Global Regulatory Brief: Risk, capital and financial stability, May 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 bank supervision in Switzerland to stress testing in Australia, the following global developments in risk, capital and financial stability from the past month stand out: 

• UK: Bank of England underline the role of the private equity sector to financial stability
• International: IMF publish new research on the rise and risks of private credit
• Dubai: FSA consults on private credit funds
• US: CFTC approves final rules on swap confirmation requirements for SEFs
• US: CFTC fines swap dealer for supervision failures
• Switzerland: FINMA publishes ordinances to implement final Basel III standards
• EU: AIFMD published in the Official Journal of the EU
• EU: EBA publishes annual assessment of banks’ internal approaches for the calculation of capital requirements
• Hong Kong: IA-published consultation conclusions of Risk-Based Capital (RBC) regime
• New Zealand: FMA issued Liquidity Risk Management Guide

BoE underlines the role of private equity to financial stability

The Bank of England’s Executive Director Nathanael Benjamin set out in a speech the importance, growth and financial stability concerns associated with the private equity sector. 

Important context: The regulatory discussion over private equity comes as market-based financing has grown significantly over the last decade, with global assets under management in the private equity sector growing from around $2 trillion in 2013 to around $8 trillion in 2023. 

In the UK, private equity plays an important role in funding UK businesses and represents growing competition and diversification within the financial sector.

Challenges: The rise in interest rates over the past two years has posed a number of challenges for the private equity sector, which experienced strong growth during a period of low interest rates. 

• The difficulties that the highly-leveraged companies backed by private equity face in the higher interest rate environment
• The consequences of a lack of exit opportunities for private equity fund investments

Regulatory concerns: Regulators such as the BoE are concerned at the backdrop of opacity which means there is a lack of transparency about the degree and kinds of leverage entering the system and growing interconnectedness between parts of the financial sector that are exposed to private equity. 

• • Impact on systemic institutions: The substantial activity which banks and other parts of the financial system are undertaking in relation to private equity reinforces the need for robust risk management frameworks 

• Impact on interlinked markets: Significant interlinkages mean that there is potential for spillovers between private and public markets in a period of stress 
• Impact on the real economy and employment: With many UK companies reliant on private markets for financing, a shock to this sector could limit their ability to access the financing they need

Looking ahead: The BoE expects private equity to grow in size and complexity and sees the competition between banks and non-banks as a sign of a healthy financial sector. 

• The Prudential Regulation Authority is focused on ensuring that the banking sector’s risk management practices keep pace with the evolution in the market
• The Financial Conduct Authority is also carrying out a review of valuation practices for private assets
• The BoE will publish a further assessment of these risks in the next installment of the Financial Stability Report in June, 2024

Closely related: The UK’s Financial Policy Committee (FPC) issued a statement recognizing the important role the private equity sector plays in channeling finance to the UK’s real economy while outlining some of the growing risks to financial stability associated with the sector’s growth.

• The increase in rates in recent years has made it more difficult for private equity funds to raise investment which has contributed to downward pressure on asset valuations and default rates on debt linked to private equity have increased and the FPC considers that the extent of transparency around asset valuations, overall levels of leverage, and the complexity and interconnectedness of the sector make assessing financial stability risks difficult.
• The PRA also published a letter to chief risk officers on the thematic review of private equity related financing activities. The PRA has been closely monitoring changes in the nature and scale of regulated banks’ PE-related financing activities. Due to the size and importance of these activities to the banking sector as a whole, and their potential impact on its safety and soundness, the PRA has carried out a thematic review of banks’ risk-management practices in this area.

IMF publish new research on the rise and risks of private credit

The International Monetary Fund (IMF) published new research on the rise and risks of private credit as part of its April, 2024 Global Financial Stability Report. 

Important context: The IMF finds that the private credit market topped $2.1 trillion globally last year in assets and committed capital with around three-quarters of this in the United States, where its market share is nearing that of syndicated loans and high-yield bonds.

The IMF observes that while private corporate credit has created significant economic benefits by providing long-term financing to corporate borrowers, the migration of this lending from regulated banks and more transparent public markets to the opaque world of private credit creates potential risks.

Risk in focus: The potential risks in the private credit sector include infrequent valuation and difficulties in assessing credit quality and systemic risk and while financial stability risks are currently limited the sector’s fast growth and interconnectedness may change this. 

