European Union Launches Clampdown On Shadow Banking

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Special funds used by big companies to park billions of euros of cash face stricter rules to make them safer, the European Commission said on Wednesday, taking a first step to reform unregulated finance known as shadow banking.

* Money market funds face stiffer rules

* Reform marks start of clampdown on 24-trillion euro sector

* G20 leaders to tackle shadow banking this week

Special funds used by big companies to park billions of euros of cash face stricter rules to make them safer, the European Commission said on Wednesday, taking a first step to reform unregulated finance known as shadow banking.

The draft law will regulate money market funds, demanding some set aside cash buffers to avoid a panic should many investors withdraw their money at once.

This would lower what EU financial services chief Michel Barnier said was a risk to the financial system from the trillion euro sector but users of the funds warn that demanding they hoard more for a rainy day would make them too expensive.

The changes are part of efforts to shine a light on shadow banking, a 24-trillion-euro industry in Europe that comprises money market funds, some hedge funds, and firms involved in securities lending and repurchase markets.

Such groups borrow and lend, just like banks do, but because they are not banks they often fall outside the remit of regulation, which is why they are considered to operate in the 'shadow' of traditional finance.

In the European Union, money market funds are mainly based in France, Ireland and Luxembourg and are heavily used by companies and banks which borrow from them.

For companies, they are an alternative home for short-term cash. Unlike banks, they have no access to support from central banks such as the European Central Bank if things go wrong.

But the vast unchartered territory unnerves regulators in part because the sector is closely intertwined with banks, who often sponsor the funds as well as relying on them for finance themselves.

"We have regulated banks and markets comprehensively," said Barnier, the EU Commissioner who has led a four-year revamp of financial rules. "We now need to address the risks posed by the shadow banking system."

The European plans draw on ideas in a global blueprint that will be submitted for approval to the world's 20 leading economies when their leaders meet in Russia on Thursday and Friday. In some cases, the EU reform is more ambitious.

HEART OF CRISIS

The reform is a response to the 2007-2008 financial crisis, which was brought on by the collapse in prices of securities tied to risky home loans.

"Shadow banking was at the heart of the crisis," said Frederic Hache, a former derivatives banker who works with public-interest group Finance Watch. "As bank regulation has since tightened, activity may shift into the shadow sector."

The most controversial element in Barnier's proposal is a requirement for one type of money market fund, known as constant net asset value (CNAV) funds, to hold a cash buffer equivalent to 3 percent of their assets.

Such funds seek to maintain a stable 1 euro per share when investors redeem or buy shares in them, to keep the value of their holding steady.

The buffer would provide a safety cushion in case there is a run on the fund, as seen in the United States when the value of one U.S. fund "broke the buck" and fell below $1 per share.

The industry says the reform would be too costly.

"Imposing a three percent buffer would make money market funds unviable," said Martin O'Donovan, deputy policy and technical director at Britain's Association of Corporate Treasurers. "To cover that, their rates would no longer be competitive."

Funds whose share price floats in line with performance are spared the buffer requirement. Imposing the buffer is meant to prompt CNAV funds to convert to funds with floating share prices, which are seen by regulators as more transparent.

The funds in the EU, which include BlackRock and Legal & General, are evenly split between the two types.

The European Union's 28 member states and the bloc's parliament have the final say on the draft law and some changes are likely.

The United States is also discussing new rules for money market funds but has stopped short so far of proposing cash buffers.

Barnier also published a "roadmap" on how the EU plans to move ahead with regulating other parts of the shadow banking sector, including a proposal to boost transparency by collecting and exchanging data among regulators.

Banks could be required to hold more capital to cover risks from links to shadow banking. Shadow banking intuitions themselves could be required to hold capital, the EU executive said.

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