A system-wide approach to macroprudential policy for non-bank financial intermediaries

This document ⁽¹⁾ is the ESRB’s response to the European Commission’s targeted consultation assessing the adequacy of macroprudential policy for non-bank financial intermediation. Non-bank financial intermediaries (NBFI entities) comprise different types of entities that have diverse business models and that are subject to different regulatory frameworks. They include NBFI entities that act as agents on behalf of clients, such as asset managers, and those that hold assets on their own balance sheet, such as insurers. The ESRB has for many years provided advice to the EU co-legislators to help ensure that the regulatory framework for NBFI entities supplies EU and national authorities with the means to identify and address risks to financial stability wherever they arise in the financial system. This response to the European Commission’s consultation builds on this advice.

It also builds on the ambitious tasks the ESRB and its members set themselves in the strategy for macroprudential policy beyond the banking sector published in 2016.⁽²⁾ Similar to a previous response by the ESRB on key macroprudential topics⁽³⁾, this response therefore goes beyond providing answers to the specific questions considered in the Commission’s targeted consultation. In particular, this response presents a conceptual approach to macroprudential oversight and financial regulation. This conceptual approach combines the prevailing focus on entities⁽⁴⁾ with a focus on activities, thereby providing a system-wide perspective. As different types of entities typically perform any given activity in combination with other activities, addressing risks and vulnerabilities will typically require several entity-based regulations (EBRs), with each EBR tailored to each type of entity to reflect the diversity of business models. But an activity may also create risks and vulnerabilities that are independent of the types of entities involved in the activity. Addressing such risks and vulnerabilities may require complementing EBR with activity-based regulation (ABR). This conceptual approach, which the ESRB will use to consider vulnerabilities and risks to financial stability across the financial system, is described in more detail in Section 1.

The ESRB acknowledges the existential challenges facing the EU and the importance of completing the capital markets union (CMU) to help meet those challenges. The EU needs to mobilise a vast amount of private savings to meet challenges arising from climate change, an ageing society, deglobalisation and a war taking place at its borders. Mobilising these private savings requires better developed and less fragmented capital markets than is currently the case. This need gives fresh impetus to make the CMU a reality.

As this “Kantian shift for the CMU”⁽⁵⁾ has profound implications for financial stability, the EU regulatory framework must put greater emphasis than is currently the case on…

…ensuring that NBFI entities and market-based finance are resilient. Non-bank financial intermediation and market-based finance can act as a complement to bank-based financial intermediation during normal times and as an alternative during times when banks are under stress. They can also provide sources of long-term funding and risk capital that the traditional banking sector cannot easily supply. With the CMU designed to leverage these benefits, the importance of NBFI entities and of market-based finance will continue to grow. This means that as a precondition for a successful CMU, market-based finance and NBFI entities need to be resilient and not propagate or amplify stress in the financial system.

…ensuring that the wider financial system is resilient. Ensuring that NBFI entities are resilient is necessary for financial stability but not sufficient in itself to ensure that the financial system is resilient. The financial system enables households, firms and other economic actors to transact, save, borrow and share risk. This relies on different types of entities undertaking a wide range of activities, such as processing payments, taking deposits, trading and managing assets, providing credit and equity funding, and sharing risk via insurance and financial instruments. Many of these activities depend on each other and rely on liquid markets, which means that the financial system is a complex web of interdependent activities and entities. Some of this complexity is inherent to the financial system and will persist under the CMU.

Progress has been made in enhancing the resilience of NBFI entities and market-based finance, but important gaps that the ESRB has highlighted previously need to be closed. In early 2024 EU co-legislators completed the revision of several important EBRs concerning key NBFI entities – central counterparties, insurers and investment funds. By improving regulation, strengthening the powers of supervisors with new microprudential tools and establishing recovery and resolution regimes, these changes will help address several vulnerabilities that the ESRB previously highlighted in letters to the co-legislators. But important gaps remain, and it is essential that the European Commission completes its work to address the risks and vulnerabilities highlighted by the ESRB. These relate to money market funds (MMFs), other investment funds, margin and margin preparedness, and crypto-assets. The ESRB’s policy positions regarding these topics are summarised in four “policy digests” in Section 2.

