Monday May 11 2020
News Source: Fund Regulation
Focus: Liquidity Risk Management
Type: General
Country: European Union
The sharp fall in asset prices observed at the onset of the COVID-19 pandemic was accompanied by significant redemptions from certain investment funds and a significant deterioration in financial market liquidity. While market conditions have subsequently stabilised, largely due to decisive actions taken by central banks, supervisory authorities and governments in the Union and globally, significant uncertainty remains concerning the macrofinancial outlook.
Previous ESRB assessments of non-bank financial intermediation have highlighted potential vulnerabilities stemming from investment funds that have short redemption periods, but invest in less liquid assets. Such liquidity mismatches increase the risk of further pressures on asset valuations in times of stress, if investment funds seek to sell less liquid assets over a short period of time to meet redemptions. This could lead to higher mark-to-market losses by other financial institutions with exposures to the same or correlated assets, or to an abrupt tightening in financial conditions.
Existing Union rules include specific obligations on fund management companies with respect to liquidity risk management in relation to the funds that they manage. For undertakings for collective investment in transferable securities (UCITS), the liquidity profile of the investments of the UCITS must be appropriate to the redemption policy laid down in the fund rules or the instruments of incorporation or the prospectus. Similarly, for alternative investment funds (AIFs) the investment strategy, liquidity profile and the redemption policy must be consistent. These rules are complemented by European Securities and Markets Authority (ESMA) guidelines on liquidity stress testing in UCITS and AIFs for fund managers to regularly test the resilience of their funds to liquidity risk under normal and exceptional liquidity conditions.
The Recommendation published by the ESRB is designed to enhance preparedness to respond to potential future adverse shocks that could lead to a deterioration in financial market liquidity, resulting in potential adverse implications for financial stability conditions in the Union.
The ESRB recognises that the investment funds sector in the Union is large and diverse. Taking this into account, the ESRB has identified two segments as particularly high priority areas for enhanced scrutiny from a financial stability perspective.
The first of these segments is investment funds with significant exposures to corporate debt. Shortly following the onset of COVID-19 pandemic, there were significant redemptions from investment funds investing in corporate debt. In addition, investment funds hold a significant proportion of the stock of non-financial corporate bonds outstanding in the Union. Any future redemptions pressures from open-ended funds with short redemption periods could result in fund managers selling less-liquid assets quickly, thereby contributing to a deterioration in liquidity conditions in corporate debt markets. This could have adverse spillover effects on other financial institutions that have exposures to these assets – such as insurance companies, pension funds or banks – or an adverse impact on the cost and availability of market-based financing for non-financial corporations.
The second segment identified by the ESRB as a particularly high priority area for enhanced scrutiny from a financial stability perspective is investment funds with significant exposures to real estate. The public health restrictions necessary to contain the spread of COVID-19 could result in a reduction in the volume of real estate market transactions and an increase in valuation uncertainty. Real estate investment funds are estimated to hold approximately onethird of the Union’s commercial real estate market. Future redemptions from investment funds that have significant real estate holdings could contribute to downward pressure on real estate valuations if accompanied by real estate asset sales in an environment of low transaction volumes. This could have adverse implications for other financial institutions that have exposures to real estate, including those that use real estate as collateral for lending.
The ESRB has recommended that the European Securities and Markets Authority (ESMA):
- coordinate with the national competent authorities to undertake a focused piece of supervisory exercise with investment funds that have significant exposures to corporate debt and real estate assets to assess the preparedness of these two segments of the investment funds sector to potential future adverse shocks, including any potential resumption of significant redemptions and/or an increase in valuation uncertainty; and
- report to the ESRB on its analysis and on the conclusions reached regarding the preparedness of the relevant investment funds
Click on the above link for further information.