Regulators won't fully understand the complexity of shadow banks and should therefore opt for radical rule changes, Britain's Financial Services Authority (FSA) said on Wednesday.
Policymakers say the opaqueness of the $60 trillion (38.27 trillion pounds) shadow banking system - a web that includes money market funds, securities lending and repos -- which operates alongside mainstream lenders contributed to the financial crisis.
Leaders of the world's top 20 economies (G20) have called on their regulatory task force, the Financial Stability Board (FSB), to come up with draft rules by the end of this year.
The dangers of shadow banking were spotted over a decade ago but little was done.
This time we need to ensure that we are sufficiently radical, FSA Chairman Adair Turner said in a lecture at the Cass Business School.
Any system this complex will defy complete understanding, and any belief that we can precisely calibrate our response to it will therefore be a delusion, said Turner, who also sits on the FSB.
Instead, regulators should play safe with a bias to prudence against such complex interconnectivity in the financial system.
Responses could include higher capital levels in the banking system, ensuring that lenders hold bail-inable debt, and capital requirements such as minimum initial margins on individual contracts.
The task of regulating shadow banks is challenging, not least in defining what is shadow banking and exactly how it has contributed to financial instability in the past, he said.
Shadow banking is not something parallel to and separate from the core banking system, but deeply intertwined with it.
The FSB has defined shadow banking as involving credit intermediation outside the banking system and includes money market funds, conduits, securitisation lending and repos.
Its recommendations may include capital charges and curbs on a bank's exposure to shadow banks.
The European Union's executive European Commission will begin consulting on possible rules for shadow banks in the 27-country bloc next Monday.
Turner said shadow banking, on some measures, is a shadow of its former self following the collapse of securitised credit, shrinking money market funds, and smaller investment bank balance sheets.
And certainly the decline along these several dimensions suggest that the immediate risks are smaller, allowing us time to think through the appropriate policies, Turner said.
Instability from shadow banking was due to a combination of mark-to-market accounting -- the pricing of bank assets at the going rate each quarter, which can create volatility -- secured funding and multi-chain maturity transformation.
The Volcker rule to ban proprietary trading at U.S. banks, and planned extra capital around retail arms of UK banks will help shield lenders from shadow bank vulnerabilities.
But while these measures are all desirable, we should be wary of considering them sufficient. A shadow banking system could develop which would fully replicate banking system leverage... harmful to both the macro economy and to the resilience of the banking system, Turner said.