Global Regulatory Brief: Risk, capital and financial stability, August edition

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 liquidity management tools in the EU to private market vulnerabilities in the UK, the following regulatory developments in risk, capital and financial stability from the past month stand out: 

• EU: ESMA consult on liquidity management tools for funds
• Dubai: DFSA publish report on the implementation of the liquidity coverage ratio
• UK: Bank of England publish overview of private market vulnerabilities
• International: FSB Chair calls for further progress to implement NBFI reforms
• Indonesia: FSA publish Q1 2024 report on Indonesia Financial Sector Development
• UK: Government announces National Wealth Fund
• US: Agencies Issue Final Rule on Mortgage Automated Valuation Models
• US: Agencies Request Comment on Anti-money Laundering/Countering the Financing of Terrorism Proposed Rule

ESMA consults on Liquidity Management Tools for funds

The European Securities and Markets Authority (ESMA) is seeking input on draft guidelines and technical standards regarding the availability and use of Liquidity Management Tools (LMTs) under the revised Alternative Investment Fund Managers Directive (AIFMD) and the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive. 

Important context: Both Directives aim to mitigate potential financial stability risks and promote harmonization of liquidity risk management in the EU investment funds sector.

• Under the revised framework for investment funds, ESMA is required to develop technical rules to determine the characteristics of LMTs available to AIFMs managing open-ended AIFs and to UCITS.
• The revised framework requires fund managers to, among other things, select at least two appropriate LMTs after assessing the suitability of those tools.

In more detail: In the draft Regulatory Technical Standards (RTS) on the characteristics of LMTs, ESMA defines the constituting elements of each LMT, such as calculation methodologies and activation mechanisms. 

• ESMA has also published draft Guidelines on LMTs of UCITS and open-ended AIFs, providing guidance on how managers should select and calibrate LMTs, in light of their investment strategy, their liquidity profile and the redemption policy of the fund.

Looking ahead: Comments are due by October 8, 2024 and ESMA expects to publish a final report and submit the draft technical standards to the European Commission for endorsement by April 16, 2025. 

DFSA publish report on the implementation of the liquidity coverage ratio

The Dubai Financial Services Authority (DFSA) published a report on the Assessment of the Implementation of the Liquidity Coverage Ratio (LCR) to provide insights into the liquidity profile of firms operating in or from the Dubai International Financial Centre (DIFC).

Context: Liquidity risk is key for institutions engaged in financial intermediation, such as those that accept deposits, and the Basel Committee on Banking Supervision developed the LCR to promote the short-term resilience of the liquidity risk profile of banks.

• It is achieved by ensuring that banks have an adequate stock of unencumbered HQLA that can be converted easily and immediately into cash in private markets to meet their liquidity needs for the next 30 days under a severe liquidity stress scenario.
• Over the recent months, the DFSA conducted an in-depth thematic review of the liquidity risk of firms subject to the LCR to assess the adequacy of their implementation.
• This review aimed to evaluate the effectiveness of current practices and identify areas for improvement.

In summary: The report highlights key findings, including areas where firms need to take action to enhance their liquidity management, and also shares best practices observed during the review. Key findings include:

• Firms’ overall DIFC portfolios of liquid assets are of good quality
• Firms prioritised the holding of High-Quality Liquid Assets (‘HQLA’) Level 1 assets over potentially higher yielding but lower quality Level 2 assets.
• Certain Firms had erroneously included ineligible securities in the pool of liquid assets forming part of the HQLA calculation. These ineligible securities should be excluded from the HQLA calculation or reclassified to a lower tier.
• The DFSA observed certain issues around the valuation of the liquid assets, specifically concerning the methodology used to value the assets (not reported at fair value) and the frequency of valuations.
• Firms maintained control of their liquidity locally and demonstrated an unfettered ability to monetise the assets under their control to meet their liabilities as they fall due.
• The DFSA identified instances where certain Firms had not implemented, or had misinterpreted, certain of the operational requirements concerning management of the pool of liquid assets, such as periodical monetisation of the portfolio and the price decline test.
• The DFSA also identified some examples of best practices around the automation of LCR computation, diversification of securities holdings in portfolios, and the use of a comprehensive methodology to assess historical volatility of all HQLA.

