February Global Regulatory Brief: Risk, capital and financial stability
The European Systemic Risk Board (ESRB) has published a comprehensive report on liquidity risk that provides a detailed framework for monitoring systemic liquidity risks in the financial system, focusing on both funding liquidity and market liquidity.
In more detail: The report emphasizes the importance of understanding and measuring risks to systemic liquidity by paying attention to financial system entities beyond banks and key asset classes beyond sovereign bonds. It outlines the following key components:
Conceptual Considerations: The report defines systemic liquidity risk and its essential dimensions, including funding liquidity risk and market liquidity risk. It also discusses the interactions between these dimensions and the potential for contagion and amplification of liquidity stress.
Monitoring Framework: The framework identifies key entities and markets that should be systematically monitored for emerging liquidity risks. It presents indicators for funding liquidity risk, market liquidity risk, and contagion and amplification risks. The framework includes composite indicators that capture the main dimensions of systemic liquidity risks.
Country Applications: The report provides examples of how the framework can be applied to specific countries, such as the Netherlands and Finland. These applications highlight the importance of considering country-specific features and financial structures when assessing systemic liquidity risks.
Case Studies: The report includes case studies that illustrate the application of the framework to real-world scenarios, such as the COVID-19 pandemic and the liquidity stress faced by GBP funds following liability-driven investment strategies in September 2022.
Main lesson: The report underscores the need for a macroprudential approach to monitoring systemic liquidity, complementing ongoing micro-prudential initiatives to increase resilience at the level of individual entities, markets, and activities. It also highlights the importance of using a comprehensive set of indicators to capture the various dimensions of liquidity risk and the interactions between them.
Significance: The monitoring framework can be applied in all EU jurisdictions and enriched by adding further dimensions in the future. It can also inform the design of early warning indicators for systemic liquidity risk and the development of systemic liquidity stress tests.
APRA highlights the need for improved valuation and liquidity risk governance in superannuation
The Australian Prudential Regulation Authority (APRA) has released findings from its review of superannuation trustees' valuation governance and liquidity risk management practices.
Summary: Conducted in December 2023, the review covered 23 trustees managing 80% of APRA-regulated assets, totaling $2.7 trillion, with $500 billion in unlisted assets. While progress has been made since 2021, 12 trustees showed significant gaps in areas like board oversight, conflict management, revaluation processes, and liquidity planning.
In More Detail: APRA expects trustees to address deficiencies promptly and align with Prudential Standard SPS 530 Investment Governance (SPS 530), warning of further regulatory action if necessary. Key findings include:
SPS 530: A significant proportion of trustees still displayed material gaps in key areas, including the need for material improvements in either or both their valuation governance or liquidity risk management frameworks to meet the requirements of SPS 530.
Unlisted asset valuation governance: There was particular weakness across board oversight and conflict of interest management, revaluation frequency and triggers, valuation control, and fair value reporting.
Liquidity risk management: There was particular weakness in liquidity stress trigger frameworks, unlisted asset liquidity risks and liquidity action plans.
What this means for trustees: APRA has said that these findings are 'concerning and highlight the need to further lift practices across the industry'. APRA will engage directly with those trustees identified as having deficiencies and will expect them to formulate appropriate and timely remediation plans. APRA expects all trustees to review the findings, assess themselves against SPS 530, and, if needed, enhance their valuation governance and liquidity risk frameworks. APRA has noted that where necessary, it will take further action to enforce SPS 530 and related requirements.
FSB publish impact report on reforms to securitization markets
The Financial Stability Board (FSB) has published the final report on the impact of the G20 Financial Regulatory Reforms on Securitization, particularly the IOSCO minimum retention recommendations and the Basel revisions to prudential requirements.
In summary: The evaluation finds that these reforms, introduced in the aftermath of the 2008 global financial crisis, have contributed to the resilience of the securitization market without strong evidence of material negative side-effects on financing to the economy.
Complex structures that contributed to the GFC – including securitizations of subprime assets, collateralized debt obligations and re-securitizations – have declined significantly, while the securitization market is more transparent.
However, the market has not yet been tested through a full credit cycle to fully confirm the evidence on enhanced resilience, particularly in the case of collateralized loan obligations (CLOs) that have seen significant growth in recent years but have not yet experienced a prolonged downturn.
Non-bank growth: The reforms appear to have contributed to a redistribution of risk from banks to the non-bank financial intermediation (NBFI) sector, with banks shifting towards higher-rated tranches.
This redistribution of risk has been driven both by an increase in non-bank financing of the economy and by the growth of non-bank investors in securitizations.
Key regulatory issues: The report highlights key issues for national authorities and international bodies to consider:
The need to monitor risks in securitization markets in light of developments such as the growth of synthetic risk transfers and private credit in securitization structures;
The effectiveness of risk retention requirements for risk alignment in CLOs, given the fact that a large part of the global CLO market does not currently operate under such requirements and given the use of third-party risk financing for CLO structures; and
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