Address by Director of Markets Supervision Gareth Murphy at a QED conference, Brussels

30 January 2014 Speech

Thank you for the opportunity to speak here today on this very important topic and in front of such a distinguished audience.

Role of financial regulation

Let me start by making a political point. Society places its trust in financial authorities. Financial regulators are charged with the responsibility of ensuring that financial services support the real economy 1. The economic function of financial intermediation is to match end-investors (big and small) with end-issuers (big and small). And, of course, to do so without posing a wider risk to the society as a whole.

Unacceptable data gaps

In the light of the financial crisis, where the taxpayer and central banks went to extraordinary lengths to provide additional capital and liquidity to stave off a total collapse of our financial system, and in the light of the substantial regulatory reform agenda of the last five years, society – reasonably – expects financial authorities to understand the financial system and to mitigate the risks of another financial crisis.2  I can tell you – having completed one of the first post-crisis analysis of the data gaps which financial authorities faced (in my previous role at the Bank of England 3), it is simply not acceptable that a future crisis could be managed with a similar lack of quality and timely data 4.

Good data in times of crisis supports targeted, timely solutions with fewer unintended consequences. Good stewardship of the financial services industry requires that financial authorities can monitor all activity. We know that the inter-linkages between different financial services firms and sectors are there and that these can make the system more complex and more fragile 6 7.

Connectivity vs Fragmentation

There are choices. We can allow connections between different parts of the system, eg banks and non-banks, and then – at the very least – monitor, and where necessary, mitigate the attendant risks. Or alternatively, we can create firewalls between parts of the financial system so that one part cannot infect another.

There is a choice between connectivity and fragmentation. So far, legislators and policy-makers have largely chosen to avoid the wholesale isolation of certain financial services sectors from each other 8.

So entities involved in shadow banking activities should not be surprised when they are subject to regulatory reporting requirements. This is a necessary part of financial authorities fulfilling their mandate for financial stability - though by no means a sufficient condition for ensuring that financial stability can be delivered.

Public good problem

As an aside, I am struck by the fact that some countries have ploughed tens of billions of euro into strategic defence and surveillance research and can track millions of communications per day using the best minds in industry and academia. Yet in the area of mapping and tracking financial services activity, I am not aware that legislators or financial authorities have had a serious discussion as to the infrastructural, technological and intellectual investment that is needed if we are to allow the financial services industry to evolve in the 21st century along a path which is financially stable. I fear that at present all the best minds who could be working in this area are busy breaking new ground in internet technology, surveillance and communications.

I see a significant 'public good problem' here. Industry does not have the incentive to provide the necessary monitoring infrastructure or human resources. That’s why the FSB has led with the Legal Entity Identifier. But this is just the tip of the iceberg. Legislators have to decide that society needs a better monitoring infrastructure. They need to mandate it and fund it.

Discipline in regulatory policy formation

Whilst the prospect of regulatory reporting may be seen by some unregulated sectors as onerous, in my view it is a necessary and disciplined first step. It is necessary for sound stewardship of the financial services sector. It is disciplined when it marks the first step along the spectrum of regulatory engagement 9. This spectrum spans a range of ever more intrusive activity from monitoring and data collection, to analysis, to policy formation, to rule-writing, to supervision, to enforcement and, ultimately, to resolution.

When approaching the regulation of shadow banking activities, it is important that legislators and policy-makers maintain a level of discipline in deciding upon more intrusive levels of regulatory engagement so that each step is backed by quality data, sound analysis and thorough cost/benefit analysis. Unfortunately, there are some cases where such discipline has been lacking in recent years.

Economic function of shadow banking activities

As the FSB indicated in November 2012, shadow banking "provides a valuable alternative to bank funding that supports economic activity"10. Some of the other benefits include:

  • Risk diversification, eg MMFs
  • Credit risk mitigation, eg securitization
  • Liquidity management, eg repo, and
  • Tailoring risk/return profiles to investor preferences, eg structured finance

Beyond these important economic functions, we know that there are also a number of not-so-good reasons for shadow banking such as regulatory arbitrage and spurious financial innovation.

Size of shadow banking

It is helpful to frame the size of shadow banking. According to the FSB (2013), shadow banking activity is conservatively estimated at over $71trn or 24% of global financial intermediation (which is estimated at $291trn). That is a little less than global GDP and just over 10 per cent of the notional OTC derivatives exposures (which is estimated at $693trn)11. Within these large numbers there are some striking regional differences. Unlike Europe, the US is more reliant on non-bank lenders 12.

It is clear that as many European banks focus on repairing their balance sheets (and preparing for SSM and CRD IV), there is a need for other forms of non-bank credit to meet the needs of the real economy 13. The EuVECA, EuSEF and ELTIF initiatives may be viewed as an acknowledgement of this.

