The European Banking Authority (EBA) recently consulted on draft guidelines which propose that European banks impose limits on the exposure they have to investment funds that fall within the definition of shadow banking entities.
Under the proposal put forward, EU financial institutions would be required to:
- Put in place effective processes and control mechanisms to address the risk arising from exposure to the shadow banking sector
- Set aggregate limits on exposure to the shadow banking sector as a whole and individual limits on exposure to shadow banking entities
It is important to note that the guidelines do not specify quantitative limits.
Effective processes and control mechanism
EU financial institutions would be required to:
- Identify individual exposure to shadow banking entities, potential risks arising from those exposures, and the potential impact of those risks
- Set out an internal risk management framework
- Ensure that risks are adequately taken into account within the institution’s ICAAP and capital planning
- Set the institution’s risk tolerance/risk appetite for exposures to shadow banking entities
- Implement a robust process for determining inter-connectedness between shadow banking entities, and between shadow banking entities and the institution
- Have effective procedures and reporting processes to the management body regarding exposures to shadow banking entities within the institution’s overall risk management framework
- Implement appropriate action plans in the event of a breach of the aggregate and individual limits set by the institution
Oversight by the management body of the institutions
The financial institution’s management body should, on a regular predetermined basis review and approve:
- The institution’s risk appetite to exposures to shadow banking entities and the aggregate and individual limits
- The internal risk management framework
- The institution’s exposures to shadow banking entities (on an aggregate and individual basis) as a percentage of total exposures and expected and incurred losses
The institute should also ensure the setting of the limits is documented, including any changes to them.
Setting an aggregate limit to shadow banking entities
Each institution should set an aggregate limit to its exposures to the shadow banking sector relative to its eligible capital. When setting this limit, an institution should take into account its business model, risk management framework and the size of its current exposures to shadow banking entities relative to its total exposures and relative to its total exposure to regulated financial sector entities.
Setting individual limits on exposures to shadow banking entities
Independently from the aggregate limit, and in addition to it, institutions should set tighter limits to their individual exposure to shadow banking entities. When setting those limits for their internal assessment process, the institutions should take into account the regulatory status and financial situation of the shadow banking entity, information available about the portfolio of the shadow banking entity, in particular non-performing loans and whether the shadow banking entity will be vulnerable to asset price or credit quality volatility.
If institutions are not able, due to either an insufficient level of information about the activities of shadow banking entities to which they have exposure or to the lack of effective processes to use that information, they should utilise a “fallback” option, which has two potential variants:
Option 1 would require an aggregate exposure limit to all shadow banking sector entities of 25% of capital.
Option 2 would use the fallback approach only for those exposures which cannot be risk-assessed appropriately.
The EBA has requested responses to the proposals in the guidelines. We will update you once the responses to the EBA’s request for feedback are published.