Looking ahead: The DFSA expects Firms that are subject to the LCR requirement to review this report and the findings, assess their relevance to the Firm, and implement appropriate actions to remedy identified deficiencies.

Bank of England publish overview of private market vulnerabilities

The Bank of England published its bi-annual Financial Stability Report which contains further consideration of the role and emerging vulnerabilities within market-based finance – including private markets – in the context of UK and global financial stability. 

Vulnerabilities in private equity: The high interest rate environment poses challenges for the private equity (PE) sector, where the use of leverage by both PE firms and their portfolio companies is widespread. 

• High interest rates will effect the PE sector through refinancing risk as debt matures and the increased drag on performance from higher financing costs.
• Vulnerabilities from high leverage, valuation opacity, and strong interconnectedness with riskier credit markets means the PE sector can generate losses for banks & institutional investors, causing market spillovers to highly correlated markets such as leveraged loans and private credit. This puts further pressure on financing conditions.
• Many of the firms considered to be most vulnerable to default that need to refinance over the coming years are private equity backed.
• The Bank of England calls for improved transparency over valuation practices and overall levels of leverage, and better risk managements practices both in the PE sector and in lenders to the sector such as banks.

Vulnerabilities in market-based finance: There remains important vulnerabilities in market-based finance can lead to forced selling, the amplification of price moves, and the impairment of core market functioning. MBF vulnerabilities include:

• Liquidity mismatch in money market funds (MMFs) and open-ended funds (OEFs) as seen in the global financial crisis (GFC) and the 2020 dash for cash;
• Instances of concentrated leverage in non-bank financial intermediaries (NBFIs), for example in liability-driven investment (LDI) funds (where stress crystallised in late 2022), and in hedge funds;
• Liquidity demands from margin calls in times of stress as seen in the ‘dash for cash’ in March 2020; and
• The insufficient capacity of markets to intermediate in stress, so-called jump-to-illiquidity risk, as also seen in the ‘dash for cash’.

Looking ahead: There are a range of upcoming regulatory initiatives relating to these topics, including:

• The Financial Stability Board will publish draft policy options on leverage in non-bank financial institutions to improve i) infrequent regulatory reporting of leverage, challenges in integrating entity and activity-level regulatory data, and a lack of appropriate risk metrics, and ii) fragmentation of data and metrics across and within jurisdictions.
• The Basel Committee on Banking Supervision will finalise reforms to enhance the liquidity preparedness of non-bank market participants for margin and collateral calls.
• The shift to T+1 settlement will reduce counterparty credit risk in financial markets and so also reduce margin requirements.
• The Irish and Luxembourg regulatory frameworks for sterling LDI funds will take effect from July 29, 2024 and contains further information on expectations for LDI funds’ buffer composition, liquidity management, and data reporting.
• The Bank of England is currently developing a new lending facility to provide liquidity directly to NBFIs in times of system-wide liquidity stress in the gilt market.
• The results from the Bank of England’s system-wide exploratory scenario (SWES) exercise will be published in Q4 2024.
• The FCA is is currently reviewing private asset valuation practices and is focusing on the personal accountabilities for valuation practices in firms, the governance of valuation committees, the information reported to boards about valuations, and the oversight by relevant boards of those practices.

Indonesian Financial Services Authority publishes Q1 2024 report on Indonesia Financial Sector Development

The Indonesian Financial Services Authority (OJK) published the year’s first quarterly report (English version) on the Indonesian financial sector development. The report consists of four key sections – (i) recent economic and financial development; (ii) special topics; (iii) policy updates; and (iv) projects undertaken by OJK’s International and AML/CFT Department.

