Luis de Guindos: Coming to the forefront - the rising role of the
investment fund sector for financial stability in the euro area
Speech by Mr Luis de Guindos, Vice-President of the European Central Bank, at the Opening
Conference, 21st Euro Finance Week, Frankfurt am Main, 12 November 2018.
* * *
I am honoured to speak at this Opening Conference of the 21st Euro Finance Week.
People often think that central bankers - by profession and perhaps even by nature - are
predisposed to constantly warn about risks. We therefore need to avoid being perceived as
'crying wolf' too often. After all, persistently warning about threats that fail to materialise may be
just as counterproductive as being over optimistic. Striking this delicate balance is crucial for
central bankers - but also for markets. And looking at how markets currently price risks across a
number of asset classes and geographies, I am not so sure that they are achieving this balance.
I am raising these doubts in particular in light of the economic and political developments that we
are currently witnessing - globally as well as in Europe.
In my remarks today, I will briefly discuss what we see as the main financial stability risks for the
euro area, before zooming in on the situation in the investment fund sector. Over the past
decade, this sector has almost tripled in terms of total assets and has taken on more risk. So it
deserves greater attention from a financial stability perspective. I would also like to emphasise
today that regulation needs to adapt to the evolving financial system. In that vein, I will discuss
what remains to be done in developing macroprudential and other policy tools in response to
evolving risks in the investment fund sector.
Financial stability risks in the euro area
In the euro area, we have now seen 22 consecutive quarters of economic growth and declining
unemployment - a development which has also been bolstered by our accommodative monetary
policy and which has supported financial stability overall. Notably, banks' profitability has
improved somewhat, though it is still at low levels, and they now have higher capital and liquidity
ratios, making them more resilient than they were before the global financial crisis. Indeed, the
results of the recent EU-wide stress test show that the banking sector has a good level of
resilience overall, albeit with some pockets of vulnerability.
However, while the fundamentals for solid growth rates over the next two years are still in place,
some risks are building up in the financial system. We are currently paying particular attention to
three major developments that could trigger financial stability concerns globally and in the euro
area.
First, the current expansion of the US is now significantly longer than historical norms and the
second longest in US modern history. Looking ahead, a down-turn in the US macro-financial
cycle could trigger a reassessment of riskier asset classes.
Second, at the global level, tensions have grown in emerging market economies on the back of a
stronger US dollar and increased trade frictions. These developments may undermine global
growth prospects and ultimately lead to abrupt increases in risk premia. This could trigger a
domino effect - leading to a sharp sell-off and further price pressures in assets with stretched
valuations - with the potential to spill over to euro area financial markets.
Third, in Europe we observe re-emerging debt sustainability concerns, both in the public and
private sector. As regards public finances, Italy is the most prominent case at the moment in light
of the overall debt level and the political tensions around the Italian government's budget plans.
The strong market reactions to political events have triggered renewed concerns about the
sovereign-bank nexus in parts of Europe. Although contagion has been limited so far, it remains
a possibility. This underpins the call for fiscal discipline and for observing and applying fiscal
rules in Europe.
But in the non-financial private sector too, debt levels remain high by both historical and
international standards. In a number of countries, debt is above thresholds that are normally
associated with a debt overhang. And growing debt levels should also be seen in the context of
buoyant real estate market developments in a number of countries.
In light of the current global and domestic developments, a common concern is that we may see
a large and abrupt surge in risk premia, triggered or amplified by uncertainty about political
actions or a shift in risk perception. At the same time, we are worried about the possible
amplification of stress in financial markets through deleveraging and forced asset selling in a
situation where asset prices are falling.
Now that the banking sector is shrinking and becoming more resilient, our radar is shifting to the
non-bank financial sector, which is more lightly regulated. In particular, we need a better
understanding of the role of asset managers and of the broader vulnerabilities inherent to
investment funds. The asset management sector now plays a much larger role in financial
markets than it did ten years ago. It may harbour leverage and liquidity risks that could amplify
any potential shock from a reassessment of risks in financial markets.
I will now look in more detail at some longer-term developments and potential risks in the asset
management sector.
Risks associated with liquidity, leverage and interconnectedness in the investment fund
sector
One of the most notable developments since the financial crisis has been the rapid growth of
asset management in the euro area and at global level. In the euro area, investment funds have
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been growing steadily, with total assets expanding by roughly 170% between 2008 and 2017 ,
reflecting both continued net cash inflows and rising asset valuations. As a result, the structure of
the euro area financial sector is changing. In 2008, total assets held by investment funds were
only 15% of banking sector assets. In 2017, euro area investment fund assets had grown to 42%
of total banking sector assets, amounting to EUR 12 trillion. This major growth in relative size is
likely to have far-reaching implications for the ability of the financial system to absorb shocks and
for the financing of the economy more broadly.
