Bring shadow banks into the light

The South African Reserve Bank. (Oupa Nkosi, MG)

The South African Reserve Bank. (Oupa Nkosi, MG)

The term “shadow banking” suggests financial alchemy is worked in the darkest corners of the world.

But it can also cover activity that, especially in South Africa, can alleviate problems such as making affordable credit available to poorer people and introducing competition to a highly concentrated industry.

Globally shadow banking is estimated to have reached over $75-trillion by 2013 and in South Africa it is estimated to be over R2-trillion.

Since the financial meltdown of 2008, regulators around the world have grappled with ways to regulate these activities to curb the risks they pose to global financial stability. South African regulators are in step with the developed world in efforts to better oversee broader financial services.

But experts cautioned this week that regulation had to be balanced against the need for greater financial inclusion and improved competition without stifling innovation.

The Financial Stability Board – an international body that monitors and makes recommendations on the global financial system – is the chief body tracking the growth of shadow banking globally.

According to the board, shadow banking broadly covers credit intermediation that falls outside the formally regulated banking system. Or, to put it another way, companies provide financial services akin to a bank but are not regulated like a bank and do not have the same protections that banks might have in the event of a collapse.

The term is expansive and covers everything from securities – or scrip – lending to peer-to-peer lending such as stokvels.

According to Anthony Smith, associate director at Deloitte Risk Advisory, shadow banking can be placed in two broad categories: activities undertaken through instruments in the debt and capital markets; and formal and informal credit lending activities.

The former are typically bank-like activities – including activities undertaken by banks but that are off-balance sheet – such as securitisation, which is the creation of a security from an underlying asset, such as a loan.

It was this kind of activity in the United States home loan market – namely the parcelling up of home loans into securities that were then sold on to investors – that sparked the financial crisis.

Formal and informal credit lending activities, said Smith, are “looser arrangements” in the retail sector, such as burial societies and pawn shops, and credit providers such as micro-finance firms that are regulated by the National Credit Regulator.

The size of the shadow banking sector is difficult to measure.
But on the basis of the board’s guidelines, it can be conservatively proxied by the assets of “other financial intermediaries” according to the South African Reserve Bank. Aggregating the data of financial intermediaries in South Africa, including the assets from money market funds, investment funds, trust companies, finance companies, hedge funds and bond schemes, the 2012 estimate stood at R2.4-trillion, according to deputy governor Francois Groepe.

The size of the shadow banking system appears to be growing globally. According to the International Monetary Fund, this is in part due to gross domestic product growth and a low interest rate environment, and while the US and European Union have the largest amount of shadow banking activity, it is on the rise in developing nations.

Intense regulations
Increased shadow banking activity in China in particular has raised eyebrows. According to the Brookings Institution, a US-based think-tank, shadow banking in China has picked up against a backdrop of intense regulation of the country’s formal banking institutions, a number of which are run by the state.

Shadow banking activities in the country cover a host of transactions and instruments, according to a March paper published by the institution. These include loans and leases by trust companies and financial firms in China that combine elements of banks and asset managers, micro-finance activities and wealth management products.

Research on shadow banking, released by the Chartered Financial Analyst Institute, revealed that investors believed a potential default of Chinese trust and wealth management products posed the greatest risk in shadow banking in the coming years.

Shadow banking

The risks to South Africa’s financial system are not as pronounced. Groepe said: “In South Africa shadow banking activities seem to be limited to direct lending by [other financial intermediaries] and to a limited extent by insurance companies, and securitisation and repurchase transactions within banks.”

Nonbank financial intermediation has become a “vital part of the financial system”, he said, because it provides “an alternative to banks for the provision of credit in support of economic activity”.

“However, the nonbank sector also poses potential systemic risks to the financial system, and to this end there is a need to monitor these risks and respond appropriately.”

South Africa participates in the board’s annual monitoring of shadow banking and the major banks in South Africa are not significantly exposed to shadow banking players globally, said Groepe. “Domestically, the exposures of banks are closely monitored by the South African Reserve Bank.”

Smith said the growth of shadow banking is also being driven by innovation, or those who see an opportunity “to disrupt traditional banking by offering a service that is cheaper and more efficient”.

The level of disruption will increase, he said, driven by a technically savvy younger generation without their predecessors’ affiliation to bricks-and-mortar institutions. The evolution of virtual currencies such as Bitcoin is an example of this.

Shadow banking also plays an important part in increasing financial inclusion such as giving the unbanked access to credit and savings products, he added. “The rise in shadow banking can also be attributed to the need for financial products in this segment of the market.”

The overhaul of South Africa’s financial regulatory regime, under the so-called twin peaks model, which is aimed at enhancing South Africa’s financial stability, is expected to widen regulators’ oversight of shadow banking activities.

Already entities such as hedge funds, which were previously unregulated, must register as collective investment schemes under regulations passed earlier this year by the national treasury.

The European Commission has proposed regulations requiring certain money market funds to hold a capital buffer of a proposed 3%, similar to capital requirements for banks.

The Financial Stability Board is expected to give guidance on the handling of money market funds by November, according to the Association for Savings and Investments (Asisa). This is relevant in South Africa in the wake of African Bank’s collapse last year. Several local money market funds were exposed to the unsecured lender’s debt.

Nerina Visser, deputy chairperson of the CFA Society South Africa, warned that overregulation could have unintended consequences. More regulation does not guarantee that “shenanigans don’t take place”, she said. “That is part of the dilemma that we face. You can’t regulate for ethical behaviour.”

If anything, overregulation risked making it more onerous for the compliant market participants, but failed to stop those that operate unlawfully, she said. The realm of microfinance was an example. “You are closing the door to smaller enterprises … that want to innovative and expand the broadness of out-financial market but they can’t afford to be compliant,” she said.

More transparency needed
This could potentially force people unable to meet costly compliance requirements to move “outside of the system”, she said. More transparency in the financial system, rather than more regulation, was needed, she argued. This allowed markets to properly price the risks associated with various transactions.

The term shadow banking was a “bad naming convention”, said Asisa representatives.

Shadow banking was incorrectly perceived as negative, said Adre Smit, consultant senior policy adviser for Asisa. Increasingly, people were moving towards it as “sustainable market-based finance”.

“You want to encourage market-based finance … where the market outside the banking system is directly funding the economy.” It needed to be transparent so market participants could get a “fair price” for taking the risk, he said.

But South Africa is a member of the G20, said Smit. “As such we are expected to fit in with global developments on the regulatory front.”

Although efforts had been made to introduce forms of national discretion, because South Africa is a “bit player” in the G20 environment “it is difficult to get the type of dispensation to meet the needs of our economy”, he added.

The national treasury did not respond to requests for comment.

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