Transcending regulatory fragmentation and the construction of an economy-society discourse: implications for regulatory policy derived from a functional approach to understanding shadow banking.

• Author: Chiu, Iris H.-Y.

1. INTRODUCTION II. WHY A FUNCTIONAL APPROACH TO UNDERSTANDING SHADOW BANKING? A. A Functional Approach to Understanding Repo Markets B. A Functional Approach to Understanding Money Market Funds C. A Functional Approach to Understanding Securitization III. THE FUNCTIONAL APPROACH AND ITS ORIGINS IV. LIMITATIONS OF THE FUNCTIONAL APPROACH V. THE OPTIMALITIES OF THE FUNCTIONAL APPROACH AND CONCLUSION I. INTRODUCTION

   The interpretation of "shadow banking" and the mapping of the shadow banking universe is the subject of significant academic commentary (1) and policy discussions. (2) This is because shadow banking is often used as a catch-all term to refer to financial activities and transactions that may not be subject to traditional realms of regulation, but the amorphous nature of the term is unsatisfactory for informing debates on regulatory boundaries and policy. Often, a "functional" approach is suggested in order to understand the nature of financial activities and transactions that are lumped into the shadow banking category. The "functional" approach focuses on the economic function of the financial activity in question, regardless of the type of institution carrying it out. (3) By looking at the economic function performed by the financial activity in question, one may better ascertain the underlying demand and supply for such function (4) and the risks that such functions give rise to, (5) particularly whether systemic risk is implicated. The approach may also highlight the functional similarities and differences with already-regulated financial activity in order to form views as to the regulatory perimeter for shadow banking activities. (6) The functional approach to shadow banking is therefore a prima facie useful approach to surveying the universe of shadow banking and informing the policymaking process in relation to shadow banking activities and transactions at national and international levels.

   This Article raises concerns as to the limitations of the functional approach, and whether such limitations would ultimately hamper the development of regulatory policy. In particular, I question whether the functional approach is too embedded in market-liberal assumptions, and gives rise to a "like-for-like" presumption in favor of the design of regulatory methodology. Further, I question whether the functional approach, though conceptually promising, is subject to the legal arbitrage that it seeks to overcome. Nevertheless, this Article does not deny the achievements made by adopting the functional approach and suggests how it should be put to optimal use.

   The Article begins by briefly sketching why commentators and policy-makers have endorsed a functional approach to understanding shadow banking. It then proceeds to examine the nature and origins of the functional approach in financial regulation more generally. I assess the achievements of the functional approach in understanding and mapping shadow banking, followed by exploring the limitations I perceive. I suggest that the optimal application of the functional approach must be stakeholder-inclusive and focused primarily on global surveillance. Such an approach is therefore not frontloaded with implications for policy-making, leaving policy choices to be debated in open and inclusive dialogues, so that the relevant international and national authorities may determine their policy choices. I argue that such an approach is optimal as it is likely to produce more objective factual findings that are unpartisan in nature and accessible to many. I argue that such an approach may be regarded as part of an endeavor toward a near-Habermasian dialogue between economy and society. Such a dialogue is desirable and may be an important piece in the wider context of the political economy of financial regulation. (7)

2. WHY A FUNCTIONAL APPROACH TO UNDERSTANDING SHADOW BANKING?

   A number of commentators define shadow banking as credit, liquidity, or maturity transformation activities that are carried out without recourse to emergency liquidity assistance or a public backstop (8) (i.e., depositary bank-like activities without the usual public sector supporting infrastructure and often also outside of the usual regulatory frameworks that apply to banks). (9) A rather crude way of looking at shadow banking is to regard all non-bank financial intermediation activities as shadow banking, an approach taken by the European Central Bank, (10) for example albeit mainly for surveillance purposes and not for the purposes of determining regulatory policy. This approach, perhaps more than anything, highlights the inadequacies of current regulatory approaches. The Financial Stability Board acknowledges that the existing mode of regulatory thinking revolves around distinguishing the banking from the non-banking sector. (11) Current regulatory approaches are often based on the label of the firm (i.e., making sectoral differentiations between banks, insurers, and investment firms).