On the positive side, an increase in market-based finance through the issuance of debt and
equity instruments can help diversify the funding base of the real economy. It also gives investors
more choice and enables them to benefit from diversification effects offered by investment
products. This holds true for retail and institutional investors alike, as an increasing share of
institutional investors are using professional asset management services. The growing share of
investors outside the core financial system tends to increase the system's risk-bearing capacity,
as traditional end-investors, typically not leveraged, can absorb any potential losses more
smoothly. One should also acknowledge that thanks to significant efforts in the last ten years,
investment funds in the EU are subject to an enhanced regulatory framework. In particular, the
fund specific regulation coupled with regulation covering certain activities, such as derivatives
and securities financing transactions, have addressed investor protection issues and risks from
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a microprudential perspective.
At the same time, the growing fund sector is creating emerging vulnerabilities from a
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systemwide perspective.
The asset management sector is highly connected with other parts of the financial system
through ownership links, common asset exposures and the provision of wholesale funding to
banks. Investment funds are not only important depositors in banks; they also provide
longerterm funding through the purchase of bank-issued debt securities. Euro area investment funds
hold about EUR 400 billion or approximately 10% in outstanding debt securities issued by euro
area banks. Banks, on the other hand, lend to funds mainly through repo transactions. So any
potential shock to the investment fund sector may quickly spill over to other parts of the financial
system.
When identifying possible weak spots in the financial system, it is sometimes useful to look back
to past crisis events. I recall some 20 years ago, when Long-Term Capital Management (LTCM),
a large and highly interconnected hedge fund, collapsed, in the wake of turbulence from the 1998
Russian crisis. The rapidly changing market environment effectively turned LTCM's business
model into a key amplifier. LTCM was betting on longer-term developments in fixed-income
markets using exceptionally high leverage. When the fund collapsed, fire-sale spillovers and
counterparty exposures threatened to erode the stability of the financial system.
To be clear, I am not predicting another LTCM crisis any time in the near future. But I would like
to use the case of LTCM to exemplify some key vulnerabilities which played a role in the collapse
- acknowledging that LTCM was not an open-ended fund and did not face redemption risk, as
most mutual funds do. In particular, let me focus on risks stemming from liquidity mismatches,
leverage and interconnectedness across the financial system.
The asset management industry keeps reminding us that vulnerabilities in funds cannot be
presumed to resemble those of banks. And it is true that investment funds do not issue deposits
and that potential losses in a fund are borne by end-investors. But there is a fundamental
difference between the equity in banks and the equity in funds. Investors in an open-end fund can
run by redeeming their units, whereas equity holders in a bank can only run by selling their
shares to other market participants. A run by investment fund unitholders can therefore resemble
a run by bank depositors. In both cases, the institution is, in principle, forced to sell assets in a
fires sale in order to meet its short-dated liabilities.
In general, asset managers are highly aware of their fund's liquidity position. In the interest of
investors, the fund managers have incentives to minimise any impact from their own actions on
financial markets, while at the same time accommodating share creations and redemptions. So
a bank-like run by unitholders in a fund may not be very likely.
But a system-wide shock with a broader impact on market liquidity conditions could quickly
change the situation. Liquidity at fund level may be squeezed if many investors wish to liquidate
their unit shares at the same time. The resulting first-mover advantages and selling pressure
could amplify stress in financial markets, especially if conditions are already fragile.
One reason why the Federal Reserve Bank of New York decided to facilitate the private-sector
bail-out of LTCM was precisely because it was concerned about market dislocations should the
company fail on some of its obligations. Letting LTCM go into disorderly fire-sale liquidation was
seen as risking a severe drying-up of market liquidity, which could have damaged financial
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markets and the wider U.S. economy.
Considering the current global and domestic uncertainties affecting financial market
developments, I am seriously concerned about declining market liquidity and the role that
investment funds might play in a possible stress scenario.
Liquidity mismatches and leverage are structural in nature and often build up slowly over time. In
the euro area, we observe that investment funds have been taking on higher credit and duration
risk in the current market environment. And we have strong indications that liquidity risks are
building up in the fund sector. The share of less-liquid assets in that sector has been growing
constantly since the global crisis, while liquidity and cash buffers have been declining.
