We recently noticed another Comment Letter posted by the Investment Company Institute. This latest, written by President & CEO Paul Schott Stevens, is in a Response to a recent Financial Stability Board paper, "Shadow Banking: Scoping the Issues". Stevens writes, "The Investment Company Institute appreciates the opportunity to comment on the background note by the Financial Stability Board entitled 'Shadow Banking: Scoping the Issues'." (See also, "Financial Stability Board, Shadow Banking: Scoping the Issues.)

ICI says, "Since our inception in 1940, we have been active participants in the development of laws and regulations that have been instrumental in the growth of fund investing in the United States and worldwide. We have been deeply engaged in the development of laws and regulations responsive to the recent financial crisis, including mechanisms to counter systemic risk and to make money market funds more resilient in the face of the most adverse market conditions, such as those caused by widespread bank failures in 2008."

They continue, "The FSB's directive from its member institutions is to "develop recommendations to strengthen the oversight and regulation of the 'shadow banking system' by mid-2011." To that end, the FSB established a task force to consider the following: (1) a definition for 'shadow banking'; (2) potential approaches to monitoring the 'shadow banking' system; and (3) possible regulatory approaches to address systemic risk and regulatory arbitrage concerns posed by the 'shadow banking' system. The Note describes the current thinking of the FSB's task force, particularly on the definition of the “shadow banking system."

Stevens adds, "The Note states that the financial crisis has shown that "the shadow banking system can also become a source of systemic risk, both directly and through its interconnectedness with the regular banking system." The Note asserts that the shadow banking system can "create opportunities for arbitrage that might undermine stricter bank regulation and lead to a build-up of additional leverage and risks in the system." The Note concludes that "[e]nhancing supervision and regulation of the shadow banking system in areas where systemic risk and regulatory arbitrage concerns are inadequately addressed is therefore important."

Stevens explains, "Crucial to the FSB's project is a definition of the "shadow banking" system, which the Note very broadly identifies as "the system of credit intermediation that involves entities and activities outside the regular banking system." Acknowledging that the definition is broad, the FSB limits the Note's view of "credit intermediation" to activities and entities involved either in extending credit (directly or as part of a chain) or in facilitating its intermediation. In further describing "credit intermediation," the Note observes that credit intermediation encompasses not only on-balance sheet transactions but also derivatives and other off-balance sheet transactions that would be part of the credit intermediation chain. The proposed definition would exclude "pure equity trading" and foreign currency transactions by entities outside of the banking system, unless such activities are part of the credit intermediation chain. The Note explicitly identifies the trading of credit-related financial instruments, such as bonds and structured/hybrid financial products, as within the definition of credit intermediation."

He says, "Although the Note begins broadly, it concedes that any focus should only be on non-bank credit intermediation where important risks are most likely to emerge. Consequently, the Note states that regulatory attention should focus on those "shadow banking" activities that give rise to either or both of the following: (1) Systemic risk: primarily arising from activities that generate maturity and/or liquidity transformation, that involve flawed credit risk transfer, and that create or facilitate leverage; and (2) Regulatory arbitrage: arising from activities that circumvent or undermine banking regulations. The Note defines "maturity transformation" as the activity of issuing short-term liabilities (such as deposits) and transforming them into medium–long term assets (such as loans). "Liquidity transformation" refers to the issuance of liquid liabilities to finance illiquid assets. For this purpose, the Note states that an asset is illiquid when it cannot be easily converted into cash without a loss in nominal value. The Note does not include a definition of "flawed credit risk transfer"; there is only a general reference to flawed credit risk transfer through securitization."

The letter states, "As a preliminary matter, ICI strongly objects to the use of the terms "shadow banks" and "shadow banking" because they are inherently inaccurate and misleading. These terms are merely epithets, connoting that all the activities so labeled lack both transparency and any regular or official status. Such is not the case. As a recent Staff Report of the Federal Reserve Bank of New York observes, "the label 'shadow banking system' ... is an incorrect and perhaps pejorative name for such a large and important part of the financial system." We urge the FSB to use more precise and neutral terminology when discussing the various roles of non-bank financial Intermediaries. As we discuss in Appendix A, those entities play a variety of important roles in the financial system. These roles may share some similarities with the role that banks play -- but there are also critical differences and those differences should be respected."

ICI's response concludes, "The FSB wields an unusually powerful tool, in its ability to forge global recommendations regarding those activities perceived to pose systemic risk and to require international attention. We urge the FSB to carefully weigh any proposals relating to non-bank financial intermediaries against its standard that "the regulatory response to shadow banking should be carefully balanced and targeted." Such balance will only be achieved if the FSB's recommendations are closely informed by, and tailored to take account of, the unique features of existing regulatory regimes and the experiences of different financial markets."

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