December Global Regulatory Brief: Risk, capital and financial stability

The Global Regulatory Brief provides monthly insights on the latest risk and regulatory developments. This brief was written by Bloomberg’s Regulatory Affairs Specialists.

Risk, capital and financial stability regulatory developments

Recent periods of financial stress and the proliferation of risks across the financial system are fueling the development of regulatory initiatives to strengthen requirements and promote international best practice. From private market bank exposures in Europe to financial stability in Abu Dhabi, the following regulatory developments in risk, capital and financial stability from the past month stand out: 

• Europe: ECB publishes review of complex exposures to private markets
• Abu Dhabi: FSRA enhances financial stability regulatory framework
• Europe: ESMA responds to Commission regarding non-bank financial intermediation
• UK: Pensions regulator shifts to more prudential-style approach
• France: AMF provides update on French fund sector use of liquidity management tools
• US: Prudential regulators set to wait until new administration before taking additional action on Basel III endgame proposal

ECB publishes review of complex exposures to private markets

The European Central Bank (ECB) has published findings from its review of bank exposures to private equity and private credit funds. 

Size and composition of bank exposures: The results of the survey show that the overall exposure to private equity and private credit funds is significant, with credit risk being the main risk. 

• The review found very heterogenous exposures across banks: several global systemically important universal banks (G-SIBs) have very broad product offerings to both private equity and private credit funds, while other banks choose either to focus on private equity funds only or to provide a more limited product offering. 
• While banks subject to European banking supervision generally appear to be less involved in the private equity and private credit segment than some of their larger US peers, a number of banks do have high exposures, and the contribution this segment makes to their profits is considerable. In addition, this market segment also leads to ancillary income, for example through advisory work and IPOs.
• The bulk of banks’ exposures are to the private equity domain, with key concentrations in portfolio company financing and investor financing. Conversely, private credit exposures seem more limited and largely focused on fund-level financing with a limited pocket of investor financing and no reported portfolio company exposures. 
• Lastly, counterparty credit risk (CCR) exposures from derivatives appear limited and mainly stem from funds and portfolio companies hedging their risks. Banks carry out this business as an ancillary service to their financing activities. The CCR exposures are quite concentrated in a few banks, mostly the larger G-SIBs.

Systematic identification: An important takeaway from the survey is that banks are not able to systematically identify transactions where they are co-lenders to portfolio companies alongside private credit funds. 

• Banks are better able to identify transactions where the borrower is owned by a private equity fund, although recent supervisory investigations also revealed weaknesses in bank processes in this area. 
• The failure to properly identify – on an aggregate level – exposures to companies that also borrow from private credit funds means that this exposure is almost certainly understated and the concentration risk cannot be properly identified and managed.

Observations on risk management approaches: The exploratory review found that the management of risks associated with bank exposures to private equity and private credit funds is largely fragmented. 

• Banks typically manage such risks either at product type level or at client type level but this approach fails to holistically capture the risks generated by these exposures. 
• Looking at risks at the level of the individual product or client type is not sufficient to provide a good understanding and management of the risks as banks need to be able to aggregate exposures across obligor type and instrument type. 
• The review also found different levels of sophistication in banks’ risk appetite frameworks for these exposures. Moreover, banks appear overly reliant on valuations provided by the fund, and this reliance appears to be only partly mitigated by independent reviews and structural transaction features. 
• Lastly, data on these types of exposure are scarce and scattered, and the structure of private equity and private credit markets is often opaque.

Supervisory actions going forward: The ECB’s exploratory review has shown that banks’ exposures to private equity and private credit funds are significant and that risk management approaches appear not to have caught up with the developments in this market segment. 

• Given that the exposures involve complex, multi-layered risks, with leverage entering at several levels, sophisticated approaches are key to effectively managing these risks. 
• The ECB will therefore continue monitoring bank exposures closely and will outline a set of supervisory expectations for the risk management of exposures to private equity and private credit funds. 
• Banks will be asked to submit information on their risk management approach as well as a gap assessment against the ECB’s expectations. 
• The ECB will then follow up with banks on an individual basis to ensure that the supervisory expectations are met.

Abu Dhabi announces enhancements to financial stability regulatory framework

The Financial Services Regulatory Authority (FSRA) – the body which regulates financial services within the Abu Dhabi Global Market (ADGM) – published a consultation on proposed enhancements to its regulatory framework for financial stability. The proposals seek to improve the FSRA’s alignment with the international best practices enshrined in the Basel Committee’s Core Principles for effective banking supervision. 

Key changes: The key areas of enhancements to the regulatory framework pertain to:

• Corporate governance expectations
• Requirements around notifications to the FSRA
• Related party transactions
• Provisioning for credit exposures
• Stress testing expectations
• Designation of domestic systemically important banks
• Expectations around management of country risk and transfer risk

Looking ahead: The consultation is open until 28 November 2024 and is relevant to all firms operating in the ADGM.

UK pensions regulator shifts to more prudential-style as pension schemes becoming systemically important

The UK Pensions Regulator (TPR) has noted that the rapid acceleration in the scale of workplace pension schemes means savers must be protected from systemic risk by a more prudential-style of regulation. 

Important context: TPR’s modelling shows that in a decade’s time the master trust market will contain schemes of systemically important size. 

