Regulation to mitigate spill-over risks (interconnectedness)

An assessment of financial interconnectedness between shadow banking entities on the one hand, and banks, insurance companies, pension funds, households and non-financial companies, on the other hand, has been presented in chapter 4 of this report. It shows that risks can spill over through direct and indirect linkages. For example, direct linkages are created when non-bank financial entities are directly owned by banks or benefit form explicit (contractual) or implicit (non-contractual) bank support. Such amplification of risks can have consequences for financial stability. Data presented in chapter 3 revealed that an important part of the linkages is located within conglomerates or consolidated entities and should not be treated as shadow banking. Section 1 will give an overview of conglomerate supervision applicable to these linkages. The remaining part is to be considered as shadow banking, and regulated according to the framework presented in section 2.

5.3.1. Conglomerates supervision

Financial conglomerates are defined as groups operating in different business activities combining banking, securities and insurance activities. The specific risks they are exposed to have been tackled by EU legislation (FICOD and delegated acts), which complements sectoral regulations.

The scope of the supplementary conglomerate supervision exercised on groups identified as financial conglomerates includes all undertakings, whether regulated or unregulated, consolidated or not, that form part of the group. For the purpose of supplementary supervision, a group is indeed defined as a set of undertakings formed by a parent undertaking, its subsidiaries, the undertaking in which the parent undertaking or its subsidiaries have a direct or indirect participation and the undertakings forming a consortium and undertakings controlled by the latter undertakings or in which the latter undertakings hold a participation.

Supplementary supervision relates to requirements to mitigate the risk of contagion within the group, the existence of conflicts of interest, circumvention of sectoral legislation, as well as the level or scale of risk concentration and intragroup-transactions, which are typical financial conglomerate risks. The requirements include transparency, appropriate risk management and internal control procedures, and reporting.

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It will be noted that interconnectedness of groups identified as financial conglomerates with shadow banking entities is not as such addressed by supplementary supervision. Nevertheless, the wider scope that is covered compared to consolidated supervision can be an important milestone to consistent and risk-sensitive approach for computing regulatory capital requirements for banks’

investments in the equity of funds that are not held for trading purposes, by appropriately reflecting both the risk of the fund’s underlying investments and its leverage. EU Member States are implementing the new requirements through the proposed update of the CRR. The second measure seeks to protect the banking sector from the risk of the default of single private sector counterparties, including shadow banking entities by establishing a supervisory framework for measuring and controlling banks’ large exposures. To achieve this, the definition of a large exposure is strengthened to limit carve outs and exemptions (which shadow banks may have previously been able to take advantage of), and to more clearly and consistently capture exposures to funds, securitisation structures and other vehicles. Banks will also be subject to a hard limit on large exposures of 25% of Tier 1 capital. BCBS members are currently in the process of implementing the framework fully by 1 January 2019. In EU Member States, similar large exposure requirements are already in effect for several years.

The EBA has issued guidelines concerning limits on institutions’ (credit institutions and investment firms) large exposures to shadow banking entities and the results of the accompanying comprehensive data gathering exercise have been published in 2016. The guidelines come into force on 1^st January 2017. Section 3.1.1 explained what entities are considered as shadow banks according to the EBA methodology. The guideline lays down requirements for institutions to set limits, as part of their internal processes, on their individual exposures and aggregate exposure to shadow banking entities to minimise the macro and micro-prudential risks. They essentially consist of qualitative limits, while quantitative limits are only used as a fall-back approach. The SSM decided to comply with these guidelines for significant institutions, the NBB has published a circular in order to apply the guidelines for less significant institutions. In the meantime, EBA asked for a mandate to report to the Commission on the effectiveness of the guidelines and propose, if appropriate, to transform certain aspects of the guidelines into a regulation. This assessment would be conducted only after an appropriate observation period.

In addition to this specific regulation addressing the links between banks and the shadow banking system, it is also important to note that such links are captured by other prudential regulations that are covering banks’ exposures to different kinds of risks. Relevant prudential policy areas that cover risks stemming from the links to the shadow banking system or the asset management industry are liquidity, the credit risk framework and the market risk framework.

The existing regulation on credit, liquidity and market risk should cover banks’ on- and off-balance sheet exposures to shadow banks just as any other exposure to third parties; while these cover contractual links, there may be a gap for non-contractual links between banks and non-bank entities.

The BCBS is in that context continuing its review of the scope of consolidation for prudential regulatory purposes with a view to developing guidance to ensure all banking activities, including banks’ on- and off-balance sheet interactions with the shadow banking system, are appropriately

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captured in prudential regimes. In particular, it is assessing the risk of banks stepping in to support shadow banking entities (i.e. step-in risk) and is considering possible ways to capture such risk in the regulatory perimeter. It issued proposals for public consultation around the end of 2015 in this regard and is in the process of finalising the work on step-in risks.

5.3.2.2. Links with insurance companies

As shown in section 4.3.3, the Solvency II supervisory data capture well the exposure of the Belgian insurance sector to other financial intermediaries and potential shadow bank entities. The regulatory risks are thus captured as well in the existing Solvency II framework. Given the important role of the unit-linked contracts — also highlighted in section 4.3.3 —, it is not excluded that some non-contractual links and associated risks may also be present. These risks are related to the potential additional non-contractual commitments, as for example explained in the Basel Committee approach to potential « step-in » risks as regards banks’ exposures to sponsored unconsolidated entities. An important mitigant for this interconnectedness risk within financial groups or conglomerates is strong risk management as well as adequate supervision at the level of the financial group or conglomerate, which should take into account these potential spill-over effects. The competent supervisor should ensure that « step-in » risks are covered, assessed and integrated in the risk management of financial groups and conglomerates.

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