From our market contacts we also hear that investors are increasingly using exchange-traded
fund (ETF) shares to gain exposure to less-liquid markets. ETFs have been growing extremely
fast thanks to their comparably low cost and high liquidity. ETFs are traded at higher frequencies
and are sometimes more liquid than the underlying instruments. But can we be sure that liquidity
in ETFs, in particular in bond ETFs, would remain stable if a sudden repricing in the markets
occurred? This is a concern in particular for bond ETFs - a small but rapidly expanding market -
which has not yet been tested in a larger distress event. Alongside liquidity risks, the ETF sector
is also subject to counterparty risks because of connections to banks through ownership links
and derivatives. Again, the fast-growing ETF segment deserves further attention from a risk and
policy perspective.
It goes without saying that leverage plays a critical role in any potential stress scenario as it
forces companies to deleverage, generating potential spillovers to asset markets. Our analysis
also shows that leverage increases the procyclical behaviour of investors and asset managers,
even if they are not excessively leveraged.
In any case, it is quite comforting that leverage in the European investment fund sector seems to
be low, on average. Average leverage multipliers reach only up to 1.3 across different fund types.
This is partly because about 60% of all investment funds fall under the Undertakings for
Collective Investment in Transferable Securities (UCITS) Directive and so face tight leverage
constraints.
On the other hand, many alternative investment funds do not face any binding restrictions on
leverage. Among those alternative funds, we find a tail of highly leveraged bond and hedge funds,
which sometimes have a leverage multiplier of more than 30.
I urge authorities to use the new data which is available to shed more light on this highly
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leveraged part of the sector. This may help to better understand some of the lightly regulated
and less transparent activities where risks may be building up. For instance, private loan funds
may potentially erode credit standards and take on higher credit risk in the current market
environment, whereas private equity funds may facilitate excessive leverage in the non-financial
sector.
Some of these activities may be escaping our attention, as statistics on them are scarce and
they are often conducted by funds outside the euro area. Leverage may be building up, for
instance, by the use of derivatives or in off-shore centres. Therefore, consistent reporting
frameworks have to be developed with a view to gaining a system-wide perspective on evolving
risks, also at global level. It will be important to develop comparable leverage measures in line
with the recommendations of the Financial Stability Board (FSB) to the International Organization
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of Securities Commissions (IOSCO). This will facilitate consistent monitoring and assessment
of the build-up of risks in the investment fund sector.
As the global crisis has shown, we cannot afford to be complacent and must remain vigilant to
possible new risks that might emerge in the financial system. So we need to better understand
the macroprudential dimension of risk in the investment fund sector. And we need to further
enhance the sector's resilience to system-wide shocks.
Possible macroprudential and other policy responses - what needs to be done?
Let me now set out a few regulatory actions which could contribute to mitigating risks arising
from interconnectedness, liquidity and leverage in the investment fund sector.
Let me start with interconnectedness and the links to banks in particular. The global financial
crisis showed that banks sometimes have incentives to step in to support unconsolidated entities
such as special purpose vehicles or investment funds with which they have a business
relationship. Explicit contractual obligations are already captured by a number of post-crisis
reforms, in particular by revisions to the securitisation framework and by enhancements to
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consolidation rules for off-balance sheet entities. But the risk that a bank provides financial
support to an unconsolidated entity that is facing stress, over and above any contractual
obligations has not yet been addressed. Such risks may be particularly relevant in the context of
close ownership links between banks and funds. For example, banks in certain circumstances
may feel a need to step in to protect their brand. To tackle this issue, the Basel Committee on
Banking Supervision (BCBS) has published guidelines on step-in risk that would require banks to
self-assess and report their material step-in risk exposures to supervisors, who should have the
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possibility for supervisory action if deemed necessary.
We also need to work on the different layers of interconnectedness between ETFs and their
counterparties. In our view, the rapid growth of ETFs, coupled with their potential to transmit and
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amplify risks to financial stability, warrants further evaluation of regulatory action. This may
include enhanced rules to limit counterparty risk exposure of ETF investors, and measures that
provide more transparency around ETF liquidity provision.
The enhanced microprudential framework for the European fund sector is a key element in
boosting the resilience of the financial system overall. But the sector's rising role in shaping the
financial cycle, and the potentially systemic nature of its risks, require a more ambitious
approach. We should aim at extending the macroprudential framework beyond banks to
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encompass the asset management sector.
In particular, we need to equip macroprudential authorities with the necessary tools to address
systemic risks both ex ante and ex post. The recent ESRB recommendation to address
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systemic risks related to liquidity mismatches and leverage in investment funds is a crucial
step towards this goal. Most importantly, from a macroprudential perspective, the proposed
measures would help national authorities in setting binding leverage limits for alternative
investment funds to mitigate systemic risk. The recommendations foresee also a role of the
authorities in suspending redemptions in a stress scenario.
