July 2022: ESRB NBFI Monitor – EU Non-bank Financial Intermediation Risk Monitor 2022

By the European Systemic Risk Board (ESRB)

The NBFI Monitor 2022 discusses the main developments related to investment funds and so-called other financial institutions (OFIs) in 2021 and provides an initial overview of the developments triggered by the war in Ukraine. Total assets of EU investment funds and OFIs grew by approximately 9% in 2021. This reflected rising valuations across asset classes and inflows on the back of a faster-than-expected economic recovery, with EU GDP growing by 5.3% for the year. Having almost doubled over the past decade, debt financing provided by investment funds and OFIs accounted for 21% of the external debt funding of euro area non-financial corporates at the end of 2021. Russia’s invasion of Ukraine in early 2022 post-dates the review period of the report. However, reflecting the profound change in the macroeconomic outlook, this edition provides some initial considerations of the war’s impact on investment funds and OFIs.

The report considers structural and cyclical risks that investment funds and OFIs are exposed to. This year’s edition emphasises three of them (Figure 1). First, stretched asset valuations amid rising market interest rates increase the risk of a disorderly market correction which could lead to losses and increased investor outflows. When faced with substantial redemption requests, investment funds holding less liquid assets could suffer liquidity strains. Second, after a break during the acute stress observed in the first half of 2020, the rise in liquidity and credit risks resumed, with bond fund portfolio holdings further exposed to lower-rated and less liquid fixed income securities. Finally, vulnerabilities associated with excessive use of leverage, as well as interconnectedness within the monitoring universe and with other parts of the financial system, could possibly lead to contagion and magnify shocks to financial stability.

To support the identification of risk, the NBFI Monitor 2022 includes three special features. These special features report on exercises carried out to complement the main monitoring sections and provide a deep dive into specific risks and vulnerabilities of investment funds and OFIs.

  • Leverage. The first special feature investigates how Archegos – a US family office pursuing hedge fund strategies – used derivatives to obtain high levels of leverage. Using supervisory data from the European Market Infrastructure Regulation (EMIR), Archegos positions with EU counterparties are tracked to show that high leverage and high concentration risks were already visible in early 2021, a few weeks before the collapse of the firm. While the analysis shows how EMIR data could be used for risk monitoring, deficiencies in the data still need to be addressed. Further progress on data management, including the merging of different regulatory datasets is also required to allow for a more comprehensive risk assessment.
  • A disorderly bond market correction could lead to the materialisation of liquidity risk. The second special feature estimates the mark-to-market valuation impact of a sudden rise in market interest rates of 100 basis points, using a sample of the largest EU bond funds. An increase in interest rates would lead to mark-to-market losses on the bond portfolio of funds (around 4% of net asset value, NAV), although the impact on individual funds varies widely. For some funds, the impact is mitigated by the use of interest rate derivatives (IRDs) to hedge this risk, while for others, derivatives increase exposure to interest rate risks, thereby magnifying potential losses. Large losses could lead to increased redemptions and result in amplification effects, as asset fire sales could further exacerbate the initial shock to bond prices.
  • Interconnectedness. The third special feature examines the specific characteristics of alternative investment funds (AIFs) held by insurance companies. Insurance companies are among the most important investors in AIFs, and such linkages within the non-bank financial system could contribute to the propagation of risk. Risks related to liquidity mismatch and leverage are similar across AIFs, irrespective of whether insurance companies hold a large proportion of funds’ assets. While linkages with insurers do not increase the level of risk for AIFs, a more in-depth analysis – which is currently not possible due to data constraints –could shed more light on the financial stability implications of interconnectedness between the two sectors.

The monitoring universe of the report includes all investment funds and OFIs. Thus, banks, insurance companies, pension funds and central counterparties (CCPs) are not covered. As investment funds and OFIs participate in a range of financial markets, including derivatives, security financing and securitisation, entity-based monitoring is complemented by activity-based monitoring to provide a holistic assessment of financial stability risks

Link: EU Non-bank Financial Intermediation Risk Monitor 2022