Macroprudential policy for funds - Central Bank of Ireland consults

On 18 July 2023, the Central Bank of Ireland (the Central Bank) started a conversation with industry through the publication of DP 11, "An approach to macroprudential policy for investment funds" (the DP).

The consultation period is open to 15 November 2023.

Further information on the DP can be found in the Central Bank's blog and on its dedicated webpage.

Why has the Central Bank published the DP?

The DP reflects the Central Bank's concern that, as the funds sector has grown and become more integral to the wider functioning of several key markets, the collective actions of investment funds "have the potential to generate systemic risk" to the financial system.

As a result, the current regulatory framework for the funds sector must evolve if it is to reduce the propensity of certain fund cohorts to amplify shocks in times of stress.

It will be remembered, for example, that, in November 2022, the Central Bank both

• obtained the approval of ESMA under Article 25 of AIFMD to introduce a 60% leverage limit for Irish real estate funds - see our summary here and

• published its Macroprudential Policy Framework for Irish Property Funds, introducing new limits on leverage and Guidance to limit liquidity mismatch in property funds.

The Central Bank has concluded that a macroprudential perspective is needed for the future regulation of the funds sector and it points, in particular, to work done recently by IOSCO and the Financial Stability Board.

The DP, then, opens a discussion with stakeholders on

• how a comprehensive macroprudential perspective for regulating the funds sector could be achieved

• what the objectives of such a macroprudential framework would be

• key principles that might underpin its design and

• potential tools that could be used to achieve these macroprudential objectives

• the practical issues that would need to be progressed if such a framework is to be made operational. 

What does the DP say?

Looking at the different issues on which the DP is seeking feedback:

Systemic risks

The Central Bank's view is that "economic frictions exist in the intermediation of financing by the investment fund sector".

These frictions include

• co-ordination problems (when individuals act in a way that is 'individually-rational', but where the aggregate collective impact of such actions is sub-optimal)

• informational friction (when there is imperfect information among economic participants) and

• incentive frictions (which can arise where agents' incentives are not aligned fully with the principals they are acting for).

These can lead to excessive risk-taking, in aggregate, across the financial system.

Typically, though, it will be the actions of investment funds collectively, rather than individually, that can generate systemic risk (for example, in the wake of the UK Gilt market volatility in 2022).

The DP also identifies two main underlying potential sources of vulnerabilities for investment funds, liquidity mismatch and leverage. These can increase the fragility of investment funds and, in stressed market conditions, they can amplify and transmit a shock to other segments of the wider financial system.

The current regulatory framework

The primary concern of the regulatory framework as it stands is the protection of investors - requirements exist, for example, on disclosure, eligible assets, diversification requirements and differentiating between funds suitable for retail investors and those for professional investors.

The DP highlights the UCITS and AIFMD regimes in the EU, which contain, among other things, rules on liquidity mismatch and liquidity management tools.

However, while the tools available at present may be able to reduce certain types of risk at the fund level, the Central Bank's view is that they are insufficient to reduce the propensity of certain fund cohorts to amplify shocks. By way of example

• the rules have largely been designed to protect investors, not to reduce systemic risk

• the frameworks in respect of liquidity management and leverage allow significant scope for interpretation by asset managers, which limits how effective the rules can be from a system-wide perspective; and

• some existing features (such as fixed, minimum liquidity requirements for MMFs) of existing frameworks may not be optimal from a macroprudential perspective - if MMFs are required to maintain their regulatory liquidity requirements in times of stress, this means that those liquid assets are less able to be used to meet redemptions.

As well as the above tools, other EU legislation, such as MiFID/MiFIR and the Short Selling Regulation, provides national (and EU) authorities with the powers to intervene in the event of crystallisation of risks to financial stability. These tools, though, are primarily ex post in nature and are intended for use in very specific, narrow circumstances, which limits their effectiveness as macroprudential measures.

The objectives and principles of macroprudential policy

The aim of macroprudential policy for the funds sector would be focused on mitigating financial stability risks to ensure that the sector grows more resilient to stresses by preventing excessive vulnerabilities building up across relevant cohorts and is less likely to amplify adverse shocks, through its interconnectedness with other parts of the financial system.

The Central Bank, though, makes explicit that macroprudential policy would not aim to target asset prices or to replace the risk management practices of funds.

