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FINANCE, RISK AND REGULATION

Towards closer supervision of non-banking institutions



Corentin Deprez (Senior Consultant) and Matteo Orlandini (Consultant).  (Photo: Avantage Reply Luxembourg)

Corentin Deprez (Senior Consultant) and Matteo Orlandini (Consultant). (Photo: Avantage Reply Luxembourg)

Non-banking financial intermediaries such as investment funds, insurance companies and pension funds have become increasingly significant in the Eurozone. Over the past two decades, their total financial assets have multiplied by ten, leading to global reflection on strengthening regulatory requirements and supervision.

The regulatory trends today

It is well known that banking institutions are supervised by National Competent Authorities (like the CSSF in Luxembourg) and the European Central Bank (ECB) and that they must comply with a long list of regulatory requirements regarding their solvency and liquidity risks. On the other hand, non-banking institutions (also known as non-banking financial intermediaries, unregulated financial entities or shadow banks) are less constrained when managing their balance sheet and capital. This may result in a competitive advantage as they are more flexible and can take on more risks.

On the 24th of August, Isabel Schnabel, a member of the Board of the ECB, highlighted in her speech the importance surrounding the increase of non-banking institutions. It is undoubtedly demonstrated by the considerable growth of their balance sheets. Only in Luxembourg, total assets have risen from 500 billion in 1999 to more than 5,000 billion in 2021 with projections set at around +20% for the year to come. 

To ensure the continuous stability of the financial industry and “anticipate” another down cycle, regulators have started a broader reflection on the regulatory requirements that should apply to the non-banking industry, in particular, with regards to the intermediation between banking and non-banking institutions. But at this stage, the questions remain open on i) the measures which would allow an efficient monitoring and control of highly-risky assets and on ii) how policy makers can design sustainable and cooperative frameworks to ensure an effective intermediation between banks and non-banking institutions.

Potential instability brought by non-banking institutions

Since banks have been submitting multiple regulatory reports for years, regulators now have a considerable database to build on. Statistical models allow them to look into the banking industry’s health and stability and to anticipate potential areas of instability. On the other hand, data provided by non-banking institutions is still insufficient and hence makes in-depth analysis inconclusive. This might create a need for a more inclusive regulatory framework, meaning that existing regulation for non-banking institutions is increasingly aligned to that of the banking industry. As the non-banking sector continues to gain in importance, this would allow regulators to be able to assess how to regulate, when needed, entities that have an impact on the financial sector. 

Intermediation between banks and non-banks, especially during recession times, is also a challenge given the constrained access to and circulation of capital and liquidity. Because of regulatory requirements, banks are limited in their ability to invest in more alternative, risky financial instruments, like non-banking financial institutions. This is particularly the case in unfavourable market conditions, where investments by banks in such assets are heavily reduced, which has a knock-on impact to the non-banking financial sector. Therefore the business model and associated risks of non-banking financial entities should be correctly assessed, classified and respective regulatory measures defined to protect from potential defaults.

Lastly, the increased liquidity risks as seen during the crisis of Covid-19 are among regulatory concerns. In recent months, money market funds were highly affected due to redemptions and required liquidity to handle the sale of shareholder positions.

Identifying a non-banking institution

A very first step taken by the European Banking Authority (EBA) was to define in a clear and comprehensive way what a non-banking institution is and how banks should report exposures to them.

As required by the Capital Requirements Regulation (CRR), banks are required to report their ten largest exposures on a consolidated basis to banking institutions as well as their ten largest exposures on a consolidated basis to unregulated financial entities, also called shadow banking entities. The identification of banking institutions is unequivocal, but it is not the case regarding the unregulated ones.

The latest consultation paper related to Article 394 of the CRR on large exposures allows to identify and correctly report exposures to shadow banking entities, now referred to as non-banking institutions.

The reporting technical standards provide details and explanations on the following:

1.     The conditions to classify shadow and non-shadow banking institutions

If institutions carry risks of solvency or liquidity at individual or group level, they should no longer be considered in the scope of shadow banking and therefore the 2013/36/EU directive should be applied to them.

2.     Designation of banking activities and services

So far, no definition is provided by the CRR to categorise banking activities. However, institutions that are not EU-regulated but which enable credit intermediation through operations from various forms of banking business like long-term lending or immediate deposits should be considered as shadow banking entities.

3.     Circumstances to exclude entities in third countries considered as shadow banking

- If third country entities have proven that they are supervised by a third-country authority.

- If the regulatory regime of the third country regulator is in line with the one of the EU.

The abovementioned guidelines have not yet been translated into national law. However, banking institutions have started to prepare the reporting of the top ten exposures on shadow banking entities. On the non-banking side, more robust guidelines are still in the works, but a revised regulatory framework is expected to be implemented to control the increasing capital and related risks. At least first steps have been made.

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