To enhance the resilience of the wider financial system, this response advocates a conceptual approach combining a focus on entities with a focus on activities. A focus on different types of entities is the natural starting point of microprudential EBR, and several macroprudential tools are also enshrined in EBR. But on its own, a focus on different types of entities does not deliver a system-wide perspective that is at the core of macroprudential oversight. It is therefore also important to consider risks and vulnerabilities by focusing on activities. Many risks and vulnerabilities that result from entities undertaking an activity will be specific to the business model of the type of entity undertaking the activity. For example, while providing long-term credit exposes a bank to liquidity risk, this risk is less important for certain NBFI entities that have longer-term liabilities. Such risks can be effectively addressed by EBR. But some risks and vulnerabilities are independent of the entities involved in the activity. For example, excessive credit growth, and the resulting risk of excessive leverage and excessive increases in asset prices, is independent of whether credit is provided by banks or by NBFI entities. Addressing such risks with EBR alone can result in measures being circumvented as activities migrate to other types of entities. Reflecting this, when targeting risks and vulnerabilities that an activity might create for the wider financial system irrespective of the entity that is undertaking the activity, ABR may be more effective than EBR, as any measure would be identical for all entities performing the activity. A focus on activities can also serve as a cross check to help ensure that different EBRs are consistent, whereby entities posing similar risks to financial stability are regulated with similar stringency, although not necessarily in an identical manner. It can also help identify entities that perform an activity outside the regulatory perimeter. By combining a focus on entities with a focus on activities, this conceptual approach provides a system-wide perspective.

The ESRB applies this conceptual approach to three activities that it considers important for financial stability – asset management, clearing and lending. The ESRB selected these activities because they have a significant actual or potential cross-border dimension, and the ESRB therefore believes their resilience will be pivotal to a successful CMU. Moreover, global developments are rapidly affecting how these activities are conducted. Asset management is central to the functioning of the CMU, as it helps mobilise and allocate capital and supports cross-border investment. To date, the international policy discussion has been focused on investment funds, which can be susceptible to the risk of investor runs and fire sales. But asset management is an activity that is also performed in various forms by several other entities. Central clearing can enhance the resilience of government bond cash and repo markets, which have experienced episodes of illiquidity and market dysfunction in recent years. The functioning of these markets is critical for the financial system, including for NBFI entities, whose footprint in these markets has been growing. But while centrally cleared transactions are subject to margin requirements, a lack of such requirements for bilaterally cleared transactions may disincentivise greater central clearing in these markets. Lending is a key source of funding for the real economy, and the diversity of lending products has increased beyond the banking sector. In addition to the growing role of debt markets globally, the lending activities of NBFI entities such as investment funds, finance companies and insurers have also increased. Although there have been important global and EU regulatory initiatives related to these three activities, notably on addressing risk related to investment funds, the ESRB believes that this conceptual approach will provide a greater system-wide perspective. The ESRB anticipates that it will apply this conceptual approach to other activities in the future.

To employ tools designed to address risks and vulnerabilities in the most effective way, two operational elements need to be strengthened – data and cooperation. To identify, monitor and assess risks and vulnerabilities in the financial system, authorities need more comprehensive and better-quality data, easier access to data and adequate resources to analyse data. As many NBFI entities operate across borders, there is also a need for cooperation between authorities both before and during crises. This is particularly important in the context of the CMU, which aims to deepen market integration in the EU, thereby also making it easier for activities and their associated risks to migrate across borders. These two operational elements are described in more detail in Section 3.

The ESRB has identified several areas where legislative action by the European Commission is needed to support financial stability and the CMU.⁽⁶⁾ The actions are split into two blocks according to their priority: those to be implemented during the first half of the legislative term (near term) and those to be implemented during the second half of the legislative term (medium term). Areas that the ESRB considers of high priority and where it therefore sees a need for near-term action are those where the ESRB has previously highlighted gaps that need to be closed (Section 2) and those that relate to data (Section 3). The ESRB believes that the actions relating to cooperation (Section 3) and to the three activities described above (Section 4) should be implemented in the medium term as they require more preparatory work. These actions are set out below and summarised in an overview table at the end of this executive summary. The ESRB is mindful that legislative changes resulting from any of these proposed actions would as a matter of course be preceded by a cost-benefit analysis conducted by the European Commission. Beyond these actions, the ESRB also encourages the European Commission to make use of the conceptual approach described in Section 1 in its regular reviews of legislation or when considering new legislation.