The DP sets out a number of key principles that could underpin and be core to the design of a macroprudential framework for funds. These include

• resilience-enhancing measures need to work on a collective or aggregate basis, aimed at the level of fund cohorts

• resilience should be built ex ante - before crisis conditions occur - and be targeted at the identified sources of systemic risk

• policy measures could either (a) seek to limit underlying vulnerabilities and/or (b) be targeted at the interconnectedness of the sector, thereby reducing the risk of contagion

• policies must have a degree of flexibility over time to take into account the evolving nature and magnitude of systemic risks

• policy intervention should follow a careful balance between costs and benefits for the broader economy and

• global co-ordination is critical in a macroprudential policy framework for the funds sector, with macroprudential measures guarding against possible shifting of risks to other parts of the financial system.

The design of macroprudential tools

Exploring the relative merits of potential tools and asking whether new tools may be required, the DP considers:

Liquidity management

Effective macroprudential liquidity measures would limit how far liquidity mismatch contributes to 'excess' asset sales in times of stress, as well as related disruption in core markets. This can be achieved primarily by either (a) reducing the underlying liquidity mismatch so any misalignment between the liquidity of the assets and the redemption frequency offered by the fund is narrowed or (b) increasing the liquidity of assets, for example, through liquid asset buffers.

Given the diversity of the sector, the DP notes that a 'one-size fits all' approach is unlikely to be effective and a mix of the above would most likely be needed.

It also suggests that further exploration of macroprudential policy options for liquidity mismatch to build resilience in fund cohorts on an ex ante basis may be warranted, perhaps in the form of an enhanced approach to existing tools. Alternatively, new, bespoke tools targeted at liquidity mismatch may need to be developed.

Leverage

Macroprudential measures targeting leverage would need to guard against unsustainable levels of leverage across segments of the funds sector and to ensure that funds are better equipped to withstand adverse shocks, rather than amplify them.

Leverage limits could address this risk but entail operational challenges that need to be overcome, in particular, in terms of (a) measuring leverage (especially, synthetic leverage) and (b) 'leakage', where funds could circumvent limits applied to cohorts of funds by establishing new entities which are not subject to the leverage limit at inception.

Interconnectedness

Tools covering the interconnectedness of funds would aim to limit material spillovers from fund cohorts to other parts of the financial system.

Existing tools, such as the concentration limits under Article 57 of MiFID II could be adapted to limit the spillover and contagion risks from the interconnectedness of funds. Concentration limits, though, could have drawbacks for the market in which they are applied, as restrictions could alter market dynamics and reduce market liquidity.

A different tool that might be used in this context is that of margining, though it is unclear whether they reduce counterparty credit risk at the cost of increasing liquidity risk.

The DP concludes that the use of interconnectedness-targeting tools (for which it accepts there is "limited existing evidence and empirical analysis" as to how effective they are) would depend on the specific nature of the risk posed by a given fund cohort.

Considerations for operationalising this framework

There are a number of important practical dimensions in developing a macroprudential policy framework foreseen by the Central Bank:

International co-ordination

The funds sector is inherently global and cross-border in nature, which may make implementation of macroprudential policy more difficult. To function effectively, a macroprudential framework would need to exhibit a high degree of consistency internationally, including a reciprocation framework.

Operationally, introducing specific macroprudential tools in one jurisdiction can lead to impacts in other jurisdictions, which could generate regulatory arbitrage. In turn, this could limit the effectiveness of any interventions.

Role of regulatory authorities

The Central Bank's view is that, underlying any framework, a key principle should be that regulatory authorities are not there to replace risk management by the funds sector. That said, there are circumstances which can justify some form of regulatory interventions with a macroprudential purpose. The nature of any intervention by public authorities, though, must be balanced against ensuring that the relevant fund manager still has ultimate responsibility for managing individual investment funds.

Data requirements

Regulatory authorities and policymakers need to have an internationally consistent data framework, which is clear on the key data needed for investment funds (including measuring their leverage, liquidity mismatch and interconnectedness). Having good quality data and processes for sharing that should be at the forefront of considerations but this will require international, as well as national and regional coordination.

A consistent data framework could also help understand who are the ultimate investors or counterparties in funds, rather than first counterparty investors - this can facilitate deeper assessments on cross-border interconnectedness.

What next?

The Central bank invites comments on the points raised in the DP until 15 September 2023.

Once it has considered feedback to the DP, the Central Bank will publish a feedback statement covering some or all of the topics raised by respondents, although no timeline is given for this.