On 14 July 2020, the Financial Stability Board (FSB) Chair wrote to the G20 Finance Ministers and Central Bank Governors on the financial stability implications of COVID-19. 

While not for the first time, the FSB identified vulnerabilities in the non-bank financial intermediation (NBFI) sector relating to liquidity mismatches, leverage, interconnectedness and investor treatment of funds as cash equivalents, which the FSB considers have been further accentuated by the current crisis.  The resilience of the NBFI sector, which includes regulated investment funds such as UCITS and Central Bank regulated AIFs, needs ‘reinforcing’ as ‘while extraordinary central bank interventions calmed capital markets, such measures should not be required’.  

In its recent evaluation of the banking reforms implemented following the 2008-09 crisis, the FSB ‘found that banks are now more resilient and resolvable, and that the benefits of the reforms significantly outweigh the costs.’  Banking reform progress, and its reported success, appears to have led to a shift in the FSB’s focus away from this sector towards macroprudential reform of the NBFI sector.  Citing its support of the COVID-19 response, the FSB intends to carry out a ‘holistic post-mortem of the market turmoil in March’ and ‘consider the nature of vulnerabilities in NBFI in relation to liquidity stress and the implications of central bank liquidity support.  This work will inform the FBS workplan on NBFI for 2021 and beyond.’

Such sentiments were recently echoed in a speech by the Governor of the Central Bank entitled ‘Making the case for macroprudential tools for the market-based finance sector: Lessons from COVID-19’.  Highlighting sector vulnerabilities similar to those identified by the FSB, the Governor also noted the success of the post-financial crisis regulatory reform of the banking system and how such reforms could, and should, be expanded to the NBFI sector; ‘The question we need to address is: would a macroprudential framework for the sector be good for the sector as a whole as well as for the stability of the financial system and ultimately the real economy?  For me the answer is clear and we should get on and address the gaps in the current framework for so as to make it fully operational’

What are the gaps and how will they be filled?

On 29 July 2020, the FSB published its peer review report on Germany’s macroprudential policy framework and tools.  In its report, the FSB welcomed German authorities’ recent introduction of liquidity management tools (increased notice periods for retail products, redemption gates and swing pricing) and suggested consideration be given to adding further tools; specifically side pockets for open-ended funds which it notes ‘were used successfully during the global financial crisis’.  The FSB, however, notes the potential limitations of such ‘micro-prudential’ tools which, when applied at the discretion of the fund manager to solve situations affecting individual funds, may not support financial stability, particularly in stressed conditions.  The FSB notes that authorities’ management of the use of such tools could result in ‘broader benefits’: 

‘authorities should consider clarifying requirements or providing guidance to promote clear and timely decision-making processes for fund managers to implement these tools, particularly in stressed conditions.  The recently-increased monitoring by BaFin and the Bundesbank of liquidity risk in open-ended retail funds in light of COVID-19 developments highlights the importance of examining this market segment from both a micro-prudential and a macroprudential perspective.’

The Governor of the Central Bank expressed a similar view in his above-mentioned speech, noting that ‘there remains a question over whether the use of tools by individual funds themselves would be sufficient from a system-wide perspective in times of stress.’  While accepting there is ‘no established playbook to guide’ the use of macroprudential tools in the NBFI sector, the Governor cited several key priority areas of:

• developing and expanding the framework for imposition of ex-ante macroprudential leverage limits.  ‘This tool can be used to build resilience by limiting the excessive use of leverage by funds.  However, such leverage limits are practical in scope since they do not cover the entire funds sector and have not been operationalised.’;
• ensuring the timely use of liquidity management tools other than by individual funds themselves which may not be ‘sufficient from a system-wide perspective in times of stress’;
• striking a balance between time-varying and structural interventions;
• prioritising international co-ordination to avoid limiting the effectiveness of macroprudential policy interventions;
• accepting the costs to reap the benefits of additional resilience in the sector.

Regulators’ interest in the development of a more comprehensive macroprudential framework for funds is not new.  However, the current crisis would seem to have increased the commitment of both global and national regulators to progress its implementation.  We are monitoring the trajectory of this and fully anticipate updates to follow.

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If you have any queries on the issues discussed in this article, please contact the Asset Management & Investment Funds team or your usual William Fry contact.

Contributed by Nessa Joyce