By Douwe Miedema
LONDON (Reuters) - Beyond the reach of regulators, and about half the size of the world's banking industry, a thriving breed of "shadow banks" is emerging that could trigger the next chapter in the global financial crisis.
Spurred by this concern, the watchdogs are turning their attention to the fringes of the global financial system, where hedge funds and money market funds are filling the gaps left by retreating banks.
"In America, increased financial activity is taking place between non-banks which are subject to little or no regulation, and Europe is catching up fast," said Godfried De Vidts, director of European Affairs a ICAP, a brokerage firm that trades only with large professional clients, such as investment banks.
The effort is the latest attempt by regulators to make the financial system safer, four years after the start of the global banking crisis. This has already led to a rewriting of the rules that will change the face of banking for good.
Tough new rules on capital requirements for banks -- known as Basel III -- are forcing banks to increase their safety buffers, while the U.S. "Volcker rule" bans overly risky bets by banks on financial markets.
And opaque unlisted derivatives will have to be traded on exchanges in the future, rather than directly between banks in "over the counter" deals.
But despite these efforts, large swathes of the financial system remain outside the remit of the regulators, even though they provide essential funding to banks, and were at the heart of the global financial crisis.
This sector, known as "shadow banking" -- much to the chagrin of the people operating in it -- is huge. The size of the sector was some $60 trillion in 2010, making it as big as roughly half the global banking industry.
"Shadow banking is not really well named. It would be preferable to have a better description of what is a wide range of non-bank intermediaries. As it stands, it sounds a bit pejorative," said ICAP's De Vidts.
A run on its funds is as much a real risk for a shadow bank as it is for a normal bank, regulators say, and could have devastating consequences for the global financial system because the two sectors are so closely linked.
Paul McCulley, the former PIMCO portfolio manager credited with coining the expression "shadow banking," warned as early as 2009 that the system "drove one of the biggest lending booms in history, and collapsed into one of the most crushing financial crisis we've ever seen."
Governments stood behind their banks when the interbank lending market dried up at the onset of the crisis, bailing them out with billions of dollars to protect depositors. But shadow banks would have no such fall-back option.
Another risk identified by the Financial Stability Board (FSB)- the powerful body mandated by the G20 group of the world's richest economies to draw up new rules for shadow banking - is that they could be used to avoid financial regulation and attract risky activities that are banned elsewhere.
"What we're doing now is looking at the types of data that the FSB will be gathering. The scope is pretty broad but it's important to get the facts on table and consider what activities could pose a risk," said Rick Watson at the Association for Financial Markets in Europe (AFME), a group that lobbies on behalf of securities firms and investment banks.
The FSB has signaled a two-pronged approach to regulating shadow banking, with tough rules such as possible capital charges and limits on the size and nature of a mainstream bank's exposure to shadow banks.
Other shadow banking activities which are seen as less systemically risky could face greater transparency requirements.
Critics of this regulatory drive say that the definition the FSB uses to describe shadow banks is intentionally vague, allowing them to probe and potentially regulate corners of the financial universe that are seen as harmless.
"The politicians want a reason for the crisis and shadow banking seems to be the target," said Richard Comotto, an academic at the ICMA center at Reading University.
Much of the debate centers around collateral - securities such as bonds or shares that guarantee a loan much in the same way as a property in a mortgage - which has become scarce after the crisis, making it harder for banks to lend.
The unsecured interbank lending market has almost completely dried up because banks have stopped lending to each other, so banks need more collateral to continue lending to clients. Much of this originates in shadow banks.
Europe's banks for instance, are paying insurers and pension funds to take bonds that are hard to sell in exchange for better quality ones, in a desperate bid to secure much-needed cash from the European Central Bank (ECB).
And blue-chip companies like Johnson & Johnson, Pfizer and Peugeot are among firms providing cash to banks, in a reversal of the established roles of clients and lenders.
These deals between companies and banks take place in the so-called repo market, another large part of shadow banking, used to raise short-term funding against collateral.
Money market funds - which pool money from largely institutional investors to put it in low-risk financial assets and that resemble deposits in a bank - are particularly worried they may be subject to tighter rules.
"A money market fund is an investment product. It's not a bank and it's not bank-like," said Jonathan Curry who heads up HSBC Global Asset Management's $75 billion money market business.
"The investors in the fund, they are the ones who bear the risks of the underlying investments - not the provider and not the broader financial system."
The repo market, which in Europe alone is roughly 6 trillion euros in size, is another explicit target for the FSB, which has suggested these markets need the help of clearing and settlement houses to reduce risk.
People working in the repo industry say the instruments themselves are safe and regulators should instead focus on the way banks use them.
But many bankers are unwilling to take a public position, as the FSB has started working on the matter. Behind-the-screens discussions are already taking place with people in the industry.
That meant banks have little to gain from picking a battle over shadow banking, said Karen Peetz, vice chairman at Bank of New York Mellon, a large player in the repo market.
"We know they are examining it because it potentially creates a competitive divide for those that are heavily regulated and those that aren't," she told Reuters.
(Additional reporting by Sinead Cruise; Editing by Alexander Smith and Giles Elgood)