• There will be seven schemes with more than £50 billion assets under management on a consolidated basis, four of which will be responsible for well over £100 billion each. 
• The Mansion House reforms announced by Chancellor Rachel Reeves are expected to drive growth and scale in the market. 

Role of the TPR: As the UK pension market evolves, the TPR’s new style of regulation will address risks not just at an individual scheme level but also in relation to the wide financial ecosystem. Specifically the TPR will focus its attention on three areas: scheme investments, data quality, and trusteeship. The TPR will also deploy a new regulatory toolkit which will include:

• A new approach to master trust supervision with tiers of engagement depending on the risks schemes present to the market and saver outcomes.
• Investing in digital, data and technology and embracing new ways of working across the organization to build a robust evidence base for regulatory action as well as driving efficiency and automation.
• Growing a team of innovation professionals and putting in place a ‘pensions market innovation hub’ to review ideas at an early stage and to provide guidance to enable safe new product development.

ESMA responds to EU on the review of the policy framework for non-bank financial intermediation

The European Securities and Markets Authority (ESMA) published its response to the European Commission (EC) consultation on assessing the adequacy of macroprudential policies for non-bank financial intermediation (NBFI).

Context: The EC has marked NBFI as a key priority for its new term and has solicited views on the adequacy of the current framework. 

Key ESMA proposals: ESMA makes key proposals across a number of areas

• Liquidity management: ESMA recognizes the progress already made regarding provisions on liquidity management tools within the context of the AIFMD and UCITS review but still considers that there is a need to address remaining issues concerning liquidity mismatches in open-ended funds (OEFs). Competent authorities could require funds that invest in illiquid assets to be structured as closed-ended funds and ESMA fully supports the FSB recommendations relating to the classification of OEFs based on asset liquidity. 
• Money market fund (MMF) regulation review: ESMA reiterates its position on the necessity to complete the reform of the MMF Regulation, considering the vulnerabilities identified in its Opinion.
• Supervision and data: ESMA proposes to progress towards data driven supervision by harmonizing the framework to analyze risks posed by investment funds (especially regarding liquidity risks) and by developing an EU system-wide stress test across NBFI and the banking sector. 
• Coordination: ESMA suggests enhancing coordination between competent authorities by the creation of a formal reciprocation mechanism for leverage limits under the AIFMD. 

AMF provides update on French fund sector use of liquidity management tools

The French market regulator – the AMF – has published an update on the use of liquidity management tools by the French fund sector. 

Context: Liquidity management tools aim at ensuring fair treatment of unit-holders in times of stress to help protect investors and they also make it possible to limit the destabilizing consequences of liquidity shocks on the financial markets. 

French fund liquidity practices: Historically, the AFM notes that French funds were poorly equipped with mechanisms to cap redemptions (gates) and with anti-dilution tools (swing-pricing or anti-dilution levies).

• To facilitate the adoption of these tools by French funds, the AMF introduced a transitional period during which gates could be introduced by simply informing unitholders by any means, subject to compliance with certain terms and conditions. 
• This transitional period ended on 31 December 2023 for most types of fund. 
• The standard prospectus templates have also been revised to include specific information on the risks associated with the absence of gates.

Anti-dilution tools: In the case of management companies that have not introduced anti-dilution tools for some of their funds, they have to declare the reasons to the AMF, provide a statement acknowledging the risks involved, and are required to reassess regularly the need to introduce these tools.

Growing adoption in open-ended funds: Analysis of the prospectuses of funds domiciled in France shows that there is widespread adoption of gates and swing-pricing in open-ended funds.

• A large proportion of funds accessible to retail investors have taken advantage of the transitional period, which has simplified the introduction process for gates and anti-dilution tools in fund prospectuses.
• When considering the population of undertakings for collective investment in transferable securities (UCITS) and general-purpose investment funds (FIVGs), the AMF found that gates accounted for 66% of net assets at end-2023 (compared with 17% at end-2022) and anti-dilution tools accounted for 45% of net assets (compared with 23% one year earlier).

Illiquid assets: Regarding open-ended funds specializing in less liquid asset classes such as real estate and private equity, the AMF finds that gates are now present in all retail real estate collective investment schemes (OPCIs) and all open-ended venture capital mutual funds (evergreen FCPRs).

Wider EU regulatory context: As part of the EU review of the UCITS and AIFM Directives published in March 2024, which will have to be transposed into national law by April 2026, all European open-ended UCITS and AIFs will have to have at least two liquidity management tools by 2026. 

• For money market funds, the requirement will be for a single liquidity management mechanism.
• The recent development in the availability of liquidity management tools by French funds is considered a head start for the future requirements on funds in the EU. 

US prudential regulators set to wait until new administration before taking additional action on Basel III endgame proposal

During a recent House Financial Services Committee oversight hearing of the bank regulators, the Federal Reserve’s Vice Chair for Supervision Michael Barr, alongside the FDIC and OCC heads, indicated the agencies would wait until after the incoming administration has had a chance to weigh in on the Basel III proposal with their policy input and perspective before moving forward with any re-proposal of the endgame rule.

Context: Following the initial Basel III proposal, which modifies and increases risk-based capital requirements for large banks, the Federal Reserve floated a re-proposal in September and was seeking comments from the OCC and FDIC. Officials have indicated that the re-proposal would include broad and material changes to the initial proposal designed to address the comments with the most material impact on the initial proposal.

View the additional regulatory briefs from this month:

• Trading and markets
• Green finance
• Digital finance

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