The Asset Based Finance Association (ABFA) is grateful for the opportunity to comment on the Commission s Green Paper on Shadow Banking.

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1 Mr Jonathan Faull Director General, Internal Market and Services European Commission 1049 Brussels Belgium By to: 31 May 2012 Dear Sir Shadow Banking Green Paper Response of the Asset Based Finance Association (UK and Ireland) The Asset Based Finance Association (ABFA) is grateful for the opportunity to comment on the Commission s Green Paper on Shadow Banking. The ABFA supports work to ensure that governments and regulators have the tools to better manage the systemic risks, and address the activities, that contributed to the global financial crisis. In this respect we would support the overall intentions behind the proposals set out in the Green Paper. The Commission will recognise, however, that as currently used the term shadow banking is both extremely broad and emotive. It has come to be associated with a wide variety of entities and activities, some of which had nothing to do with the financial crisis or its aftermath. Such a broadbrush approach presents a risk of removing, or negatively impacting, economically beneficial activities in a bid to curtail the damaging activities with which they are being bracketed. These concerns are particularly acute for our industry as it is not definitively certain whether our members would be considered to be conducting shadow banking activities or not. The Green Paper, and the work carried out by the FSB and other bodies before it, provides a useful starting point for consideration of the systemic risks to the financial system which exist outside the perimeter of conventional banking regulation. As the Commission recognises, however, detailed work will be required to identify the risks that are intended to be addressed, how particular activities give rise to those risks, and how those risks can be best managed and mitigated. Any approach that seeks to encompass qualitatively and quantitatively different activities carried out by a diverse range of entities to different purposes is unlikely to deliver appropriate levels of supervision and regulation for any entity or activity. It will also risk negatively impacting on the real economy. Background The ABFA represents the asset based finance industry in the United Kingdom and Ireland. The industry is an increasingly important source of funding for the real economy. It is one with over 50 years experience providing funding to businesses of all sizes, with particular expertise in financing the Small and Medium Sized Enterprise (SME) sector. At the time of the latest available statistics (end of 2011), ABFA members were providing 19.5 billion of funding to around 42,000 businesses in the UK and Ireland. The industry has continued to provide funding throughout the economic downturn. The industry specialises in the provision of cashflow finance and working capital for investment. Members do so through the provision of invoice finance (factoring and invoice discounting, in the 1

2 main) and asset based lending services to their clients. In brief summary, funding is provided on the basis of the assets within a business. Normally this would be provided against the debts owed to those businesses by their customers (represented by their unpaid invoices), and this is often combined with facilities against a wider range of assets such as plant, machinery and stock. ABFA membership is diverse and includes both financial services institutions and credit institutions. It is comprised of: the asset based finance businesses of the main UK and Irish banks, both the established banks and the new challenger banks; the specialist business finance practices of a number of international banks; the finance businesses of a number of large commercial organisations; and a range of smaller independent specialist companies. The industry has developed and largely defines itself on the basis of the principle by which finance is provided (that is, the assets within a business), rather than by the entity which provides it. The ABFA was a founder member of the EU Federation for the Factoring and Commercial Finance Industry. Colleagues from our fellow national associations around the EU will also be submitting their own responses to the Green Paper. Terminology For reference, under invoice finance arrangements, funding is provided by the purchase by the financier of the debts owed to the client. Thus invoice finance cannot be correctly referred to as lending (although if invoice finance is combined with funding advanced against other assets, a charge is normally taken against those assets and that aspect of the arrangement can be correctly described as lending ). The ABFA uses the term asset based finance as the collective description for invoice finance and asset based lending. A number of different terms are used to describe the financing provided by this industry across Europe and this can cause significant confusion. The terms receivables finance and sales finance are often used interchangeably to describe invoice finance. Factoring is often used as a collective description for the entire industry, but strictly factoring should only be used to refer to the specific type of invoice finance through which a financier would provide finance, manage their client s sales ledger and collect the debts themselves. The term trade finance is also sometimes used to describe a range of finance types that may include invoice finance and asset based lending. Asset based finance, as the ABFA defines it, is distinct from asset finance. In an asset finance arrangement, a loan would normally be secured on, and arranged for the purposes of obtaining, a particular asset. This would amortise over time. An asset based finance arrangement would normally be a revolving funding facility provided to an end-user client provided on the basis of the purchase of the unpaid debts owed to them, and sometimes secured on other assets within the business. In other words, this type of finance is based on the assets to support cashflow, rather than to fund the acquisition of an asset. We note that the Green Paper uses the term asset-backed financing in the context of securitization vehicles (page 8). In our view, this is qualitatively and quantitatively distinct from our industry in terms of practice, participants and purpose, and also in terms of its potential for creating systemic risks. So for purposes of clarity we use the term invoice finance for the remainder of this submission. 2