• Companies that tap the private credit market tend to be smaller and carry more debt than their counterparts with leveraged loans or public bonds, making them more vulnerable to a rise in rates 
• Private market loans rarely trade and therefore cannot be valued using market prices. Instead, they are often marked only quarterly using risk models, and may suffer from stale and subjective valuations across funds
• While private credit fund leverage appears to be low, the potential for multiple layers of hidden leverage within the private credit ecosystem does raise concerns given the lack of data 
• There appears to be a significant degree of interconnectedness in the private credit ecosystem with some banks having concentrated exposures to the sector
• Though liquidity risks appear limited today, a growing retail presence may alter this assessment. Private credit funds use long-term capital lockups and impose constraints on investor redemptions to align the investment horizon with the underlying illiquid assets

Policy implications: The IMF recommends that authorities should consider a more active approach to private credit, focusing on monitoring and risk management, leverage, interconnectedness and concentration of exposures. They also recommend that:

• Authorities should enhance cooperation across industries and national borders to address data gaps and make risk assessments more consistent across financial sectors
• Regulators should improve reporting standards and data collection to better monitor private credit’s growth and its implications for financial stability
• Securities regulators should pay close attention to liquidity and conduct risk in private credit funds, especially retail, that may face higher redemption risks 
• Regulators should implement recommendations on product design and liquidity management from the Financial Stability Board and the International Organization of Securities Commissions

DFSA consult on private credit funds

The Dubai Financial Services Authority (DFSA) issued a call for evidence on its credit funds regime as it seeks to account for international regulatory developments and also feedback from the funds industry. 

Summary: There are five areas of the current regime where feedback is specifically sought: 

1. Overall approach to private credit funds 
2. Investment objective 
3. Types of credit facilities 
4. Leverage 
5. Permitted fund structures

Looking ahead: Feedback is open until May 10, 2024. 

Closely related: The DFSA is also seeking public comments on proposed amendments to the regime for the rulebook on the regulatory regimes for Credit Funds, Public Property Funds and Real Estate Investment Trusts (REITs). This includes allowing fund managers authorized by the DFSA to manage External Funds that are Credit Funds subject to certain conditions.

CFTC approves final rules on swap confirmation requirements for SEFs

The Commodity Futures Trading Commission (CFTC) has adopted a set of rules related to uncleared swap confirmations for swap execution facilities (SEFs). The rules are designed to address certain issues which have been addressed in CFTC staff no-action letters, including the most recent CFTC No Action Letter No. 17-17.

• The final rules allow SEFs to incorporate terms of underlying, previously-negotiated agreements between the counterparties by reference in an uncleared swap confirmation without being required to obtain such underlying, previously-negotiated agreements
• They require confirmations of both cleared and uncleared swaps to take place “as soon as technologically practicable” after execution
• Further, the amended rules make clear the SEF-provided confirmation under CFTC Regulation 37.6(b) shall legally supersede any conflicting terms in a previous agreement, rather than the entire agreement
• The rules will become effective 30 days after publication in the Federal Register
• Upon the effective date, No Action Letter No. 17-17 will expire

CFTC fines swap dealer for supervision failures

The CFTC fined Australia and New Zealand Banking Group Ltd (ANZ), a provisionally registered swap dealer, $500,000 for failing to ensure its spoofing surveillance tool was operating effectively. 

Specifically, the order found that thousands of orders were not timely surveilled for spoofing and ANZ should have, but did not receive a substantial number of surveillance alerts that would have been generated during two gap periods.

• A CFTC investigation found that during both periods, there was a mismatch between the time when the relevant data was ingested into the surveillance tool and the time when the tool was run
• It notes that the tool was run on a daily basis before certain data was ingested into the tool, and thus the tool failed to survey any of the futures data from the vendor at issue
• After discovering the first period of surveillance gaps, ANZ did not put into place additional safeguards to prevent the timing issue from recurring
• The Commission notes “substantial cooperation” by ANZ during its investigation, including disclosure of both events, which resulted in a reduced penalty
  

EBA publishes annual assessment of banks’ internal approaches for the calculation of capital requirements

The European Banking Authority (EBA) published its 2023 Reports on the annual market and credit risk benchmarking exercises which aim to monitor the consistency of risk-weighted assets (RWAs) across all EU institutions authorized to use internal approaches for the calculation of capital requirements. 

Important context: These annual benchmarking exercises are designed to contribute to improving the regulatory framework, increasing convergence of supervisory practices and helping to restore confidence in internal models.

Market risk in focus: For the majority of participating banks, the results confirm a relatively low dispersion in the initial market valuation (IMVs) of most of the instruments, and a decrease in the dispersion in the value at risk (VaR) submissions compared to the previous exercise.

From a risk factor perspective, FX portfolios exhibit a lower level of dispersion than the other asset classes. In general, variability is substantially lower than in the previous exercise. This is likely due to an improvement in the data submission, which impacted the dispersion of the risk measures, decreasing the dispersion in general.

Credit risk in focus: The report shows that the relative share of the Exposure at Default (EAD) subject to the Internal Ratings Based (IRB) method appears practically constant in the last few years.

Swiss regulator FINMA publishes ordinances to implement final Basel III standards

The Swiss Financial Market Supervisory Authority FINMA published ordinances to implement the final Basel III standards in Switzerland. 

