On 18 July 2023, the Central Bank of Ireland (the “Central Bank“) published its latest discussion paper entitled “An approach to macroprudential policy for investment funds” (the “Paper“). The purpose of this Paper is to advance the debate on a potential future approach to the development and operationalisation of a macroprudential framework for the investment funds sector.

In recent years, financial regulators worldwide have increased their focus on the risks posed to the financial system by the growth in non-bank financial intermediation (“NBFI“), with the rise of investment funds emerging as a key component of the global NBFI sector.

Summary

As outlined by the Governor of the Central Bank in his accompanying blog post “A macroprudential framework for investment funds” the Paper takes a holistic view when considering the development of a macroprudential framework for the funds sector. Whilst the Paper is careful not to propose specific policy measures at this juncture, it does outline a number of high-level objectives and principles to be considered when developing such a framework, as well as posing key questions throughout for consideration by stakeholders:

  • The Paper notes that as the investment funds sector plays a larger role in the financial system, its systemic importance will grow too. Accordingly, resilience-enhancing measures need to work on a collective or aggregate basis, aimed at fund cohorts.
  • Resilience needs to be built before crisis conditions occur. Sufficient policies should be in place targeted at the identified sources of systemic risk, though ex post tools remain important as part of a wider toolkit.
  • Policy measures could either seek to limit underlying vulnerabilities and/or be targeted at the interconnectedness of the sector, reducing contagion risk.
  • Policies should have a degree of flexibility so they can respond to systemic risks as they evolve.
  • Policy intervention should be the result of a careful balance between costs and benefits for the broader economy.
  • Global co-ordination is a critical enabler when designing a macroprudential policy framework for the funds sector. Macroprudential measures should take a system-wide perspective and guard against the possibility that risks shift to other parts of the financial system.

The aim of macroprudential policy for the funds sector would be to ensure that this growing segment of the financial sector is more resilient to stresses and less likely to amplify adverse shocks. The Central Bank notes that macroprudential policy can achieve these aims by preventing the build-up of excessive vulnerabilities across relevant cohorts of the funds sector and/or limit the potential for the sector to amplify adverse shocks through its interconnectedness as part of the financial system. The rationale for macroprudential policy intervention stems from the need to address risks that are not covered by other parts of the regulatory framework and as such it isn’t appropriate for regulators to fully rely on individual fund managers to address the build-up of systemic risk.

The key principles of a macroprudential framework would include resilience enhancing measures, building resilience before crisis conditions occur, limiting underlying vulnerabilities and requiring global co-ordination to be a critical enabler.

Vulnerabilities

This Paper highlights the two main underlying potential sources of vulnerabilities for investment funds as being liquidity mismatches and high levels of leverage.

Liquidity Mismatch can be summarised as the difference between the redemption terms that a fund offers and the amount of time it may take the fund manager to liquidate fund holdings in an orderly manner (i.e. by not impacting prevailing market prices) to satisfy redemption requests and can arise when open-ended funds (“OEFs“) are invested in less liquid assets, while allowing their investors the opportunity to redeem their shares at a higher frequency.

Leverage can be (a) “financial leverage” which arises if funds use debt to finance their investments; or (b) “synthetic leverage” which arises from derivative instruments or securities financing transactions that can create exposures contingent on the future value of an underlying asset. Rapid deleveraging in response to adverse shocks can give rise to spillovers across the financial system.

Vulnerabilities such as these can result in actions by investment funds that have the potential to amplify adverse shocks. For such actions to become of systemic concern, the interconnectedness of the funds sector with the real economy or the rest of the financial system is a key consideration. The interconnectedness of investment funds with other parts of the financial system can result in the transmission of underlying vulnerabilities in investment funds via shocks, to other parts of the financial system and/or the real economy both via direct channels (i.e. through the credit or funding it supplies) or indirect channels (i.e. through asset fire-sales and falling collateral prices).

Macroprudential tools

Looking to the availability of potential macroprudential tools for investment funds, the Paper examines the tools and techniques that investment funds can deploy to address vulnerabilities and risks in respect of liquidity management, leverage and interconnectedness. These include the narrowing of any misalignment between the liquidity of assets and the redemption frequency offered by investment funds, the use of regulatory stress testing focusing on leveraged-related risks and tools aiming to limit material spillovers from fund cohorts to other parts of the financial system.

The Paper assesses how the various EU directives address topics such as leverage restrictions, liquidity mismatches and product requirements. It also poses the proposition that the current regulatory framework for funds – which has primarily been designed at a global level from an investor protection perspective – has not been sufficient to reduce the propensity of certain fund cohorts from amplifying shocks.

The Paper suggests tools could target the interconnectedness of funds with other parts of the financial system as well as, or instead of, targeting their vulnerabilities. Policy tools targeting the interconnectedness of funds have received comparatively less attention and remain underdeveloped vis-à-vis tools targeting vulnerabilities. Policy tools targeting interconnectedness would differ conceptually from those targeting the vulnerabilities in funds. Instead of aiming to enhance the resilience of fund cohorts, tools covering the interconnectedness of funds would, instead, aim to limit material spillovers from fund cohorts to other parts of the financial system.

Recent policy initiatives

The Paper is clear that the governance of any macroprudential framework for the funds sector will need to be based on the availability of high quality data and entail arrangements for international coordination, reflecting the global nature of capital markets. On governance, the Central Bank concludes that in order to function effectively, a macroprudential framework would ideally have a high degree of consistency internationally, including a reciprocation framework. The Central Bank is building on recent significant policy work on resilience and on liquidity management of OEFs conducted by international bodies such as the Financial Stability Board policy recommendations on addressing structural vulnerabilities from liquidity mismatch in OEFs and the IOSCO guidelines on anti-dilution liquidity management tools (both issued in July 2023).

The publication of the Paper also follows closely the public consultation on a review of the funds sector by the Department of Finance entitled “Funds Sector 2030” which includes a focus on delivering key opportunities in the short-medium term for funds providing credit intermediation.

Concluding remarks

The Paper highlights that the funds sector, both globally and in Ireland, is diverse and is increasingly relevant for the functioning of the financial system and the financing of the real economy. Collective actions of fund cohorts can generate systemic risk and the materialisation of this risk can arise from a shock and the interplay between leverage and liquidity mismatch, and interconnectedness of the fund cohorts.

As seen by the onset of the COVID-19 shock in 2020 and the UK Gilt market episode in 2022 central banks across the world have increasingly intervened more directly in markets to restore the functioning of certain core markets in times of stress. The Paper therefore constitutes an important contribution to the global conversation on how the regulatory framework should reflect the changing nature of financial intermediation, cognisant that the current regulatory framework should evolve to strengthen both the resilience of the NBFI sector and overall market functioning. The Paper concludes that a fundamental aspect of this evolution in regulatory thinking will be to develop an international macroprudential framework to enable the continuing successes of the non-bank intermediation market and of the investment funds sector.

Next Steps

The Central Bank has invited feedback on the Paper until 15 September 2023. Following consideration of all responses the Central Bank will publish a feedback statement covering some or all of the topics raised by respondents.