3 Shadow Banking Green Paper As noted above, the ABFA supports work to give governments and regulators the tools to better manage the systemic risks and address the activities that contributed to the global financial crisis. In this respect we would support the overall intentions behind the proposals set out in the Green Paper. The term shadow banking is, however, both extremely broad and emotive. It has come to be associated with a wide variety of entities and activities, some of which had nothing to do with the financial crisis or its aftermath. There are few, if any similarities, between the purposes, operations and systemic risks associated with, for instance, the operations of a factoring company which supports local businesses at one extreme, and a global money market fund at the other. Moreover we are concerned that a presumption of guilt has come to be associated with the term shadow banking and this can never be a starting point for the making of good policy. We welcome the importance placed in the Green Paper, and reiterated by Commissioner Barnier in his comments at the conference on 27 April 2012, of not damaging the alternative financing products that complement bank lending and are of direct benefit to the real economy. Moreover, the ABFA recognises that the Green Paper is an initial expression of policy intention and that it is likely that specific work will then be undertaken relating to different entities and activities. But the ABFA has significant and enduring concerns about the coherence of the term shadow banking and its subsequent use as the basis for policy-development. The Green Paper does not currently provide sufficient clarity. Detailed work is required to clearly identify: The systemic risks that are intended to be addressed; The activities that give rise to those risks and how they do so; and The types of organisations that are carrying out the identified activities. Defining Shadow Banking As the Commission recognises, it is very difficult to give a clear and coherent definition of what is and is not shadow banking. The FSB s definition of the shadow banking system as the system of credit intermediation that involves entities and activities outside the regular banking system provides a starting point. The Commission expands on this in the Green Paper, setting out possible shadow banking entities and activities to consider. Based on the entities set out on page 4 of the English language version of the Green Paper, it is assumed that organisations providing invoice finance services would probably be considered in the fourth category: Finance companies and securities entities providing credit or credit guarantees, or performing liquidity and/or maturity transformation without being regulated like a bank. However, as set out above, our members provide finance through a very specific mechanism and this category remains very loosely defined. We would also make the observation that some invoice finance companies belong to banking groups and all invoice finance companies would use the banks for refinancing and so the industry is not outside the regular banking system in this sense. Turning now to the questions set out in the Green Paper: 3

4 WHAT IS SHADOW BANKING? a) Do you agree with the proposed definition of shadow banking? The high-level definition of shadow banking used in the Green Paper is sensible enough. We note that it largely follows the FSB s definition as the system of credit intermediation that involves entities and activities outside the regular banking system. However, as set out above, for the purposes of mapping out potential regulatory approaches, the term is so broad as to be incoherent. In addition, the term is pejorative and this, combined with the wide variety of unrelated activities potentially caught within it, is not likely to lead to effective and proportionate regulation for any type of entity or activity. In a practical sense, the definition of the term is not helpful in identifying the risks that are of most concern, and the specific activities and entities that generate those risks. Put simply, we believe that the invoice finance industry might, prima facie, be considered to be part of the shadow banking sector, based on the current definition of that term. However, we also believe that our industry does not generate and/or contribute to any of the risks that this exercise is intended to identify and address. The use of such an imprecise concept will not provide a sound principle upon which to base any set of supervisory or regulatory interventions. On that basis, we must record our disagreement with the proposed definition for the purposes of policy development. All the responses offered to subsequent questions are done so on this basis i.e. agreement with the broad intentions behind the overall approach, but disagreement with the utility and relevance of the term shadow banking for policy development (particularly given its negative connotations), and with uncertainty as to whether it would cover invoice finance. We only offer responses from the perspective of, and on the issues relevant to, the invoice finance industry. b) Do you agree with the preliminary list of shadow banking entities and activities? Should more entities and/or activities be analysed? If so, which ones? We offer no comment about other entities and activities that should be analysed. WHAT ARE THE RISKS AND BENEFITS RELATED TO SHADOW BANKING? c) Do you agree that shadow banking can contribute positively to the financial system? Are there other beneficial aspects from these activities that should be retained and promoted in the future? Yes. The industry represented by the ABFA may be considered to be shadow banking under the current definition and it is clear that it contributes positively to the financial system and the economy. Moreover, it does this in a simple and transparent way. Specialisation and the close management of risk are two of the defining principles of the invoice finance industry and it continued to provide essential funding into the real economy throughout the financial crisis when funding from the real banking industry was restricted. Moreover, the UK government has recognised the increasing restrictions that are being placed on the mainstream banking sector and is doing a great deal of important work in encouraging and promoting non-bank sources of finance for SMEs in particular. 4