In summary: These ordinances contain the implementing provisions for the Federal Council’s revised Capital Adequacy Ordinance (CAO) for banks which will enter into force on January 1, 2025. The five new ordinances are:

1. The Trading Book and Banking Book and Eligible Capital of Banks and Securities Firms
2. The Leverage Ratio and Operational Risks of Banks and Securities Firms
3. The Credit Risks of Banks and Securities Firms
4. The Market Risks of Banks and Securities Firms
5. The Disclosure Obligations of Banks and Securities 

Important context: FINMA supports the introduction and application of the final Basel III standards in Switzerland as a means to remedy the deficits in banking regulation identified as a result of the 2008 financial crisis. 

• In addition, the Swiss financial sector with its strong international ties will benefit from a strict implementation that is closely aligned with the standards
• The Basel Committee will continue to review the country-specific introduction and application for consistency with the final Basel III standards through the Regulatory Consistency Assessment Programme (RCAP)

AIFMD published in the Official Journal of the EU

Revisions to the Alternative Investment Fund Manager (AIFM) Directive aimed at improving the regulatory framework applicable to EU investment funds in the EU has been published in the Official Journal of the EU. 

In summary: The revisions aim to harmonize the rules for the managers of alternative investment funds (AIFMs) managing AIFs which originate loans, as well as:

• Clarify the standards applicable to AIFMs that delegate their functions to third parties 
• Ensure equal treatment of entities providing custody services (‘custodians’)
• Improve cross-border access to depositary services
• Optimize supervisory data collection
• Facilitate the use of liquidity management tools across the EU

Looking ahead: The AIFMD entered into force on April 15, 2024 and Member States have 24 months to transpose the EU rules into national legislation.

Hong Kong Insurance Authority publishes consultation conclusions of Risk-Based Capital (RBC) regime

Hong Kong’s Insurance Authority (IA) published consultation conclusions regarding the implementation of the Risk-Based Capital (RBC) regime. 

Summary: Respondents were generally supportive of the proposals outlined, with comments mainly on areas such as capital requirements and valuation of assets and liabilities and the IA has made amendments accordingly. The six rules are:

1. Insurance (Exemption to Appointment of Actuary) Rules (Cap. 41Q)
2. Insurance (Valuation and Capital) Rules (Cap. 41R)
3. Insurance (Submission of Statements, Reports and Information) Rules (Cap. 41S)
4. Insurance (Maintenance of Assets in Hong Kong) Rules (Cap. 41T)
5. Insurance (Marine Insurers and Captive Insurers) Rules (Cap. 41U)
6. Insurance (Lloyd’s) Rules (Cap. 41V)

Looking ahead:  The finalized rules will be tabled at the Legislative Council for negative vetting in May, 2024; with a view to coming into operation in tandem with the commencement of the Insurance (Amendment) Ordinance 2023.

New Zealand FMA issues Liquidity Risk Management Guide

New Zealand’s Financial Markets Authority (FMA) published a guide to help ensure effective liquidity risk management (LRM) among managed funds.  

In summary: The guide sets out key features of LRM that managers must consider and implement to measure liquidity, conduct suitable stress testing and use liquidity management tools when required. This addresses the following:

• Overarching framework and strategy
• Governance
• Contingency plans 
• Product design
• Disclosure and communication
• Monitoring framework
• Liquidity-management tools
• Stress testing
• Use of leverage to adjust risk/return
• Record keeping, data and systems
• Evaluation and review

Regulatory expectations: The FMA expects to understand how Supervisors have engaged with Managers and how Managers have considered their own liquidity risks and implemented appropriate LRM in the context of the funds they manage. 

• Where Managers have not considered features in this guide, the FMA is likely to seek explanations on how effectively they are managing liquidity risk
• Where a Manager or Supervisor is in breach of their responsibilities, the FMA’s action will depend on the severity and extent of misconduct, considering prevailing market conditions, and any ongoing or potential investor harm 

Background context: Investors expect to be able to withdraw money, or transfer between schemes, in a timely way and fund liquidity is about how fund assets can be sold without negatively impacting the price of those assets or needing to secure funding (if applicable). 

• The FMA considers good management of fund liquidity to be an important part ensuring investors are treated equitably and that funds perform and operate in line with the information given to investors 
• Effective LRM also plays an important role in supporting orderly and stable markets, particularly during volatile conditions
• Poorly-managed liquidity risk may mean some investors unfairly bear the costs of others leaving the fund, or force managers to sell fund assets for a lower price than would otherwise be the case

International dimension: This guidance builds on the focus of the Financial Stability Board (FSB) and International Organisation of Securities Commissions (IOSCO) on effective liquidity risk management and on the FMA’s previous work, following the two most recent global market shocks. 

View the additional regulatory briefs from this month:

• Trading and markets
• Green finance
• Digital finance

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