G20 caution on shadow banking

World leaders are expected to take a softly-softly approach to regulating the so-called shadow banking sector when they meet in Russia next month.

They want to avoid damaging the flow of financing essential to the global economy.

Though governments have cracked down on risk-taking by conventional banks in the wake of the financial crisis, shadow banks, an assortment of financial intermediaries that handle $60-trillion of transactions a year - roughly the same size as the world economy - are a source of systemic risk to taxpayers.

Such intermediaries, which include hedge funds, money market funds and "structured investment vehicles", provide credit to the financial sector but, unlike banks, have no access to central bank support or to safeguards such as deposit insurance and debt guarantees.

They often rely on short-term funding sources, such as the re-purchase or repo market, in which borrowers sell the lender a security as collateral and agree to buy it back at a set time and price.

At their meeting on Thursday and Friday next week, the Group of 20 economies will endorse reforms but stop short of rushing through far-reaching changes because of shadow banking's role in providing liquidity to the still fragile banking sector, say sources familiar with the G20's work.

The use by banks of off-balance-sheet vehicles to repackage and sell-on US sub-prime mortgages kick-started the financial crisis in 2007 but such shadow banking activity, known as "securitisation", is viewed as essential in helping wean banks off central bank money and getting them to fund themselves.

"There is a fuss about this because the crisis of 2008 was essentially a shadow-banking crisis. Most of the lending in the US and UK was financed by short-term repo," said Alistair Milne, a professor of financial economics at Loughborough University.

"The shadow banking reform is more about avoiding trouble in future, so they can take more time," added Milne, a former Bank of England and UK Treasury official.

Regulators pushed through in record time a regulatory regime for conventional banks - the Basel3 framework - that forces them to hold more capital.

There is a growing appreciation at the G20 that, unlike the action on banks, which targeted the institutions themselves, reform of the more complex shadow banking world should focus on the sector's activities.

"Just increasing capital requirements won't work in most cases because it's not about entities but mostly about markets, interlinked transactions and networks," said Andres Portilla, director of regulatory affairs at the Institute of International Finance.