Going beyond the ESRB recommendation, I would argue in favour of complementing the powers
that are currently envisaged for authorities with ex ante tools targeting liquidity risks at system
level. Existing liquidity management tools may mitigate liquidity risk ex post, but they might not
suffice to prevent the build-up of vulnerabilities in exuberant times ex ante.
The toolkit available to macroprudential authorities should therefore include additional ex ante
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requirements such as minimum liquidity buffers and redemption notice periods. Mandatory
liquidity buffers require funds to hold sufficient high-quality liquid assets for the fund to be able to
meet redemptions and margin calls under many foreseeable scenarios. The introduction of
minimum notice periods would help align a fund's liability structure with the liquidity- and
riskprofile on the asset side. Overall, such tools could be used to raise the sector's resilience to
potential investor runs or spikes in margin calls. Setting these requirements would greatly limit
the sector's ability to build-up liquidity risk in exuberant times.
Finally, given the cross-border nature of the investment fund sector, we need to strengthen the
European perspective in the supervision of investment funds while also ensuring a globally
consistent approach to monitoring. Arguably, the investment fund industry in the EU is highly
concentrated in a few jurisdictions, but - due to the diverse asset holdings and investor locations
- the impact of adverse developments in this sector may be felt across the EU. Hence, I call for
further investigation of the case for bringing investment fund supervision and the potential
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activation of macroprudential tools to the European level.
In a related debate, the FSB announced recently that it will no longer use the term "shadow
banking" in its future communications to avoid the pejorative connotations. Hedge funds and
other asset managers will instead fall under a broader group of non-bank financial intermediaries.
We very much welcome the change in terminology, as it supports a closer focus on emerging
vulnerabilities in the asset management sector, regardless of whether these are considered to
be bank-like or not.
Concluding remarks
We have come a long way since the financial crisis. We have implemented a range of regulatory
reforms that have addressed many issues that the crisis brought to light both in the bank and
non-bank financial sectors. Nevertheless, the ever evolving nature of our financial system and the
undisputable argument that the next crisis will be different require us to remain vigilant.
The tectonic shifts in the structure of the financial system brought about with the rise of asset
management call strongly for further policy work in this area. We need to better understand what
these shifts in the financial system imply for financial stability and the financing of the real
economy. On the positive side, an increase in market-based finance can help to diversify the
funding base of the real economy and investors are increasingly benefitting from diversification
effects. However, as the risks arising from leverage and liquidity mismatches in investment funds
are potentially systemic, we need to take a more ambitious policy approach to systemic risk.
Extending the macroprudential framework to the asset management sector and developing
policy tools to address emerging risks will be an important step in preparing for possible future
stress scenarios.
1
Figures exclude money market funds (MMFs).
2
These include the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive, the
Alternative Investment Fund Managers Directive (AIFMD), the European Market Infrastructure Regulation (EMIR)
and the Securities Financing Transactions Regulation (SFTR).
3
E.g. see International Monetary Fund, Global Financial Stability Report, Chapter 3: "The Asset Management
Industry and Financial Stability", April, 2015.
4
See Testimony of Chairman Alan Greenspan on private-sector refinancing of LTCM before the Committee on
Banking and Financial Services, U.S. House of Representatives, October 1, 1998.
5
E.g. new data is reported under the Alternative Investment Fund Managers Directive (AIFMD).
6
See FSB "Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities", 12
January 2017.
7
See Basel Committee on Banking Supervision, Guidelines on the identification and management of step-in risk,
October 2017 and Financial Stability Board, Assessment of shadow banking activities: risks and the adequacy
of post-crisis policy tools to address financial stability concerns, July 2017.
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Ibid.
9
See ECB Financial Stability Review Special Feature C, Counterparty and liquidity risks in exchange-traded
funds, forthcoming November 2018.
10
See European Systemic Risk Board, "Macroprudential policy beyond banking: an ESRB strategy paper", July
2016.
11
See Recommendation of the European Systemic Risk Board of 7 December 2017 on liquidity and leverage
risks in investment funds (ESRB/2017/6) published 14. February 2018.
12
See ECB Macroprudential Bulletin, "Macroprudential liquidity tools for investment funds - A preliminary
discussion". The article states that redemption duration restrictions could be differentiated based on the fund
type, or a limited number of fund "profiles" that represent a combination of key fund characteristics, including the
asset and liability side of the fund.
See also ECB contribution to the European Commission's consultation on Capital Markets Union mid-term
review 2017.