The Financial Stability Board of global regulators wants to make it harder and costlier for banks to do business with the $60 trillion shadow banking sector in a bid to curb risks.
Leaders of the Group of 20 (G20) top economies asked its regulatory task force last year to begin work on supervising the non-banking financial sector, which acts like banks in financing long-term credit.
The leaders were alarmed at the size and role the lightly regulated shadow banking sector -- which includes money market funds, securitisation and securities lending -- played during the financial crisis.
Some conduits and money market funds blew up during the financial crisis.
The FSB unveiled draft recommendations for closer supervision and regulation of shadow banks on Thursday.
The shadow banking system can also be a source of systemic risk both directly and through its interconnectedness with the regular banking system, the FSB said in a statement.
The recommendations will be finalised by the end of 2012.
The FSB will also update G20 leaders on the work at next month's summit in Cannes, France.
Although the sector can provide an alternative source of funding and liquidity, it also presented opaque risks that can quickly ripple through the financial system, it said.
It can also create opportunities for arbitrage that might undermine stricter bank regulation and lead to a build-up of additional leverage and risks in the overall financial system, the FSB said in a statement.
Short-term deposit-like funding of non-bank entities can lead to 'runs' in the market if confidence is lost, the FSB said.
Any shadow banking entities a bank sponsors should be included on its balance sheet so that it would have to account for them in its mandatory regulatory capital buffer, and leverage and liquidity ratios, the FSB said.
Limits on the size and nature of a bank's exposure to shadow banking entities should be enhanced, it added.
While work on the draft recommendations continue over the coming 12 months, the FSB has also mapped out a template that member supervisors will use to gather data on the shadow banking sector.
The shadow banking sector has grown from $27 trillion in 2002 to $60 trillion by 2010 and represents between 25 and 30 percent of the global financial system, FSB research showed.
The United States has the largest share with $24 trillion in 2010 or 46 percent, with sizeable markets in Britain, Japan, Germany, France and the Netherlands.
The FSB is pursuing a two-pronged approach to regulating the sector -- the banks that support it and the shadow-banking entities themselves.
Money market funds have rejected their inclusion in the FSB's definition of shadow banks, saying they are subject to rigorous constraints.
(Editing by David Holmes)