Non-bank credit intermediation

Some might argue that the aim of non-bank intermediation is to circumvent bank capital rules. We need to be careful here. What are the actual economic risks that we seek to mitigate through bank-like regulation? Are we comparing like with like? For example, not all non-bank intermediation creates leverage. And most shadow banking activity does not rely (directly or indirectly) on central bank support or depositor protection schemes.

The most obvious risks relate to:

  1. investor runs leading to asset fire-sales;
  2. pro-cyclical effects amplifying the credit cycle; and
  3. weak credit assessment leading to bad loan origination.

Financial authorities need to, first, take stock of their current tool kit for mitigating these risks. For example, various parts of funds regulation deal with liquidity, concentration and even excessive leverage. Where new tools are being considered (for example, macro-prudential tools), it is important that they are not considered in isolation from the regulations which apply in other sectors.

Economic costs of bad lending

For example, one area that deserves more attention is the operational capability of non-banks to assess credit, monitor loans and manage impairments and write-downs 14. Unlike equity investments, when loan investments go wrong there are deadweight bankruptcy costs which impact real businesses and the real economy 15.

There is a difference between loans that go bad in the normal course of business (which may be linked to the business cycle) and an excessive stock of bad loans which stem from systematically poor lending standards. Regulation can play a role in avoiding the latter. Having regard for the CRD, this point needs to be given more prominence in the shadow banking debate, for example in the context of non-bank securitization, loan origination by funds and peer-to-peer lending.


To conclude, the shadow banking system has the potential to support the needs of the real economy. Regulatory engagement with all shadow banking activities is inevitable. The first step along that path is efficient data-gathering and monitoring. This will support a disciplined approach to focussing on the key risks and assessing appropriate regulatory tools to mitigate those risks. And finally, coherence with other areas of financial regulation is necessary if we are to avoid unintended consequences.


1 The aim of financial regulation is to mitigate the factors (or 'frictions') which stop this from happening efficiently. This means (i) protecting investors, (ii) ensuring fair and orderly markets and (iii) safeguarding financial stability. See IOSCO (2003).

2 See Laeven and Valencia (2012).

3 See Murphy and Westwood (2010).

4 The term of art, at present, is the capability to collect and manage ‘big data’. See Ayi Armah (2013) and Padmanabhan (2013).

5 See Poszar et al 2010.

6 See Gai et al 2011.

7 This leads to a complex topology of exposures and flows (differentiated by legal claim, maturity profile, recallability, settlement cycles and so on) linking one end of the map with the other. See Claessens et al 2012.

8 Though I would add that there are aspects of ESMA’s recent guidelines on UCITS and other ETF issues related to the use of collateral and recallability which aim to limit the links between funds and other parts of the financial system, especially where such links are not for the fund investors’ benefit.

9 See Moloney and Murphy (2013).



12  According to ECB President Mario Draghi “in the United States 80% of credit intermediation goes via the capital markets.... in the European situation it is the other way round.... 80% of financial intermediation goes through the banking system”. And there are other countries such as Australia and Canada which offer interesting case studies in the role of non-bank intermediation.

13 Indeed, Michel Barnier, European Commissioner for Internal Markets and Services, has previously noted that financial intermediation “should not be left entirely and solely in the hands of the banks while recognising that alternative financing can play a role once it is conducted within a solid and transparent framework.”

14 See Central Bank of Ireland 2013.

15 See White 1983, Leland and Toft 1996.


Ayi Armah, N., (2013) “Big Data Analysis: The Next Frontier”, Bank of Canada Review.

Central Bank of Ireland (2013),"Loan Origination by Investment Funds", Discussion Paper.

Claessens, S., Pozsar, Z., Ratnovski, L., and Singh, M., (2012) "Shadow Banking: Economics and Policy", IMF Staff Note.

Financial Stability Board (2013), "FSB Global Shadow Banking Monitoring Report".

Gai, P., Haldane, A., Kapadia, S., (2011), "Complexity, Concentration and Contagion", Journal of Monetary Economics.

Haldane, A., (2009), "Rethinking the Financial Network", Speech at the Financial Student Association, Amsterdam.

IOSCO, (2003), "Objectives and Principles of Securities Regulation".

Laeven, L., Valencia, F., (2012) "Systemic Banking Crises Database: An Update," IMF Working Papers 12/163, International Monetary Fund.

Leland, H., Toft, K., (1996), "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads", Journal of Finance.

Moloney, K., Murphy, G., (2013), "The Spectrum of Regulatory Engagement", Law and Financial Markets Review.

Padmanabhan, S., (2012), “Banking on Quality Data”, Speech at the Conference on Data Quality Management, Indian Institute of Banking and Finance.

Pozsar, Z., Adrian, T., Ashcraft, A., and Boesky, H., (2010), “Shadow Banking", FRBNY Staff Report No. 458.

Westwood, R., Murphy G., (2010), "Data gaps in the UK financial sector: some lessons learned from the recent crisis", Proceedings of the Fifth Irving Fisher Committee Conference, Basel.

White, M., (1983), “The behavior of firms in financial distress”, Journal of Finance.