last year.

The Financial Stability Board (FSB) and International Organization of Securities Commissions (Iosco) yesterday jointly released revised proposals for identifying globally systemic "non-bank non-insurance" (NBNI) firms, with the bulk of changes focused on rules for asset managers.

The overall structure of the methodology remains unchanged: firms will first be screened for "materiality" to narrow the number that need close assessment, and the remaining pool will be examined on the basis of their size, interconnectedness, complexity, substitutability and global integration.

The first consultation, launched in January 2014, attracted criticism from major asset managers for its reliance on size as a screening measure, and for its treatment of the way in which asset managers may create and transmit financial risk.

"The size of a fund is not indicative of systemic risk," wrote BlackRock in its submission. The asset manager argued that due to the diversity of strategies within a large fund, there is no "obvious meaningful way" to aggregate them. Instead, leverage would be a better measure, it said.

Other large asset managers, including Pimco and State Street, made similar arguments, emphasising that even very large firms can pose little systemic risk if they are not strongly interconnected.

The FSB and Iosco seem to have taken this on board. The methodology for finance companies and market intermediaries is "near-final" the institutions said, but the methodology for investment funds and asset managers has been redesigned.

First, investment funds and asset managers will now be subject to screening both on the basis of size and leverage, although the exact indicators to be used is still an open question.

Second, while asset managers will be assessed on the basis of size, interconnectedness, complexity, substitutability and global integration, this is not an "exhaustive list", the FSB and Iosco said, adding they "are interested in hearing views on additional or alternative indicators".

Due to the complexity of regulating the multitude of different business models that fall into the asset manager category, the proposals give national authorities more latitude in determining the proper indicators, than under the rules for identifying systemic banks.

A further challenge relates to data quality. Throughout the document the FSB and Iosco run up against the issue of gathering accurate data on the areas most relevant to NBNI firms. For example, cross-border activity was mooted as a further screening mechanism, but was dropped on the grounds of poor disclosure in many jurisdictions.

The FSB and Iosco stressed they have not yet designated any NBNI firms as systemically important, and the process of designing policies to be applied to those that are deemed systemic has not yet begun.

Shadow banking remains an ill-understood area of global regulation, and the FSB has been leading efforts to shed more light on the sector. However, its approach has often been challenged – not just by asset managers but also by researchers at the IMF, who argued the FSB's definition understated the scale of the sector, in a paper published in January.

Daniel Tarullo, the Federal Reserve governor who heads the FSB's Standing Committee on Supervisory and Regulatory Cooperation, yesterday hinted there remains some way to go on designing an appropriate response to shadow banking.

"Understanding the key drivers and transmission mechanisms of risks posed by the failure of an NBNI financial entity to the global financial system is the first step of designing the appropriate policy tools to address such risks," he said in a statement accompanying the FSB-Iosco consultation.

Comments on the proposals should be submitted to the FSB by May 29.

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