What Irish investment funds might expect from macroprudential regulations

The Central Bank has said the development of such a framework is a priority for it in the coming years with the initiative the latest trailed in the EU in the name of financial stability.

Opponents to the macroprudential regulation of investment funds are of the opinion that investment funds do not impose systemic risk and consequently that regulation for this purpose is not justified. In spite of differing perspectives, EU supervisory authorities are examining the extent to which non-bank financial intermediaries (NBFIs), which includes investment funds, should be regulated for the purposes of achieving financial stability. The Central Bank is leading European policy discussions on this matter.

Components of a macroprudential framework for investment funds will likely focus on three key issues: liquidity management and the removal of liquidity mismatches; prevention of excessive buildup of leverage; and management of the interconnectedness and transmission of market disruption in the investment funds sector to the real economy.

Liquidity management

The issue of liquidity management has been on the regulatory agenda for years, but work in this area has recently accelerated. At present, there are several policy initiatives that may lead to changes in the manner that liquidity management tools (LMTs) are deployed by investment funds. This includes: ESMA’s consultation paper setting out draft regulatory technical standards on LMTs under the AIFMD II Directive; the Central Bank’s assessment of the use of price-based LMTs by fund managers and its analysis of the responses to its industry questionnaire on the use of LMTs, and; the European Commission’s targeted consultation on the adequacy of macroprudential policies for NBFIs.

The draft regulatory technical standards published by ESMA on LMTs are broadly consistent with the Irish regulatory framework, however there are some notable differences – such as the requirement that the suspension of subscriptions and redemptions be applied simultaneously and that redemption fees be levied in favour of the investment fund. If adopted, the current draft regulatory technical standards will remove discretion to accept subscriptions while an investment fund is closed for redemptions and will remove the flexibility to pay redemption fees to the manager of the investment fund’s service providers.

The Central Bank’s assessment of the use of price-based LMTs has yet to be concluded. Nonetheless, the scrutiny in relation to the application of price-based LMTs is likely to require fund managers to enhance their risk and governance frameworks in relation to dual pricing, swing pricing, and anti-dilution levies, as well as adopt policies in relation to trigger levels for the adoption of swing pricing and anti-dilution levies.

The recent target consultation by the Commission to analyse the adequacy of the macroprudential framework for NBFIs, including investment funds, is in its early stages and does not require a response from industry until 22 November 2024. While it is very early to speculate on the outcome of the consultation, there is a reasonable prospect that national competent authorities (NCAs) in the investment fund sector will be required to assess unmitigated liquidity mismatches and also for guidelines to be developed by ESMA for use by NCAs in relation to the conditions when binding directions should be given to fund managers on the use of specific LMT tools in relevant market conditions.

Leverage

Leverage restrictions seek to impose limits on the level of exposure of investment funds generally or in relation to a cohort of investment funds. If implemented appropriately, leverage restrictions should operate as a constraint on the formation of asset price bubbles and limit rapid asset price depreciation in times of deleveraging.

In the investment funds sector, there are already detailed reporting requirements on the use of leverage and there are various restrictions on the extent of leverage, for example in relation to loan origination funds, funds investing in Irish real estate and funds pursuing liability driven strategies (LDI funds). Restrictions on leverage are also accompanied by risk governance requirements, which require fund managers to manage counterparty exposure.

It is difficult to gauge how policy discussions on leverage restrictions for the purposes of financial stability will develop into investment fund rules. However, it is clear that the case for imposing leverage limits on the investment funds sector ought to be well founded.

Recent initiatives of the Central Bank that imposed leverage restrictions on investment funds investing in Irish real estate and on LDI funds suggest that the monitoring and oversight of leverage should be an ongoing supervisory issue. Furthermore, in relation to investment funds that invest across EU financial markets, macroprudential regulations should be determined and harmonised at an EU level.

Restricting the extent to which investment funds are permitted to be leveraged comes at a cost to the economy and doing so at a time when the financing needs of the real economy are acute – as noted in the recent report on the future of European competitiveness by Mario Draghi – means that in the absence of verifiable evidence that investment funds pose a risk to financial stability, this not an area that should be subject to further regulation.

A version of this article was originally published by Finance Dublin.