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Systemic risk: from global debate to local rules

Systemic risk: from global debate to local rules

Julie Patterson

Wealth & Asset Management, EMA FS Risk & Regulatory Insight Centre

KPMG in the UK


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The global systemic risk debate for investment managers and funds has swung to and fro in recent years, but has now moved to clear policy recommendations. Within Europe, at both EU and national level, regulators are adopting a more active supervisory approach and are considering new rules. Given the demands of implementing new EU regulation, not least MiFID II and the PRIIP KID, firms may understandably have taken their eye off the systemic risk ball. Now is the time to re-engage and think through the business impacts of increased supervisory scrutiny and new requirements.

The global state-of-play

The Financial Stability Board (FSB) and European Central Bank (ECB) have re-asserted their view that the activities of investment managers and funds can pose systemic risk, and that some entities are “too big to fail”. They recognise that open-ended funds have been generally resilient and have not created financial stability concerns in recent periods of stress, with the exception of some money market funds. Nevertheless, they cite imperfect liquidity transformation and leverage, which could amplify the effects of market shocks, as the main vulnerabilities of funds. Regulators remain concerned about bond market pricing and liquidity, and about the mismatch between the illiquidity of eg real estate and a fund’s unit redemption frequency.

The ECB acknowledges (PDF 2.04MB) that leverage in investment funds is generally well below that of banks and that, within Europe, the UCITS Directive and the AIFMD requirements go some way towards addressing systemic issues. In response to industry criticism of the focus on open-ended funds, the ECB says it will conduct further assessment of pension funds and sovereign wealth funds.

The FSB has issued 14 policy recommendations, with a focus on open-ended funds (liquidity management, leverage and securities lending), and has re-activated its work on the identification of globally systemically important financial institutions within the sector.

The nine recommendations on liquidity management cover liquidity profile data, risk management tools, greater consistency between the underlying assets and the frequency of unit redemptions, and disclosures to investors. Regulators are required to collect more information from fund managers and to review disclosures to investors. They are also required to make available to fund managers a range of liquidity management tools - such as swing pricing and redemption fees - and “where relevant” to consider system-wide stress testing.

For funds that use leverage, recommendations cover the collection of data and the need for convergence around simple and consistent leverage measures. To address the lack of a consistent measure of leverage in the industry, IOSCO is asked to develop risk-based measures.

ESMA takes up the baton

In Europe, many of these recommendations are already in place in EU or national requirements, although a few – such as industry-wide stress testing – are new. However, ESMA is subjecting the sector to tougher scrutiny, although its approach will take into account that the fund management industry is a “very different sector” to the banking industry, said ESMA’s Chair, Steven Maijoor.

More generally, Mr Maijoor has questioned whether national regulators sufficiently assess and address the risks that their supervised entities might be creating in other parts of the EU, and calls for greater convergence in national supervisory approaches. ESMA (PDF 152 KB) will develop a common procedure to impose leverage limits, and a connected approach to information gathering and sharing of experiences by supervisors in relation to liquidity management tools.

Some national regulators started to implement the thrust of the FSB’s recommendations ahead of their publication. France’s AMF, for example, has issued guidelines on best practice for the stress testing of funds. Also, although its study last year found no immediate concerns about the domestic exchange-traded funds market, it says their continued growth requires “heightened vigilance”.

The UK’s FCA has published a wide-ranging set of proposals (PDF 328 KB) to improve the way open-ended funds invested in illiquid assets cope with investor redemption demands during exceptional market conditions. And BaFin is discussing guidelines (PDF 515 KB) for liquidity risk management. Compared to some other Member States, the German toolbox for managing and mitigating liquidity risks of investment funds is small.

The debate is growing tentacles

A number of other issues are viewed as part of the systemic risk debate.

After years of heated debate, the MMF Regulation was agreed in principle in late 2016 by the legislators, but questions remain as to how some of the rules will operate in practice. There is also concern that smaller players may be forced out of the market, resulting in a more concentrated sector, which would run counter to the objectives of the Capital Markets Union (CMU) initiative.

IOSCO has pronounced (PDF 204 KB) that loan-originating funds are “shadow banking” instruments. It identifies the main risks at this stage as credit, liquidity, regulatory arbitrage (between banking and non-banking lenders) and systemic market. In contrast, a number of national regulators have introduced rules enabling the development of loan funds in their states and the Commission is considering whether anything is needed at EU level, under the CMU banner.

Security of fund assets remains on the agenda, with ESMA (PDF 544 KB) seeking a common approach to depositary functions for UCITS and AIFs, and consulting further on asset segregation.

What it means for firms

Firms around Europe will face ongoing scrutiny of their fund operations. They will need the systems and people resources to respond to regulators’ demands. Firms can use the implementation of MiFID II as the opportunity to improve their data capacity and to strengthen product processes and governance.

Key questions for firms:

  1. Are we on track to full compliance with the new MiFID II product governance requirements?
  2. Do we have the systems to collate, analyse and report on the use of derivatives and leverage across our fund ranges?
  3. Do we operate best practice in our liquidity management processes?
  4. In stressed market conditions, are we able to make use of the full range of liquidity management tools that our national regulator currently allows?
  5. Are we fully engaged with EU and national debates on new leverage and liquidity requirements?

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