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Joggers run past the Bank of Canada building in Ottawa.CHRIS WATTIE/Reuters

First the banks faced a crackdown. Now shadow banking's under the spotlight.

Coming out of the financial crisis, regulators and central bankers devoted their attention to reforming the world's banks, piecing together new rules that altered how these crucial institutions operate. The crackdown spawned the likes of the Basel III Accord and the Dodd-Frank Act.

With the heavy lifting behind them, the watchdogs are now zeroing in on shadow banking. This sector encompasses a slew of different activities, that differ from country to country.

In China, non-bank lenders and pawn shops are all the rage, while in Canada shadow banking has centred on transactions that shift things off bank balance sheets, with mortgage securitization driving the bus, followed by repo transactions.

Despite the differences, the overall sector is teed up for an overhaul because its current structure has the potential to bring ruin to the global financial system. "Shadow banking should be made less susceptible to run-like behaviour and contagion," Timothy Lane, deputy governor of the Bank of Canada, said in a speech in late June.

The reason: while traditional banking has developed mechanisms to keep the system afloat in times of crisis – deposit insurance, for instance, gives individuals assurance that their money will be protected should a bank go belly up – such safeguards aren't as common in shadow banking.

Here in Canada, the watchdogs are following in the footsteps of the Financial Stability Board, which drafted some rough strategies that might remove some of the sector's risks.

The first of these: collateral quality. Watchdogs are worried by what is known as "wrong way risk."

Typically, collateral is put up as a guarantee when borrowing money, to offer the lender some security if the borrower defaults. However, during the financial crisis, the value of many forms of collateral plummeted. That means these values moved the wrong way: during times of crisis, collateral is supposed to be worth more because it's so safe.

To prevent this from happening again, there's a proposal to enforce minimum quality standards that will determine how much collateral is necessary between lenders and borrowers.

Securitization is also teed up for some reforms. Currently, critics argue that the banks can simply offload their mortgages to investors, leaving them with no skin in the game and little reason to be cautious about borrowers.

To change this, the banks may be required to maintain a certain minimum share of the securities they sell. Such a change would dramatically affect Canada because mortgage securitization is the most popular form of shadow banking here. And it's growing rapidly. The value of securitized mortgages soared to $386-billion at the end of 2012 from $160-billion in 2007.

Across the Pacific, the Chinese central bank recently opted for a different tactic to curtail the amount of cash sloshing through its shadow banking sector. Overnight, the People's Bank of China cut the amount of cash it gave to its banks, hoping to limit how much they could then lend out to shadow banking institutions.

However, the sudden policy reversal caught the market off guard and panic ensued, forcing the bank to scale back its efforts. (The Economist and Reuters break it down here and here.)

For now Canada's reform proposals are subject to changes, and the central bank will announce its recommendations at the G-20 meetings in St. Petersburg in September.

But the BoC's deputy governor wants to make one thing clear: "While the term 'shadow banking' tends to suggest something secretive or illicit … on the whole, shadow banking serves a useful purpose."

The goal then, is not to destroy the sector, but to make sure it's safe.

(Tim Kiladze is a Globe and Mail banking reporter.)

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