FSB Examines ETFs And Shadow Banking
Monday, April 18, 2011

The Financial Stability Board (FSB) has published notes on financial stability issues in relation to exchange-traded funds (ETFs) and on its work to develop recommendations to strengthen the oversight and regulation of the shadow banking system.

Based in Basel, Switzerland, and established to coordinate at the international level the work of national financial authorities and international standard setting bodies, the FSB said that it has issued the notes as part of its role of monitoring market developments relevant to financial stability and advising on their implications for regulatory policy. In doing so, it seeks to identify potential vulnerabilities and the actions that may be needed to address them.

The first note highlights recent developments in the ETF market, which has experienced strong growth and rapid innovation, and in which there has been an increase in product variety and, in some cases, complexity. It aims at encouraging the financial industry to adapt risk management practices, disclosure and transparency to the pace of innovation in this market.

In Rome earlier this month, the FSB had pointed out that there are signs that the low interest rate environment may be leading investors to search for yield in more complex non-standard market segments that increase exposure to liquidity risks. Developments in some segments of the ETF market, but also of the commodities and high-yield markets, are examples that warrant closer surveillance by regulatory authorities, it said.

Work is therefore underway nationally and internationally to assess whether recent innovations and the related increase in complexity in some segments of the ETF market add to financial system risks and whether regulatory actions are needed to address potential shortcomings in the management of counterparty, collateral and liquidity risks, and in market transparency.

The FSB’s second note provides information on the work of the FSB to develop recommendations to strengthen the oversight and regulation of the shadow banking system, which it broadly describes as “credit intermediation involving entities and activities outside the regular banking system.”

Although intermediating credit through non-bank channels can have advantages, for example by providing an alternative source of funding and liquidity, the FSB says that, as the recent financial crisis has shown, the shadow banking system can also be a source of systemic risk both directly and through its interconnectedness with the regular banking system.

It can also, it adds, create opportunities for arbitrage that might undermine stricter bank regulation and lead to a build-up of additional leverage and risks in the system. Enhancing supervision and regulation of the shadow banking system in areas where systemic risk and regulatory arbitrage concerns are inadequately addressed is therefore important.

The G20 Leaders at the November 2010 Seoul Summit asked the FSB to develop recommendations to strengthen the oversight and regulation of the shadow banking system. The FSB has since formed a task force to develop initial recommendations for discussion that would clarify what is meant by the shadow banking system; set out potential approaches for its monitoring; and explore possible regulatory measures to address the systemic risk and regulatory arbitrage concerns it poses.

The note sets out the current thinking of the task force. It proposes that monitoring and policy responses should be guided by a two-stage approach: firstly by casting the net wide to cover all non-bank credit intermediation so as to identify potential areas where new risks might arise; and then, secondly, by narrowing the focus to those parts of the system where maturity/liquidity transformation, flawed credit risk transfer and/or leverage create important systemic risks.

Based on the work of the task force, the FSB will consider initial draft recommendations at its July plenary meeting and, thereafter, the recommendations to be submitted to the G20 in the autumn.

The FSB welcomes comments from the public on both of the notes.