Philip R Lane: A better understanding of the geography of risk will help
us assess the financial stability implications of market-based financing
Address by Mr Philip R Lane, Governor of the Central Bank of Ireland, at the International
Capital Market Association Conference, Dublin, 19 May 2016.
* * *
Introduction
I welcome the opportunity to speak at the 48th ICMA conference. A focus on capital markets
is timely, given the widespread consensus that Europe would be better served by a more
balanced financial system, in which financial markets play a larger role and provide
alternative channels to banks in a range of financial intermediation activities (European
Systemic Risk Board 2014). This basic message drives the agenda for Capital Markets
Union (CMU) in Europe, which is supported by the central banking community (Central Bank
of Ireland 2015, European Central Bank 2015). An enhanced role for market-based finance
has the potential to foster greater risk diversification, while also enhancing financial stability
by limiting the fallout from banking crises.
As a mechanism for individuals and institutions to obtain access to a diversified pool of
financial assets and a key investor base for corporates seeking to obtain market-based
funding, the investment funds sector plays an especially important role. In what follows, I
focus on the role of investment funds in the intermediation of international financial flows.
Of course, the investment funds sector is extremely diverse. Among the key differences in
the design and operation of funds are: equity versus debt; leveraged versus long-only; level
of liquidity; ease of redemption; actively-managed versus passive index-based; geographic
scope; maturity horizon (with money market funds focusing on the short end and
infrastructure funds orientated at the long end); use of derivative products for funding and
asset allocation; type of funding (retail; asset-backed securitisations); and ownership
structure (hedge funds, mutual funds, special purpose vehicles). The facilitation of
equitytype investments is critically important in view of the risks associated with an excessive
reliance on debt funding. At the same time, market-based debt funding provides an important
alternative to bank-based debt funding, with multiple funding channels a key element in the
design of a resilient financial system.
It is also important to recognise the inter-connections between market-based and
bankbased funding channels, with the banking sector itself dependent on financial markets to
raise equity and different grades of bond funding, while also relying on securitisations to
release tranches of performing and non-performing loans from its balance sheet. In addition,
a banking group may include various financial entities that play central roles in the operation
of securities markets.
Historically, the investment funds sector has been more lightly regulated than the banking
sector. A basic reason for the enhanced regulation faced by banks is the importance of
protecting retail depositors, in view of the deposit-based funding structure of banks and the
inherent maturity mismatch between short-term deposit liabilities and long-term illiquid assets
such as loans to corporates and households.
However, the scale of the non-bank financial sector and the scope for bank-like maturity and
liquidity mismatches between the liabilities and assets of some types of investment funds has
given rise to increased regulatory scrutiny in recent years.
Non-bank financing amounts to $80 trillion globally.1 Given the importance of non-banking
funding channels, the Financial Stability Board (FSB) has been working for a number of
years to understand this sector and frame policies to address the financial stability risks
related to non-bank funding. In addition, an annual monitoring exercise examines many
jurisdictions that host significant non-bank debt funding activity, including Ireland.2
Potential risks to financial stability from non-bank funding can arise in many forms. The risk
categories receiving the greatest attention in the international debate are: (i) the fragility
caused by leverage; (ii) a range of liquidity risks related to the possibility that redemptions
of more liquid or shorter-maturity liabilities may lead to defaults or forced assets sales that
dislocate secondary markets (see, amongst others, Haldane 2009, Caruana 2010,
International Monetary Fund 2015); and (iii) the inter-linkages with other sectors (banks,
insurance companies and pension funds, non-financial corporates), typically arising from
credit exposures.
It should be no surprise that these are key areas of focus. Indeed, during the global financial
crisis, we witnessed a perfect storm whereby these elements combined to amplify shocks to
the international financial system.
The international policy debate
The FSB has led the way in developing a policy framework that groups different market
finance activities according to their economic functions (Financial Stability Board 2012).
However discussions around the choice of regulatory tools to mitigate financial stability risks
have been challenging.
It is sometimes argued that the policy objective should be to ensure that all lending activity is
subject to similar regulations. Rather, the purpose of regulation should be to mitigate the
risks associated with these activities. In effect, regulation should be proportional to: (a) the
impact of failure; and (b) the probability that such a failure would crystallise. In principle,
regulation should be based on a solid understanding of the business models and an analysis
of the detailed data on the assets and liabilities of the financial vehicles supporting these
activities. For example, a closed-ended investment vehicle has a very different risk profile
compared to a retail bank. Equally, an open-ended investment vehicle holding highly rated
sovereign debt has a substantially different risk profile to a retail bank. A failure to meet
redemption requests may have damaging consequences for an asset manager but it is quite
unlike the type of default event that arises when a retail bank closes its doors to deposit
withdrawals.