5 We are concerned by the presumption of guilt that has come to be associated with the term shadow banking and its potential implications for policy-making. Types of entity and activities should be assessed on their own merits. d) Do you agree with the description of channels through which shadow banking activities are creating new risks or transferring them to other parts of the financial system? The risks identified: (i) deposit-like funding structures leading to runs ; (ii) build-up of high, hidden leverage; (iii) circumvention of rules and regulatory arbitrage; and (iv) disorderly failures affecting the banking system, are all important to consider. They are not, however, relevant to the invoice finance industry. Invoice finance companies provide funding to an end-user client (normally an SME). Our members do not operate deposit-like funding structures in the normal course of their business (reference to (i) above). One of the general purposes of the banking system has to be to provide funding into the real economy. On this basis, invoice finance provides a mechanism by which socially and economically necessary risk is being transferred to where it can be better managed. No additional risks are being created. At its core, the invoice finance industry is about the effective management of risks on a day to day basis. There is no extensive transaction chain within which risk and leverage can build up unseen (reference (ii)). The basic risk transfer model for invoice finance is relatively simple: A bank would provide funding to an invoice financier, whether this is a subsidiary of the bank or an independent financier. The bank would account for this through its capital requirements and liquidity calculations and would actively manage its exposure; and An invoice financier would provide funding to clients in the real economy. The nature of the products provided are that it would actively manage this exposure to an extent that would, arguably, far exceed that seen in many real bank or shadow bank forms of business finance. Within the UK, our members compete on a largely level playing field regardless of the type of entity and the situation is comparable in the Republic of Ireland. The key differentiators are members costs of capital and their ability and appetites to manage risk. Unfortunately, there has been limited development of a pan-eu market for invoice finance and so regulatory arbitrage is not a significant consideration (reference (iii)). The industry delivers funding into the real economy and this demands a sophisticated understanding of local economic conditions. It is not a truly commoditised product and by its very nature it is unlikely that it will ever become one. The core mechanisms by which the finance is provided (specifically by the sale and purchase of the debts owed to a client, represented by its unpaid invoices) are normally deeply entrenched in national company and property law regimes. This, combined with the differing natures of the national economies across the EU, has meant that the industry in different EU member states has tended to develop in ways very particular to the respective legal contexts. Certain organisations are active in more than one EU market (the larger banks, in particular) but they are still largely treated as separate markets. By way of example, the regulation of invoice finance is stricter in France than in many other EU member states, for a variety of reasons. This has shaped the French market, and the entities that 5

6 operate in it, in specific ways. However that has not meant that financiers have been able to circumvent this regulation by moving their operations to other member states. Given the scale of the funds involved, the disorderly failure of a single invoice finance business is unlikely to have a significant effect on the banking system (reference (iv)). It is also important to emphasise that the exposure that an invoice finance company would have would be spread across its client base and would be actively managed. Even the exposures associated with a bank-owned invoice financier would be unlikely to significantly impact on the parent bank. We would also emphasise again that the transparency in the risk transfer chain associated with invoice finance, and the inherent attention to risk management, means that it would be clear to all involved where significant risk was building up. As far as conduct of business regulation is concerned, whilst a small number of ABFA members have failed in the past, it is extremely rare that any customer would lose money. Normally a funding bank or another member would step in to maintain the facilities, and the industry has shown stable growth over a number of years. e) Should other channels be considered through which shadow banking activities are creating new risks or transferring them to other parts of the financial system? We only comment insofar as the invoice finance industry is concerned. In that context we would not identify any additional channels. WHAT ARE THE CHALLENGES FOR SUPERVISORY AND REGULATORY AUTHORITIES? f) Do you agree with the need for stricter monitoring and regulation of shadow banking entities and activities? We only comment insofar as the invoice finance industry is concerned and we do not believe that stricter monitoring and regulation of this industry would do anything to address the issues and risks that contributed to the global financial crisis. As a more general point, it is self-evident that more effective and better focused regulatory and supervisory tools are required to better identify and manage the build of risk within the global and European financial system. However a broad-brush approach is unlikely to deliver these objectives and the risks associated with each type of entity and activity must be considered in their own right. Moreover, we would observe that better focused is not the same as stricter. g) Do you agree with the suggestions regarding identification and monitoring of the relevant entities and their activities? Do you think that the EU needs permanent processes for the collection and exchange of information on identification and supervisory practices between all EU supervisors, the Commission, the ECB and other central banks? It is not clear whether invoice finance would be considered to be a shadow banking activity and further clarity would be very welcome in this respect. We agree with the recommendation from the FSB that regulatory measures should be targeted, proportionate, forward-looking and adaptable, effective, and should be subject to assessment and review. It follows from this that identification and monitoring of relevant entities and their activities must be done on the basis of the systemic risks that they present. We do not believe that the suggestions set out in the Green Paper do this. An entity/activity specific approach will be required. 6

