Fresh from putting the squeeze on banks to behave themselves, regulators are scrutinising so-called shadow banks, alternative lenders such as investment funds doing big business out of countries like Ireland.

The third-biggest shadow banking market in the euro zone behind Luxembourg and the Netherlands, Ireland has amassed €2.9 trillion of assets, according to data from the European Central Bank, by way of business-friendly laws and tax exemptions.

It’s also the euro zone’s largest centre for what are known as financial vehicle corporations, holding companies for assets that investors set aside with a view to reselling. These were used by banks during the crisis to offload creaky US subprime mortgages.

Debt crisis

Non-bank lenders are a growing source of credit in the wake of the debt crisis, when banks cut off lending to meet strict new rules on risk and interest rates plumbed record lows. While some funds now make loans directly to businesses, most buy loans and securities from banks and companies as a way of passing on credit to them. The ECB is not unhappy with the sector’s development and wants to develop more of this US-style market-based funding to reduce the zone’s reliance on banks.

But with shadow banking more than doubling to €23 trillion over the past decade and likely to outgrow the regular banking industry within five years at that pace, the ECB needs to make sure it isn’t hiding any risky practices that could destabilise the system.

As a result, Ireland has started to probe an area hitherto largely uncharted.

"We do have a team of economists that is looking at what I would call the regulatory perimeter – activity that is not quite in the regulatory spotlight but is in the penumbra," said Gareth Murphy, head of markets supervision at the Irish Central Bank and responsible for overseeing investment funds.

“We are a good way down the road in terms of understanding the challenges of mapping this area.”

Just defining the shadow banking industry is difficult. Nearly half – about 44 per cent – of what would be deemed shadow banks in the euro zone belong to institutions for which there is no detailed balance sheet data.

The ECB believes a large chunk are holding companies based in Luxembourg and the Netherlands that are unlikely to even be involved in lending.

In continuing efforts to better define the industry, European regulators are also hoping to better trace risk between trading partners. While they may be able to quantify an entity’s assets, the accompanying risk exposure can still be hard to assess because these lenders often filter that through derivatives. They also may have links outside the euro zone to groups for which no data is available.

New rules for reporting derivative trades came into effect in Europe last year. But many of the data fields were returned blank, a source said, meaning regulators still don't have enough information.

Another attempt at finding clarity is regulators’ demand since last year that European hedge fund managers report their exposures and risk profiles. While Ireland’s Central Bank tries to sketch the true profile of some 7,000 funds and financial vehicle corporations already here, the Government tries to attract more.

Over the years, Ireland has already adapted laws and taxes to make itself a location of choice for these types of lenders, which can load up on debt with minimal amounts of equity. Now it plans to unveil a strategy next week to raise the numbers employed in the international financial services sector by 10,000 over five years from 35,000 currently.

Brass plate

Simon Harris

, Minister of State at the Department of Finance, who will make the announcement, rebuffs any suggestion that the presence in Ireland of “brass plate”-style companies with no staff or offices, makes it a weak link in global financial stability.“The type of stuff that we are trying to attract into this country I don’t believe there are any kind of regulatory concerns with,” he said.

“We are talking about jobs with substance. We are talking about well-regulated products.”

Other Irish politicians say more needs to be done, and point to the fact Dublin-based off-balance-sheet vehicles were a key link between Europe and the US subprime crisis.

Tougher rules on lending have encouraged money to flow into the shadow banks.

"The suggestion is that our regulation is a lot tighter, and that is true for the banks but it is not true for the IFSC," said Pearse Doherty, finance spokesman for Sinn Féin. "We need a proper open debate about what kind of investment strategy we want." – (Reuters)