Let me highlight one other difference between market-based and bank-based funding that
poses novel challenges to policy makers. Typically, bank loans are originated and held until
maturity on the balance sheet. In contrast, the assets of market-based financing vehicles are
1
As measured by the activities of the Other Financial Institutions (OFI) sector. The OFI sector is the national
accounts grouping of financial services providers that are not monetary financial institutions (MFIs) or
insurance corporations and pensions funds (ICPFs).
2
FSB (2015). This monitoring report focuses on so-called shadow banking, using a range of definitions. The
narrow measure of shadow banking is defined as the classification of non-bank financial entities into five
economic functions through which non-bank credit intermediation may pose bank-like systemic risks to the
financial system. The OFI measure of shadow banking is defined as all financial intermediaries that are not
classified as banks, insurance companies, pension funds, public financial institutions, central banks, or
financial auxiliaries. The broad measure of shadow banking is defined as the Monitoring Universe of
NonBank Financial Intermediation (MUNFI), which includes Other Financial Intermediaries, Pension Funds and
Insurance Companies. According to the narrow measure, shadow banking activity amounts to $36 trillion (26
jurisdictions), while the OFI measure aggregates to $80 trillion (20 jurisdictions and euro area) and the broad
measure to $137 trillion (20 jurisdictions and the euro area).
often tradable on secondary markets. The greater the liquidity of these assets, the less there
is a mismatch - in terms of liquidity - between the assets and liabilities of these vehicles.
When loans are recalled or redemption requests made, assets may need to be sold on these
secondary markets to meet these liabilities. So the question arises as to the liquidity of
secondary markets in times of stress. Clearly, the answer depends on the assets in question
and the performance of individual secondary markets under stress. For instance, there is a
world of difference between the liquidity of markets for highly-rated sovereign debt and
emerging market equities during periods of heightened financial stress. Equally, many of the
assets held by certain financial vehicle corporations and special purpose vehicles may not
benefit from active secondary markets.
It follows that the judgements about the liquidity of assets should determine the liquidity
management and redemption policies operated by these vehicles. Bearing this in mind, the
challenge for international policy makers is to develop a proportionate regulatory framework
that differentiates between investment vehicles based on the performance of the associated
secondary markets.
It is also important to take into account the potential for indirect contagion by which adverse
shocks can adversely affect a broad range of financial firms and markets through a variety of
externality-generating mechanisms such as fire sales, liquidity spirals and information
spillovers (Clerc et al 2016). The potential for indirect contagion may warrant a
macroprudential policy framework for non-bank funding activities that varies regulations for
liquidity, margins and haircuts over the financial cycle and provides a role for regulatory
authorities in disclosing aggregated information during stressed episodes.
Beyond the policy discussions, much supervisory work needs to be done by financial
authorities. There are national and international dimensions to this work. The cross-border
nature of these activities means that national supervisors will struggle to gain a full picture of
the risks without support from peers elsewhere. In Europe, the Alternative Investment Fund
Managers Directive (AIFMD) already empowers financial authorities to limit leverage
employed by alternative investment fund managers, although work is still ongoing to
determine how that power should be used and in what circumstances. And of course,
international bodies such as the FSB, IMF and ESRB rely on the input and insight from
national authorities so as to be able to piece the jigsaw of activities together. All of this
requires extensive dialogue, cooperation and data. The Central Bank of Ireland is active on
all these fronts and is pressing for greater supervisory convergence in the measurement of
risks associated with market-based financial intermediation.
The Irish non-bank financial sector
Figure 1 shows the sectoral composition of the Irish non-bank financial sector. In addition to
significant insurance and pension fund sectors, Ireland hosts entities (mainly investment
funds and securitisation vehicles) that support a large amount of non-bank financial
intermediation (Moloney and Murphy 2013).
Figure 2 shows that Irish-resident entities account for a sizeable proportion of funds activity
in the euro area, such that Ireland plays an important role as an international financial centre
for the investment funds industry.
From a domestic perspective, it is important to understand the linkages between the activities
of these sectors and the domestic economy and any potential risks to the domestic
jurisdiction. In fact, Figure 3 shows that Irish-resident collective investment vehicles: (i) have
a proportionately low exposure to Irish-resident assets; and (ii) are owned by relatively few
Irish-resident investors. Furthermore, these data overstate the ultimate exposure of Irish
residents, since these include Irish-resident entities that are owned by foreign investors. Put
another way, Irish-resident collective investment vehicles are largely invested in offshore
assets and are mostly owned by foreign investors.