7 We do not have a view on whether the EU needs permanent processes for the collection and exchange of information on identification and supervisory practices, but we would reiterate the points made above about invoice finance services predominantly being provided on a national rather than EU-wide basis. h) Do you agree with the general principles for the supervision of shadow banking set out above? i) Do you agree with the general principles for regulatory responses set out above? We agree with the high-level principles recommended by the FSB that regulatory measures should be: targeted; proportionate; forward-looking; and adaptable, effective; and should be subject to assessment and review (page 7). We also agree with the Commission s consideration that an approach to supervising shadow banking should be: performed at the appropriate level; be proportionate; take into account existing supervisory capacity and expertise; and be integrated with the macro-prudential framework (page 6). We also welcome the Commission s consideration that a specific approach to each entity/activity should be adopted, striking a balance between indirect regulation, appropriate extension or revision of existing regulation, and new regulation, with consideration of the role of complementary nonregulatory measures (page 7). These principles must be carried through into subsequent work. j) What measures could be envisaged to ensure international consistency in the treatment of shadow banking and avoid global regulatory arbitrage? It is clear that an international approach to certain activities identified as shadow banking will be required. We would reiterate the point made above, however, that invoice finance by its very nature tends to be delivered within national markets. WHAT REGULATORY MEASURES APPLY TO SHADOW BANKING IN THE EU? Current regulatory treatment of invoice finance For background, the regulatory position of organisations providing invoice finance varies across the EU, with some jurisdictions subject to statutory regulation and others not. Provision of invoice finance itself is not subject to direct statutory regulation in the UK. Conduct of business regulation As noted above, in the UK invoice finance services are provided by both banks and other types of organisation and so the quantum of regulation on the conduct of business side varies across the membership. It varies according to the: nature of the parent organisation - the extent to which the principles associated with bank regulation are applied to the invoice finance business, for instance; and type of additional activities that the financier may provide - some members would be licensed under the consumer credit regime, for instance. Of course, all members are subject to regulation under the Anti-Money Laundering regime. 7

8 Indirect prudential regulation Quite rightly, the focus of the Green Paper is on prudential regulation and the systemic risks that institutions and activities may present. ABFA members do not, in the normal course of their business, accept deposits or otherwise hold financial assets for the account of others. Where the funding deployed by an invoice financier is ultimately provided from a bank (whether this be a bank providing funding to its invoice finance division, or to an external company) this is incorporated within the source banks capital requirements and liquidity calculations. Hence the funding provided by the industry is already subject to significant degree of indirect prudential regulation. This model has proved to be extremely robust, with the industry able to maintain fund levels throughout the financial crisis. In brief summary, the systemic risks associated with this industry are minimal and are already managed through the interaction of the industry with the conventional banking sector. k) What are your views on the current measures already taken at the EU level to deal with shadow banking issues? We do not have the expertise to comment in detail on the full range of measures taken by the EU to address shadow banking issues. However with regard to this industry, we note with very serious concern the suggestion of extending the provisions of CRD IV to non-deposit taking finance companies (pages 9 and 11 of the Green Paper). Providing that the methodologies used by the banks to assess the risks associated with funding invoice based finance are robust (and historically they are low-risk and very well-monitored products) it is not immediately clear what further benefits a doubling-up of regulation in this respect would provide. Indeed, it is likely to have a significantly negative impact on the availability of finance to SMEs, or potentially increase the costs of providing that finance. OUTSTANDING ISSUES l) Do you agree with the analysis of the issues currently covered by the five key areas where the Commission is further investigating options? We agree that the mapping of existing regulatory and supervisory regimes for the entities and activities identified as shadow banking will be an important exercise, providing that the high-level principles identified by the FSB and the Commission are adhered to. We reiterate our significant concern regarding the suggestion that the provisions of CRD IV might be extended to non-deposit taking finance companies. This is likely to have a significant negative impact on the availability of finance to SMEs in the EU. None. m) Are there additional issues that should be covered? If so, which ones? n) What modifications to the current EU regulatory framework, if any, would be necessary properly to address the risks and issues outlined above? We do not have a view on any modifications to the current EU regulatory framework that may be necessary. o) What other measures, such as increased monitoring or non-binding measures should be considered? 8

9 We welcome the recognition by the Commission that alternative and complementary non-regulatory measures should be considered (page 7). These would, of course, be specific to types of entities and activities. Clearly representative Associations will have an important part to play in these considerations and the ABFA looks forward to contributing to policy development in this area going forward. Please do not hesitate to contact us if the Commission requires further information on the issues raised in this response. Yours faithfully Kate Sharp Chief Executive Officer Cc. Martin Merlin, Head of Unit MARKT 02, Financial Services Policy and Relations with the Council 9