The European Commission this week released the first prong of its enhanced regulatory approach toward the so-called shadow banking sector with proposed new rules for money market funds.
Shadow banking – which the commission defines as the system of credit intermediation that involves entities and activities outside regular banking – is less regulated than the traditional banking sector. The Financial Stability Board estimated the size of the global shadow banking sector was €51 trillion in 2011.
The commission is first targeting money market funds (MMFs) with the goal of improving their liquidity and stability, which would help the funds better weather redemption demands in a faltering market.
“We have regulated banks and markets comprehensively. We now need to address the risks posed by the shadow banking system,” Internal Markets Commissioner Michel Barnier said in a statement. “It plays an important role in financing the real economy, and we need to ensure that it is transparent and that the benefits achieved by strengthening certain financial entities and markets are not diminished by the risks moving to less highly regulated sectors.”
Barnier is referring to the fear that as new financial safeguards are put in place to regulate the traditional financial sector, certain business could be pushed into the shadow sector. The commission's actions are a result of its overall scrutiny of the financial system following the 2007 economic crisis.
In Europe, money market funds hold roughly 22 percent of short-term debt securities issued by governments or the corporate sector, according to commission data. Money market funds also hold about 38 percent of short-term debt issued by banks.
Under the proposal:
· MMFs must have at least 10 percent of their portfolio in assets that mature within one day, and another 20 percent in assets that mature within a week;
· To prevent a single issuer from bearing “undue weight” in constant net asset value MMF, a single issuer would be capped at 5 percent of the MMF's portfolio in value, or 10 percent for standard MMFs.
· MMFs will be required to establish a predefined capital buffer, which would be used to stabilize redemptions during periods of decreasing value of the MMF's investment assets.
· Clear labeling will be required to indicate whether a fund is short-term (not exceeding 397 days) or standard.
· Customer profiling will be implemented to try to anticipate any large redemptions.
· Managers will be required to conduct internal credit risk assessment.
The rules would apply to money market funds domiciled or sold in Europe.
In the future, the commission also plans further action targeting the transparency of the shadow banking sector, securities law and securities financing transactions, and a framework for interactions with banks. On this last piece, the commission is suggesting tighter rules governing how banks interact with unregulated financial entities. Because of the linked nature between the traditional and shadow systems, the shadow system presents a major contagion risk, the commission said. The commission also plans to look at the creation of resolution rules for non-bank institutions, and further structural reform of the banking system.
Similar recommendations from the Financial Stability Board were expected to be endorsed during the G20 summit scheduled for later this week.