   Moreover, the adoption of conventional regulatory paradigms is inappropriate for understanding shadow banking as it is inaccurate to only view non-bank institutions as part of the shadow banking landscape. This seems to suggest that such institutions are conducting covert or unconventional activities or are not adequately regulated. On the contrary, such institutions may be regulated under a different label, such as investment management. Thus, sectoral regulation may fail to accommodate financial innovation that firms carry out to mimic activities in another regulated sector. Further, many banking institutions are indeed involved in various activities that could be described as shadow banking. Banks carry out significant credit, liquidity or maturity transformation outside of the conventional regulatory framework, and these activities may pose risks that are not taken into account in those regulatory frameworks.

   Fein is right in pointing out that much of shadow banking is actually conducted by banks, and hence, existing regulatory labels based on sectoral differentiation do not provide much guidance in understanding the nature of shadow banking and implications for regulatory policy. (12) The limitations in current regulatory definitions leave non-bank institutions that perform economically similar functions out of the regulatory perimeter for banks. Further, unconventional activities undertaken by banks are also arguably beyond the regulatory perimeter. Hence, pockets of regulatory arbitrage can be taken advantage of by financial institutions, due to anomalous differences in regulatory treatment.

   Shadow banking involves financial innovation, which on the one hand may be regarded as serving genuinely useful purposes, but on the other hand may be perceived as a form of regulatory arbitrage. (13) As such, it can be argued that existing sectoral regulation or the non-bank/bank distinctions are inherently unable to capture the novelty and the boundary-shifting nature of shadow banking activities or transactions. A functional approach to understanding shadow banking is necessary as the regulatory/legal understanding of banking has become obsolete and unduly narrow in scope. Whether or not it is purposed to overcome regulatory arbitrage, the functional approach reaches into the economic structures and models of financial intermediation activity to discern the objectives, methodology, and risk profiles of innovative or alternative activity. The adoption of a functional approach in understanding shadow banking transcends the limitations of currently fragmented regulatory approaches adopted in different jurisdictions. It may also be the first step towards developing regulatory policy, but here I urge the exercise of caution, as will be shortly discussed. For example, a functional approach to shadow banking is able to unpack the economic purposes of the rehypothecation market (repo market), while highlighting which aspects of the market are in the "shadows"--with distinguishing characteristics like being unmonitored, unregulated (whether or not for the purposes of regulatory arbitrage or avoidance), and unconventional (or as an alternative or innovative means of achieving similar economic effects traditionally achieved via other means, usually regulated). I argue that the functional approach is able to provide an objective narrative of the nature of shadow banking in terms of their economic and legal functions. Such analysis is also able to tease out the shadowy aspects of such activities. However, I suggest that the functional approach should not be used to justify policy-making based on a "like-for-like" approach with reference to what is already regulated, an argument that will be developed in Part IV.

   I next turn to how the functional approach can be used to flesh out the nature and key attributes of three shadow banking areas: the repo markets, money market funds, and securitization.

   1. A Functional Approach to Understanding Repo Markets

      In repo markets, highly liquid securities such as government debt may be used to fund short term borrowing by banks and other wholesale sector institutions. For example, in the overnight repo market, financial institutions, usually banks, enter into agreements to sell such securities to a dealer (likely another bank) in order to buy them back the following day at a premium. The dealer is able to rehypothecate the same security instrument for the same short term funding purpose. Manmohan Singh and Peter Stella report a high level of rehypothecation, or collateral re-use, in shadow banking markets. (14) Such short term funding is essentially perpetuated by constant use of collateralization to meet short term liabilities, as long as the market for the underlying collateral remains liquid and market confidence remains stable. The repo market is an innovative means of meeting banks' short term funding needs, as traditional deposit inflows may be too inadequate and slow...