Financial operators on the fringes of the traditional bank system could be made to hold more capital and mainstream banks forced to limit exposure to risk in the $60 trillion (38.07 trillion pound) shadow banking sector, a draft EU paper showed.
In the draft consultation document obtained by Reuters, the bloc's executive European Commission said shadow banking, including money market funds, exchange-traded funds, repurchase agreements and securities lending, could play a potentially useful role.
But the Commission said the financial crisis showed they pose major risks to financial stability if they fail in a disorderly way.
As long as such activities and entities remain subject to a lower level of regulation and supervision than the rest of the financial sector, reinforced banking regulation could drive a substantial part of banking activities beyond the boundaries of traditional banking and towards shadow banking, the paper said.
Brussels is keeping an eye on how far global initiatives progress in making the sector more transparent before committing itself to concrete action.
World leaders from the G20 countries have asked their regulatory task force, the Financial Stability Board (FSB), to come up with recommendations for regulating shadow banking, which involves credit, leverage and deposit-like funding on a large, lightly regulated scale.
The draft paper examines steps the EU has taken to regulate parts of the shadow banking sector as regulatory bodies have already begun to build up expertise in shadow banking.
However, it would appear that the EU will need to go further in establishing permanent structures for the collection and exchange of information on identification and supervisory practices between the Commission, the European Central Bank (ECB),other central banks and all EU supervisors, it said.
New powers for supervisors may be needed.
The Commission considers that a specific approach to each kind of activity must be adopted, the paper added.
Approaches would range from simple registration, ongoing supervision, indirect and direct regulation and extending macroprudential prudential supervision to the sector, such as by raising capital requirements to dampen frothy activities.
Ways to limit or discourage exposures to shadow banking entities are being examined.
Banks may need to include their shadow banking entities in calculating capital and liquidity buffers and leverage limits under the new global Basel III bank rules. EU banking rules, which determine how much capital lenders must hold, are currently limited to institutions that take deposits and provide credit but could be extended to shadow bank entities.
The Commission is also looking at whether wind-down mechanisms are needed for shadow bank entities.
The EU executive is due to publish its consultation paper as soon as next month and hold a public hearing in Brussels on April 27. It will then take into account the FSB's work before assessing its own next steps.
(Reporting by Huw Jones; Editing by Jodie Ginsberg)