1. Near term

• Address vulnerabilities in EU MMFs – Section 2, Policy Digest 1. Vulnerabilities in MMFs remain unaddressed and continue to pose risks to financial stability. While these vulnerabilities are being addressed in the United States and the United Kingdom, the EU is falling behind international regulatory developments. It is key that the European Commission expedites reforms to the MMF Regulation and that these reforms reflect the recommendation of the ESRB and the opinion of the European Securities and Markets Authority (ESMA). These include increasing liquidity requirements and abolishing amortised cost accounting for MMFs.
• Progress the work to address vulnerabilities in investment funds – Section 2, Policy Digest 2. The regulatory and supervisory framework for investment funds continues to improve, but further efforts are required to reduce liquidity and leverage-related risks. The ESRB is exploring new policy tools to mitigate liquidity risk from a financial stability perspective and enhance investment fund resilience. These include tools that would give authorities the power to mitigate liquidity risk in a similar way that Article 25 of the Alternative Investment Fund Managers Directive (AIFMD) enables them to address risks associated with leverage. Once this work is finalised, the ESRB will communicate its conclusions to the European Commission. In the meantime, in order to mitigate risks associated with excessive leverage, the European Commission should revisit metrics and limits prescribed in the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive and AIFMD.
• Implement proposals and recommendations by international bodies on margining to ensure liquidity preparedness for margin calls – Section 2, Policy Digest 3. The Basel Committee on Banking Supervision (BCBS), the Committee on Payments and Market Infrastructures (CPMI), the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB) are finalising several proposals and recommendations, covering both centrally cleared and bilaterally cleared derivatives and securities markets, to ensure that participants in these markets are better prepared to meet margin calls, particularly when margin requirements surge in times of stress. It is important that the European Commission reviews whether EU legislation needs to be enhanced to fully reflect these proposals and recommendations and proceeds accordingly.
• Clarify the regulatory perimeter for crypto activities – Section 2, Policy Digest 4. The Markets in Crypto-Assets Regulation (MiCAR) has laid the groundwork for regulating parts of the crypto market. This initiative should be pursued in the next legislative review to address the activities and related risks left unregulated in segments of the crypto markets. This is because several crypto activities mirror activities performed in traditional finance without a comparable regulatory framework. One way to ensure greater consistency would be to extend MiCAR to activities involving crypto-assets that it does not yet fully cover, such as lending and decentralised finance. This would also mean clarifying how decentralisation should be assessed and distinguishing the line between fully and partially decentralised finance. Another way – provided crypto-assets become widely adopted – would be to regulate them in the same way as the traditional finance activities they are mirroring. The regulation of these activities could also apply when they are carried out in a fully decentralised way. The feasibility of this will be assessed by the European Banking Authority (EBA) and ESMA for a report that the European Commission will deliver to the European Council and the European Parliament.
• Harmonise the classification of crypto-assets across EU Member States – Section 2, Policy Digest 4. The definition of a financial instrument is not harmonised across Member States, which leads to differences in how crypto-assets are classified. As the Markets in Financial Instruments Directive (MiFID) is a directive, its definition of financial instruments has not been transposed into national laws in a fully harmonised way. This situation will be partially addressed by forthcoming ESMA guidance for national competent authorities (NCAs) on the criteria for classifying crypto-assets as financial instruments. However, there may be a need to harmonise the classification of financial instruments and crypto-assets in level I legislation. As there is also uncertainty about the legal status of crypto deposits at EU level, similar considerations apply.
• Ensure that authorities have the data and analytical resources they need – Section 3, Chapter 1. To address risks to financial stability, authorities need (i) more comprehensive and better-quality data, (ii) easier access to data, and (iii) more resources to analyse data. To ensure more comprehensive data, a joint monitoring mechanism like the one established under the European Market Infrastructure Regulation (EMIR 3.0) might be a model to close data gaps and allow the ESRB to develop further policy proposals for the activities of asset management, clearing and lending. To improve data quality, the ESRB sent a letter⁽⁷⁾ to the European Commission in July 2022 pointing out that persistently poor data quality poses risks to financial stability. The letter made several proposals to improve the situation. To improve access to data, the ESRB sent a letter⁽⁸⁾ to the co-legislators in August 2024 stressing the need for “access by default”. In the letter, the ESRB expressed its opinion that enhanced data sharing between the European System of Financial Supervision (ESFS) as proposed by the European Parliament in March 2024 would improve the situation. To harness increasing volumes of valuable data using sophisticated analytical tools, authorities also need the financial resources to invest in IT and human capital. This should be adequately reflected in the budget of the European Supervisory Authorities (ESAs).

