The Warsaw Voice » Advice from Law Firm » Monthly - October 26, 2012
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Shadow Banking
The Amber Gold affair is still making headlines and is being widely discussed. It will likely stimulate a broader discussion about “shadow banking” in general.

What is shadow banking?
This term was defined recently in the Green Paper on Shadow Banking issued by the European Commission on March 19, 2012 (the “Green Paper”). It is “the system of credit intermediation that involves entities and activities outside the regular banking system” which overlap, supplement or copy, to a certain extent, the regular banking system and create additional sources of financing, allowing for the diversification of risk and creating an alternative to banking products. There is intense debate in the European Commission whether or not such activities should be regulated. According to the Polish government, issued in May 2012 (the “Polish Position”), the definition itself is ambiguous and should be clarified by making a direct reference to offering deposits and other saving products. In the Commission’s opinion, shadow banking covers in particular securitization, securities lending and repo transactions, whereas the entities include in particular: (i) special purpose entities performing liquidity and maturity transformation (e.g. various securitization vehicles), (ii) Money Market Funds (MMFs) and other types of investment funds or products with deposit-like characteristics, which may be vulnerable to massive runs, (iii) finance companies and securities entities, and (iv) insurance and reinsurance undertakings that issue or guarantee credit products.

The Polish shadow banking market does not seem to be very broad at the moment, which is simply due to the underdevelopment of the financial market in Poland in comparison to other financial markets. Securitisation has never been a popular form of liquidity and/or maturity transformation in Poland, and repo transactions have never become a common form of financing on a scale that could be dangerous to the economy. This does not mean, however, that such transactions can be overseen and forgotten, as the market is constantly changing and may become less conservative.

As the Polish government pointed out, the Polish shadow banking sector is dominated by deposit-like offers and high-interest lending to individuals and firms who have been excluded from the regular banking market for various reasons (in particular through a lack of creditworthiness). At the same time, in Poland and elsewhere, the danger lies in the lack of sufficient capital and other forms of guarantees on the part of the shadow banking market players, and in these entities becoming recognized, in particular by consumers, as being equal to banks. In addition, there is also a risk of the shadow banking market placing competitive pressure on the regular banking market, which may lead to a loss of confidence among professional market players and resulting in financial instability on the regulated market.

The European Commission has identified the following risks related to shadow banking. First, the risk of “runs” in the case of deposit-like funding structures. Many shadow banking entities are financed with short-term funding that is prone to sudden and massive withdrawals of funds by the clients, such as those observed in relation to Amber Gold’s assets in Poland. Second, the issue of hidden high leverage arises where activities are leveraged with collateral churned several times not subject to the lending limits imposed on banks. Third, the circumvention of rules and regulatory arbitrage must be taken into consideration where shadow banking can be used to avoid the regulation or supervision applied to regular banks. Last but not least, there are the disorderly failures affecting the banking system due to direct borrowing from the banking system, as well as massive sales of assets that may affect prices of financial and real assets.

Measures to be adopted
As shadow banking is interacting with the regular banking market, it should be looked at closely. Both the European Commission and the Polish government have indicated that access to information on shadow banking is important for adopting appropriate measures regarding this part of the financial market. Therefore, it is crucial to establish clear rules and/or legal provisions allowing access to information gathered by shadow banking entities, and to information on their activities. As a result, various approaches may be adopted, in particular the indirect regulation of links between banks and shadow banking entities, the extension or revision of existing laws to include shadow banking entities, and the adoption of new regulations specifically directed at shadow banking entities and activities.

Shadow banking in Poland
As indicated above, shadow banking in Poland is heavily represented by entities offering deposit-like products with very high and rather unrealistic returns, and entities lending at the maximum legally allowed interest. Such entities have been identified in the Polish Position as particularly dangerous for the financial markets and for consumers who are not able to distinguish between banks, which offer safer products with lower returns, and entities offering riskier products that are not as safe and may be subject to “runs,” but which offer considerably higher returns than banks.

However, it seems that in Poland, apart from all the European measures indicated above, education is crucial. People have to be educated to be more aware of the riskier products and why they are offered higher returns. People should know that lower returns are directly related to the entire system of granting deposits collected by banks and capital adequacy requirements.

At the same time, other forms of shadow banking should not be overlooked. Securitisation and repo transactions are something that links the regulated banking system and shadow banking, making both areas interconnected.

Agnieszka Kowalska, legal advisor and senior associate at Gide Loyrette Nouel
Paweł Grze¶kowiak, advocate and partner at Gide Loyrette Nouel

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