Economic and financial development: OJK reported that Indonesia’s smooth presidential transition brought certainty to Indonesia’s financial services sector, boosting investor confidence and resulting in a steady financial services sector, with improved intermediation and manageable credit risk across the sector. 

• Monetary indicators demonstrated stability and there was substantial expansion in manufacturing activities. 
• The Indonesian Capital Market experienced post-election rebound after a period of wait-and-see from investors, evidenced by inflows in equities market, positive JCI performance and investors growth. 
• Despite domestic stability and growth optimism, OJK were cautious of global uncertainties.

Special topics: The report highlighted the (i) maintaining of economic momentum amidst unwinding of COVID-19 restructuring credit policies; (ii) double-edged sword of Buy-Now-Pay-Later in Indonesia; and (iii) the vast development of sustainable finance in the financial services sector. 

Policy updates: OJK highlighted that their policy priorities of 2024 are to ensure the resilience of the financial services sector to support economic growth. The report outlined policies which the regulator had implemented, or was in the process of drafting, across the following areas –

• Maintaining financial system stability
• Developing Sharia financial services sector
• Strengthening OJK’s governance
• Developing financial sector technology innovation and digital/crypto asset supervision
• Strengthening financial services sector and market infrastructure

International projects: The report outlined OJK’s involvement in international standard setting and cooperation with other regulators. 

• It also highlighted Indonesia becoming the 40th member of the Financial Action Task Force (FATF) in October 2023, underscoring the country and OJK’s commitment to improve the effectiveness of their AML/CFT regime.

FSB Chair calls for further progress to implement NBFI reforms

The Financial Stability Board (FSB) Chair Klaas Knot published a letter to G20 Finance Ministers and Central Bank Governors highlighting historically high debt levels of both government and private sector borrowers and vulnerabilities in real estate markets and non-bank financial intermediation (NBFI) as areas that deserve continuing attention. 

Important context: Developments in the global financial system over the past decade have increased the reliance on market-based intermediation. 

• NBFI has grown to almost half of global financial assets and become more diverse. 
• However, the experience of the 2008 global financial crisis, the March 2020 market turmoil and more recent episodes of market stress demonstrated that NBFI can also create or amplify systemic risk.

Key vulnerabilities: The letter notes that many of the underlying vulnerabilities that contributed to stress in the NBFI sector during recent market incidents are still largely in place.

• These vulnerabilities raise the potential for sharp price corrections in the event of a shock, which could be more likely amid heightened geopolitical uncertainty and rich asset valuations in some markets. 
• Knot calls for full implementation of the agreed G20 financial regulatory reforms to address these vulnerabilities.

In parallel: The Financial Stability Board published a progress report on enhancing the resilience of NBFI which highlights a number of challenges hampering progress, including data challenges that impede a full assessment of NBFI vulnerabilities and the formulation of effective policy responses. 

• This report underlines the policy priorities as being a reduction in excessive spikes in liquidity demand, enhanced liquidity supply in stress scenarios, and enhanced risk monitoring particularly with regard to leverage in NBFI. 

Looking ahead: Addressing leverage-related vulnerabilities in NBFI is a key area of current policy focus, and the FSB expects to publish by the end of 2024 a consultation report with proposed policy solutions. 

• The FSB continues to monitor and analyse NBFI vulnerabilities on an ongoing basis through the development of additional metrics and analytical tools. 
• The FSB will continue to conduct targeted deep dives in specific areas, including solvency and liquidity risks in an environment of rising interest rates, and vulnerabilities in private credit.

UK Government announces National Wealth Fund

UK Chancellor Rachel Reeves and the Business Secretary Jonathan Reynolds have announced the formation of a new National Wealth Fund which will align the UK Infrastructure Bank and the British Business Bank. 

In more detail: Under the Government’s new plans, the National Wealth Fund will bring together key institutions to mobilize billions more in private investment and generate a return for taxpayers.

