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Tight new rules may boost shadow banks, U.S. risk watchdog warns

A Wall Street sign is pictured outside the New York Stock Exchange in New York, October 28, 2013. REUTERS/Carlo Allegri (UNITED STATES - Tags: BUSINESS) - RTX14RP0

By Douwe Miedema

WASHINGTON (Reuters) - Tough new rules to make banks safer after the credit crisis are imperfect and could boost less-regulated activities in the so-called shadow banking system, a top U.S. government research group said on Tuesday.

The Federal Reserve's annual check of the financial health of the banking system, known as stress tests, for example, fell short on several counts, the Office of Financial Research said in its annual report to Congress.

In the tests, an increasingly crucial tool for the Fed to supervise banks, banks estimated losses across hundreds of variables. That means the outcome might not align with what the Fed wants to know, or not be comparable across the industry.

"Many new policy tools designed to make the financial system stronger and more transparent are still largely untested and may have unintended side effects," said the OFR, which is part of the Treasury Department.

The OFR was set up after the 2007-09 financial crisis to help regulators to gain better insight into the financial system, and the office has unparalleled access to data. It is also engaged in various projects to improve data quality.

The Fed's stress tests also largely ignored the risk that banks might not be able to access funding to run their business during a crisis, focusing instead on macroeconomic shocks such as faltering growth, the OFR added.

The OFR also highlighted the risk of reduced lending by banks as a host of global and U.S. measures force banks to raise the amount of equity capital as a percentage of their total balance sheet.

Loan growth by large banks had been slow in the past few years, the OFR said, possibly forcing potential borrowers into the arms of the shadow banking sector.

Shadow banking is a loosely defined group of firms performing bank-like activities that are not regulated as banks, such as hedge funds, money market funds, pension funds and large insurance firms.

One sign such a move is taking place came after bank regulators had tried to curb leveraged lending, a type of financing used by private equity firms to acquire highly indebted companies.

There was little indication such activity had declined, the OFR said, and one possible explanation was that the lending previously done by banks had been taken over by private funds like hedge funds or exchange-traded funds.

The OFR also said other areas of concern in the financial system include excessive risk-taking as investors sought to boost low yields, and the threat of market disruptions as more heavily regulated banks were less willing to take on risk to smooth out trading hiccups.

(Reporting by Douwe Miedema; Editing by Meredith Mazzilli)