The European Banking Authority (EBA) is consulting on guidelines on the criteria to set limits on EU institutions' exposures to shadow banking entities (SBEs). The consultation closes on 19 June 2015.
- The guidelines confirm that all Money Market Funds (being UCITS or alternative investment funds (AIFs)), all other AIFs and all unregulated funds will be treated as SBEs.
- Banks, investment banks and other institutions subject to the Credit Requirements Regulations (CRR) which are exposed to SBEs will have duties under the guidelines.
- These will include a duty to have 'effective processes and control mechanisms' to identify its individual exposures to SBEs, all potential risks to the institution arising from those exposures, and the potential impact of those risks.
- It will also include the use of a 'principal approach' and 'fallback approach' to limit financial institutions' exposures to SBEs.
- The managers of funds which are SBEs will need to consider how they can make it easier for CRR institutions who invest or trade with them to discharge their obligations under the guidelines.
Why is the EBA consulting on the guidelines?
Article 395(2) of CRR requires the EBA, taking into account the effect of the credit risk mitigation under Articles 399 to 403 as well as the outcomes of developments in the area of shadow banking and large exposures at the EU and international levels, to issue guidelines to set appropriate aggregate limits to such exposures or tighter individual limits on exposures to SBEs which carry out banking activities outside a regulated framework.
What concerns with shadow banking does the EBA highlight?
The EBA identifies the following concerns regarding shadow banking, as well as seeking to explain both the micro-prudential and macro-prudential risks:
- Run risk and/or liquidity problems.
- Interconnectivity and spillovers.
- Excessive leverage and procyclicality.
- Opaqueness and complexity.
When will an institution subject to the CRR typically have an exposure to a SBE?
Where the institution makes an investment in, for example, a fund which is a SBE or otherwise dealing as principal, for example by entering into a total return or credit default swap, with a SBE.
How will SBEs be defined?
SBEs are undertakings that: (1) carry out one or more credit intermediation activities; and (2) are not 'excluded undertakings'.
What will be caught under the definition of credit intermediation activities?
Credit intermediation activities are bank-like activities involving maturity transformation, liquidity transformation, leverage, credit risk transfer or similar activities.
These include at least those listed in the following Credit Requirements Directive (CRD) activities:
- Taking deposits and other repayable funds.
- Lending including, inter alia: consumer credit, credit agreements relating to immovable property, factoring, with or without recourse, financing of commercial transactions (including forfeiting).
- Financial leasing.
- Guarantees and commitments.
- Trading for own account or for account of customers in any of the following: (i) money market instruments (cheques, bills, certificates of deposit, etc.); (ii) foreign exchange; (iii) financial futures and options;(iv) exchange and interest-rate instruments; (v) transferable securities.
- Participation in securities issues and the provision of services relating to such issues.
- Money broking.
- Portfolio management and advice.
The EBA states in the commentary that this should not, however, be taken as an exhaustive list of activities within the scope of 'credit intermediation'.
What types of entity will, by definition, be excluded?
The guidelines identify eleven types of 'excluded undertakings'. These include credit institutions, investment firms, insurance undertakings and UCITS funds. The reason for excluding these institutions, according to the EBA, is that they are subject to an appropriate and sufficiently robust prudential framework and are subject to consolidated prudential supervision.
What will this definition mean for fund managers?
As the commentary to the guidelines indicates, if all funds would be considered as falling within the scope of the definition of SBEs except if they are non-MMF UCITS (and third country firms subject to equivalent requirements). All MMFs (being UCITS or AIFs)), all AIFs and all unregulated funds would fall within the scope.
What duties are proposed for institutions with exposures to SBEs?
An institution with an exposure to a SBE will be expected to have 'effective processes and control mechanisms' to identify its individual exposures to SBEs, all potential risks to the institution arising from those exposures, and the potential impact of those risks. More particularly, an institution will be required to:
- Set out an internal framework meeting the requirements set out in the guidelines for the identification, management, control, and mitigation of the risks above.
- Ensure that risks outlined above are adequately taken into account within the institution’s ICAAP and capital planning.
- Based on the assessment conducted above, set the institution’s risk tolerance/risk appetite for exposures to SBEs.
- Implement a robust process for determining interconnectedness between SBEs, and between SBEs and the institution. This process should in particular address situations where interconnectedness cannot be determined, and set out appropriate mitigation techniques to address potential risks stemming from this uncertainty.
- Have effective procedures and reporting processes to the management body regarding exposures to SBEs within the institution’s overall risk management framework.
- Implement appropriate action plans in the event of a breach of the limits set by the institution in accordance with the rules on limiting exposures.
The guidelines also set out special duties for the management bodies of institutions with exposures to SBEs.
How will an institution be expected to limit its exposures to SBEs?
The guidelines will require an institution to use a 'principal approach' as follows:
- Set an aggregate limit to its exposures to the shadow banking sector relative to its eligible capital taking into account certain factors set out in the guidelines.
- Independently from the aggregate limit, and in addition to it, set tighter limits to its individual exposures to SBEs, taking into account certain factors set out in the guidelines.
What if an institution is unable to apply the 'principal approach' above?
If an institution is unable, due to either an insufficient level of information about the activities of SBEs to which it has exposures or to the lack of effective processes to use that information, to apply the principal approach set out above, it will be required to apply a limit of 25% of its eligible capital to its aggregate exposures to SBEs. This 25% figure is consistent with the current limit in the large exposures framework under the CRD and CRR. The EBA is consulting on two options for determining the fallback approach.
How is the EBA required to develop the guidelines?
In developing the guidelines, the EBA must consider whether the introduction of additional limits would have a material detrimental impact on the risk profile of institutions established in the EU, on the provision of credit to the real economy or on the stability and orderly functioning of financial markets.
Practical considerations for fund managers if the proposed guidelines are accepted
- To help institution’s due diligence: consider what information can be provided to institution regarding interconnectedness between the fund and any other SBEs.
- To help institution’s due diligence: consider what information can be provided to institution regarding interconnectedness between the fund and the institution.
- Consider systems for providing information above on a regular basis for helping institution’s senior management discharge its oversight duties under the guidelines.