Following the financial crisis, the European Commission undertook“the biggest reform of financial services ever seen in Europe”. In 2012, as part of this ongoing process Commission released a Green Paper on Shadow Banking to highlight the emergence of risks in the unregulated or less regulated financial system. These groups borrow and lend, just like banks do, but their operations remain in the shadow of traditional finance, and certainly, often beyond the reach of traditional regulations.

In the past few years, problems related to the shadow banking sector occurred in some of the world’s biggest economies. The 2008 financial crisis, as demonstrated by the Deloitte Shadow Banking index, which reached its peak in 2008 and plummeted in the same year, is argued to have been partly caused by the large proportion of unregulated borrowing and lending in the U.S. Some experts, for example, Frederic Hache from Finance Watch, claimed that Shadow Banking was at the heart of the 2007-2008 financial turmoil. Even in the more vibrant Chinese economy, the People’s Bank of China, the nation’s financial regulator, released warnings about the excessive and unsafe borrowing activities in the financial sector this summer,highlighting the danger of a financial crisis caused by expanding non-bank financial intermediaries.

Having the world’s second largest Shadow Banking System (SBS), with assets worth €17 trillion in 2011, the Eurozone has experienced some trouble. The Cypriot financial crisis has struck the nerves of the EU financial system. Though the high leverage ratio and a lack of restructuring initiatives were widely considered to be the culprits, it was the SBS that exacerbated the situation before the Cypriot financial system spiralled out of control. In other words, unregulated financial institutions associated with banks, boosted the proportion of loans on banks’ balance sheets, reducing the stabilityof the financial industry and thus accelerating the spread of the existingcrisis.

The EU has made tremendous efforts tointroduce better rules and further harmonise already exiting legislation applicable to the financial sector in EU member states. These include the adoption of the Capital Requirements Regulation and Directive, as well as the establishment of the European System of Financial Supervision (ESFS). The ESFS is made up of three supervisory authorities - the European Securities and Markets Authorities, the European Banking Authorities and the European Insurance and Occupational Pensions Authority, and also comprised of the European Systemic Risk Board and the Joint Committee of the European Supervisory Authorities and the national supervisory authorities. The creation of these supervisory bodies demonstrates the determination of policymakers to prevent the repetition of past mistakes.However, despite the hard work done by these bodies, risks still exist under their radar.

Now is the time to address the SBS. Post crisis regulatory overhaul has instigated the movement of certain activities to the murkier SBS for reasons of regulatory arbitrage. These intermediaries should not continue to operate beyond the remitof EU regulation. This is why we should warmly welcome the Commission’s recent Communication on Shadow Banking. This Communication contains a roadmap aimed at limiting the emergence of risks in the SBS, in particular “risks of a systemic nature”.

Specific measures mentioned in this Communication include requirements imposed on financial entities in their dealings with the SBS, improvements in the market framework with better risk transfer instruments, strengthened securitisation arrangements, as well as some additional initiatives to increase the transparency of the SBS. These initiatives should limit contagion and arbitrage risks. Though this blueprint has been described as, using Germany’s Finance Ministry’s words, “not going far enough”, we should acknowledge the good intentions behind the push for reform in this Communication. Specific proposals include the Money Market Fund Regulation that has just been proposed by the Commission and a proposal on securities lending which is unlikely to be addressed before the current parliamentary mandate comes to an end.

Recent history has shown that certainty in ensuring financial institutions are behaving responsibly should not be underestimated. The Commission's initiatives in this regard are positive. Indeed prevention is better than cure. The latter having proved to be far more complex and elusive than most financial experts pre-2007 had had imagined possible.