2. Medium term

• Consider how reciprocity under Article 25 of the AIFMD could be implemented – Section 3, Chapter 2. Recent experiences with implementing leverage limits under Article 25 AIFMD have highlighted the importance of engagement between Member States and coordination to ensure the effectiveness of these measures. Given the cross-border nature of the investment fund sector, a reciprocation framework – coordinated by ESMA – is needed to ensure that alternative investment funds (AIFs) do not have an incentive to move to different jurisdictions to avoid regulation and would help ensure consistency across the EU in the implementation of such measures. Such a framework is already applied to banking but would need to be adapted to reflect the higher levels of cross-border activity in the investment fund sector.
• Review existing arrangements for policy cooperation across the EU – Section 3, Chapter 2. It is important that the European Commission reviews existing arrangements for policy cooperation concerning NBFI entities to ensure that they remain fit for purpose and promote the CMU. To do this in a consistent manner, the European Commission should develop a methodology to guide its approach. The ESRB has sketched out a methodology that could inform the European Commission. In line with this methodology, the ESRB believes that – in general – the wider the geographical impact and the reach of policies, and the more systemic the risks are at a European level, the greater the case for more cooperation at the European level and for giving enhanced powers, which may include direct supervisory powers, to the ESAs.
• Assess and work on the conditions for enabling the ESAs to supervise the most systemically relevant cross-border actors in financial markets – Section 3, Chapter 2. It is important that the European Commission follows up on the conclusions of the European Council of 17 and 18 April 2024, which invite the European Commission to assess and work on the conditions for enabling the ESAs to effectively supervise the most systemically relevant cross-border capital and financial market actors. The ESRB believes the methodology that it has sketched out might be helpful for the European Commission and that further analysis should be done to outline the systemic importance of different categories of NBFI entities.
• Enhance transparency in asset management activities and better incorporate a macroprudential perspective in associated regulation – Section 4, Chapter 3. In addition to investment funds, asset management is performed in various forms by several entities, some of which are exposed to similar vulnerabilities as those in investment funds. Current regulation does not sufficiently account for their potential impact on financial stability, and some entities are not subject to any prudential EU-wide regulation. To enhance financial stability, the European Commission should consider expanding the regulatory perimeter and introducing reporting requirements for more opaque forms of asset management. Depending on the findings drawn from these data, it should also consider introducing ABR that would establish common minimum standards for disclosure, risk management and governance, as well as adapting Article 25 AIFMD to give authorities powers to limit leverage and liquidity mismatches. Given the global nature of asset management activities, the European Commission should – through its participation in the FSB and other global fora – promote the need to enhance transparency, develop a macroprudential perspective and address risks associated with asset management activities beyond investment funds.
• Incentivise the central clearing of government bond cash and repo markets – Section 4, Chapter 4. The functioning of government bond cash and repo markets is critical for the financial system, including for NBFI entities, whose footprint in these markets has been growing. These markets have experienced several episodes of illiquidity and dysfunction in recent years. The European Commission should consider introducing margin requirements in bilaterally cleared government bond cash and repo transactions and ways to facilitate the central clearing of such transactions. This would incentivise a move to central clearing, thereby reducing the risk of episodes of illiquidity and funding stress, and contribute to a much-needed strengthening of the resilience of these markets.
• Establish ABR that would enable authorities to set (i) borrower-based measures (BBMs) and (ii) exposure concentration limits on highly indebted firms – Section 4, Chapter 5. BBMs are intended to reduce the risk of excessive credit growth and counterparty risk and should be applicable to all lending to households and non-financial corporations (NFCs), regardless of the provider. This should be developed in different phases. First, a legal framework should be created regarding BBMs for residential real estate (RRE) loans to households. Second, after an analysis of the practical feasibility of BBMs for loans to NFCs, the legal framework should be expanded to include commercial real estate (CRE) loans to NFCs, and eventually to other NFC loans. Finally, the feasibility of also capturing market-based finance with BBMs should be studied to avoid circumvention of any measure applied to loans through bond issuance. The measures should be calibrated and activated by the relevant national authorities. Similarly to BBMs, exposure concentration limits on highly indebted firms would address excessive credit growth and counterparty risk.

Endnotes

⁽¹⁾ References in the executive summary are limited to key documents. More detailed references are provided in the introduction and later sections.

⁽²⁾ See European Systemic Risk Board (2016a).

⁽³⁾ See European Systemic Risk Board (2022b).

⁽⁴⁾ The term “entity” is used akin to the term “sector”. It refers to a group of firms with the same core business model rather than individual firms within that group. For example, banks and insurers are considered different types of entities, and the term entity is used to refer to all banks or to all insurers.

⁽⁵⁾ See Lagarde (2023).

⁽⁶⁾ Although it is important that the EU Commission follow up on the areas identified, this response does not constitute an ESRB recommendation in the form of Article 16 of Regulation 1092/2010 of the European Parliament and of the Council of 24 November 2010 on European Union macro-prudential oversight of the financial system and establishing a European Systemic Risk Board (OJ L 331, 15.2.2010, p.1). This response is therefore not subject to the corresponding “comply or explain” mechanism, as set out in Article 17 of the same Regulation.

⁽⁷⁾ See European Systemic Risk Board (2022c).

⁽⁸⁾ See European Systemic Risk Board (2024d).