• £7.3bn of additional funding will be allocated through the UK Infrastructure Bank so investments can start being made immediately, and this funding is in addition to existing UKIB funding.
• The National Wealth Fund is intended to crowd in private capital to sectors such as ports, heavy industry, and manufacturing. 

Looking ahead: Chancellor Reeves asked Treasury to engage with industry, government departments and the UK’s public finance institutions to set detailed plans in motion.

• Further detail will be set out ahead of the government’s international investment Summit later in the year. 
• The government will bring forward new legislation when parliamentary time allows to cement the National Wealth Fund in statute, making it a permanent institution.

Basel Committee finalizes adjustments to IRRBB standard

The Basel Committee on Banking Supervision has finalized targeted adjustments to its standard on interest rate risk in the banking book (IRRBB). 

In summary: The Committee has made targeted adjustments to the specified interest rate shocks in the IRRBB standard in line with its commitment to periodically update their calibration. The Committee has also incorporated targeted adjustments to the current methodology used to calculate the shocks, including:

• Expansion of the time series used in the calibration from December 2015 to December 2023.
• Replacement of the global shock factors with local shock factors calculated directly for each currency using the averages of absolute changes in interest rates calculated over a rolling six-month period.
• Move from a 99th percentile value in determining the shock factor to a 99.9th percentile value, to maintain sufficient conservatism in the proposed recalibration.
• Reducing the rounding of the interest rate shocks from a multiple of 50 basis points to a multiple of 25 basis points.
• These targeted changes have been implemented to address problems with how the current methodology captures interest rate changes during periods when rates are close to zero. The changes are unrelated to the Committee’s ongoing analytical work on IRRBB following the March 2023 banking turmoil.

Looking ahead: The revised standard should be implemented by January 1, 2026 and will be incorporated into the consolidated Basel Framework.

US agencies issue final rule on mortgage automated valuation models

Federal bank regulators, the Consumer Financial Protection Bureau (CFPB), and the Federal Housing Finance Agency (FHFA) adopted a joint final rule to implement the quality control standards mandated by the Dodd-Frank Act for the use of automated valuation models (AVMs) by mortgage originators and secondary market issuers in determining the collateral worth of a mortgage secured by a consumer’s principal dwelling. 

The details: Under the final rule, institutions that use AVMs in certain credit decisions or securitization determinations must adopt policies, practices, procedures, and control systems that:

• Provide a high level of confidence in estimates produced by AVMs;
• Protect against the manipulation of data;
• Avoid conflicts of interest;
• Conduct random sample testing and reviews; and
• Comply with applicable nondiscrimination laws. 

Compliance timeline: The rule is effective 12 months after publication in the Federal Register.

US agencies request comment on anti-money laundering/countering the financing of terrorism proposed rule

The Office of the Comptroller of the Currency, the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the National Credit Union Administration (collectively, “the Agencies”) issued a Notice of Proposed Rulemaking (NPRM) on a proposed rule that would amend the requirements of supervised banks to establish, implement and maintain Anti-Money Laundering (AML) and Countering the Financing of Terrorism (CFT) programs under the Bank Secrecy Act (BSA). 

The details: The NPRM seeks to align the Agencies’ AML/CFT compliance program rules with a separate proposed rule by the Financial Crimes Enforcement Network (FinCEN) required under the Anti-Money Laundering Act of 2020. Among other things, the Agencies’ NPRM proposes:

• An interagency statement describing the purpose of an AML/CFT program requirement;
• The addition of the terms “effective” and “risk-based” to the existing AML/CFT program requirement of banks; and
• Minimum requirements of an AML/CFT program, including a risk assessment process; and 
• Adding customer due diligence requirements as a component of AML/CFT program rules.

Timeline: Comments on the proposal are due 60 days after publication in the Federal Register.

View the additional regulatory briefs from this month:

• Trading and markets
• Green finance
• Digital finance

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