Ireland's role in global financial intermediation means that traditional interpretations of
balance of payments flows are not too helpful and the patterns of ultimate ownership are
quite different to those suggested by the residence of investment vehicles. Put differently, the
geography of risk also matters. Contagion can travel across borders because of the
international nature of their assets and liabilities. Stress arising elsewhere can affect
Irishresident investment vehicles, and vice versa. It follows that the Central Bank of Ireland has a
role not only to understand linkages to the domestic economy but also to work with
international peers in the oversight and supervision of non-bank financial intermediaries.
In related manner, Figure 4 shows the currency composition of the money market funds
sector. This sector is dominated by sterling- and dollar-denominated funds, with only a minor
share for euro-denominated funds. This pattern further underlines the international,
crossborder nature of the Irish-resident funds sector.
Effective monitoring is a key pillar of good regulatory engagement (Moloney and Murphy
2013). The Central Bank of Ireland has led the way in collecting detailed data on collective
investment vehicles and continues to prioritise initiatives that make data collection more
efficient and effective (Godfrey et al 2015). This serves to inform international policy
discussions and, more importantly, to support various Central Bank teams for risk analysis
and supervisory purposes (Moloney and Murphy 2016).
Recent work includes extending the reporting requirements for financial vehicle corporates to
all Irish special purpose vehicles, providing a more detailed picture of the international links
based on the domicile of the consolidating entity (if any) and the country of the sponsoring
entity. Figures 5 and 6 show the geographical composition.
I should also mention the Central Bank of Ireland's work programme to develop methods to
analyse the risks of investment funds under stressed scenarios. The aim of this work is to
empirically inform supervisory and policy priorities by providing various measures of the
leverage, liquidity and interconnectedness risk factors discussed earlier. It will also set a
standard for some of the risk analyses that we expect from asset managers.
Conclusions
Vibrant capital markets are essential for a well-developed and stable financial system,
offering important benefits for both savers and firms and governments that seek
marketbased funding.
At the same time, risks to financial stability require appropriate management, including by
central banks. To this end, there needs to be a better understanding of the cross-border
nature of the assets and liabilities of non-banks to give us a better indication about how and
where shocks might be transmitted the system.
In this regard, understanding the financial network requires effective engagement of
regulatory authorities and this starts with good data collection. It is also the basis for better
policy discussion and supervisory co-ordination.
It is why exercises such as the annual FSB Shadow Banking Monitoring Exercises are
important. And why I support the further expansion by the FSB of the scope of coverage of
this exercise to include all notable centres of market and non-bank financial activity.
Ultimately, a better understanding of the geography of risk will help us to assess properly the
nature of the risks posed by market-based financing.
Continued progress needs to be made to forge closer cooperation among central banks and
financial regulators. Such enhanced cooperation needs to be underpinned by an improved
framework for collecting, managing and sharing data (Lane 2014). Ultimately, better data and
closer cooperation will support more coordinated and decisive supervisory action, especially
in times of market stress.
References
Caruana, Jaime (2010), Systemic risk: how to deal with it. Bank for International Settlements.
Central Bank of Ireland (2015) Response to European Commission consultation on the
Green Paper on Capital Markets Union.
Clerc, Laurent, Alberto Giovannini, Sam Langfield, Tuomas Peltonen, Richard Portes and
Martin Scheicher (2016), "Indirect Contagion: The Policy Problem," European Systemic Risk
Board Occasional Paper No. 9.
European Central Bank (2015) Building a Capital Markets Union - Eurosystem contribution
to the European Commission's Green Paper [online] available:
ecb.europa.eu/pub/pdf/other/150521_eurosystem_contribution_to_green_paper__building_a_cmuen.
European Systemic Risk Board (2014), "Is Europe Overbanked?," Advisory Scientific
Committee Report No. 4.
Financial Stability Board (2012) Strengthening Oversight and Regulation of Shadow Banking:
A Policy Framework for Strengthening Oversight and Regulation of Shadow Banking Entities.
Financial Stability Board (2015) Global Shadow Banking Monitoring Report 2015.
Godfrey Brian, Neil Killeen and Kitty Moloney (2015), "Data Gaps and Shadow Banking:
Profiling Special Purpose Vehicles' Activities in Ireland," Central Bank of Ireland Quarterly
Bulletin, Q3 (2015).
Haldane, Andrew (2009) Rethinking the Financial Network [speech], 28 April 2009,
Amsterdam.
Lane, Philip R. (2014), "Cross-Border Financial Linkages: Identifying and Measuring
Vulnerabilities," CEPR Policy Insight No. 77.
Moloney, Kitty and Gareth Murphy (2013), "The Spectrum of Regulatory Engagement," Law
and Financial Markets Review 7(3), 138-143.
G20 (2009) Declaration on Strengthening the Financial System, London Summit April 2009,
The Larosiere Group (2009) The High Level Group on Financial Supervision in the EU
Report.