Hearing before the Committee on Economic and Monetary Affairs of the European Parliament

Introductory statement of Mario Draghi, Chair of the ESRB,
Brussels, 29 May 2017

It is a pleasure to address you today in my capacity as Chair of the European Systemic Risk Board (ESRB).

The ESRB’s unique, Union-wide, cross-sectoral perspective allows us to identify and to work to mitigate risks resulting from the ongoing changes to the structure of the financial system. These changes provide many opportunities to finance the real economy, but as financial intermediation continues to shift from banks to non-banks, there is a need to identify migrating risks and emerging vulnerabilities. Moreover, we need to develop tools which would mitigate risks to financial stability, regardless of where those risks might materialise in the financial system. Macroprudential policy works best when it is implemented in time to enhance resilience and mitigate any build-up of vulnerabilities in the financial system. In this context, I would like to highlight the ESRB’s work on systemic risks beyond banking.

EU Shadow Banking Monitor

I am pleased to inform you that today the ESRB is publishing the second EU Shadow Banking Monitor.[1] This report is a key element of the ESRB’s risk monitoring framework, which casts the net wide when mapping shadow banking entities and activities.

Let me start by giving you some figures. The broad shadow banking system, comprising the total assets of investment funds (including money market funds) and other financial institutions, and therefore including all entities of the financial sector except banks, insurance corporations and pension funds, represented around 38% of the total assets of the EU financial sector at the end of 2016. Although the growth in broad EU shadow banking assets slowed in 2016, it has expanded by 30% since 2012. Its interlinkages with the other parts of the financial sector are also significant. Therefore, macroprudential authorities need to watch out for the new risks and vulnerabilities emerging in these parts of the financial sector.

The EU Shadow Banking Monitor highlights several risks which require our attention. Liquidity, leverage, procyclicality and interconnectedness are the main themes discussed in this report.

I will begin with liquidity risk and the risks associated with leverage among some types of investment funds. Here I am mainly referring to investment funds which either invest in less liquid assets while offering daily redeemable shares, or which are highly leveraged. Excessive leverage can act as an amplification channel during periods of financial system stress and lead to fire sales, while liquidity mismatch can also increase risks to financial stability as price movements are intensified when assets are sold in less liquid markets. Moreover, leverage and liquidity risks are intertwined and can magnify stress in the financial system. Leveraged investment funds are more sensitive to changes in asset prices, stress conditions may force them to deleverage by selling assets in order to obtain liquidity. Abrupt deleveraging typically involves fire-sale feedback loops where there is a risk of liquidity shocks spreading through the underlying markets. Therefore, given that the investment fund sector is growing relative to the financial system as a whole, the ESRB is analysing systemic risks posed by liquidity mismatch and leverage in the types of investment funds exposed to these risks. I hope to report on this work in more detail at one of our next meetings.

Leverage and liquidity risk, together with procyclicality, also need to be closely monitored in the context of the use of derivatives and securities financing transactions (SFTs). In derivatives transactions, counterparty credit risk is reduced by collateralising exposures through margins, while collateral also plays a central role in SFTs. Haircuts further protect the surviving counterparty against a fall in the value of the collateral provided in case of default. Margins and haircuts thus contribute to financial stability by absorbing losses and helping to manage financial risk. They also limit the build-up of leverage. For example, the size of the haircut on SFT collateral determines the amount of funding which can be obtained for a given amount of collateral. Margins and haircuts can, however, also be strongly procyclical. At lower levels in good times, they allow the build-up of leverage. When they increase in a downturn, they can lead to forced deleveraging and even trigger negative liquidity spirals. In this context, the ESRB recently published a report[2] that considers a number of potential macroprudential tools that target margin and haircut requirements. The ESRB also identified practical challenges in implementing such tools that need to be addressed and therefore require further work.

Finally, the EU Shadow Banking Monitor identifies interconnectedness and contagion risk, both across different parts of the financial sector and within the shadow banking system, as potential channels for amplifying systemic stress. Interconnectedness, as a natural feature of an integrated financial system and a reflection of financial intermediation flows, may take many forms. It needs to be monitored given its potential to act as contagion paths in periods of financial stress.

The European Market Infrastructure Regulation (EMIR) has given us access to comprehensive data on derivatives transactions. These data will enable the ESRB to take an EU-wide perspective and examine risks related to derivatives markets across entities. To this end, the EU Shadow Banking Monitor, building on the first analysis of the EMIR data[3], examines linkages between shadow banking entities in derivatives markets. It finds that non-bank financial institutions are taking a substantial proportion of outstanding trades (measured by gross notional outstanding value) in the three largest derivatives markets, i.e. interest rate, foreign exchange and credit derivatives markets, amounting to 7%, 19% and 10% respectively[4]. Additionally, the report examines the landscape of counterparties with whom non-bank financial institutions engage in derivatives transactions.

The EU Shadow Banking Monitor also shows that 60% of EU banks’ exposures to shadow banking entities are to non-EU domiciled entities. In particular, the analysis shows the strong linkages between EU banks and US-domiciled shadow banking entities. These findings highlight the global and cross-border interconnectedness of the banking and shadow banking systems and the need for international cooperation in monitoring and addressing cross-sectoral risks.

The risk monitoring framework for the shadow banking system has benefited from recent regulatory reforms and data advances, and is already taking shape. But challenges still remain. For instance, additional efforts are required to close the remaining data gaps so as to enable cross-border and cross-sectoral risks to be mapped consistently, and to provide a more holistic view of all entities engaged in shadow banking. In addition to having more granular data, the risk assessment of shadow banking would also benefit from data being available on a consolidated and non-consolidated basis.

I have given you an overview of the risks highlighted by the EU Shadow Banking Monitor. Let me conclude with some observations as regards macroprudential policy in general.

Macroprudential policy beyond banking

Considerable progress has been made in analysing the non-banking sector. Let me give you an additional example: EIOPA conducted its first EU-wide occupational pensions stress test in 2015 and has recently launched its second such test, to which the ESRB contributed by preparing the adverse scenario, in close cooperation with EIOPA and the ECB. However, macroprudential policy beyond banking is still at a formative stage. While some instruments already exist for specific purposes, a comprehensive and flexible macroprudential toolkit needs to be established. I have already mentioned instruments such as margin and haircut requirements for derivatives and securities financing transactions, as well as liquidity and leverage requirements for investment funds. These should all be further investigated and, where appropriate, the regulatory framework should be expanded. Moreover, the design of recovery and resolution regimes for central counterparties and insurance corporations should have a macroprudential profile. The ESRB has raised these issues in its response to the European Commission’s consultation on the review of the macroprudential policy framework, and it continues to work on these topics. It is important to give the macroprudential authorities the appropriate tools so that they can act in time and prevent any build-up of systemic risk.

Review of macroprudential policy in the EU in 2016

Finally, let me underline that the national institutional frameworks of macroprudential policy are of paramount importance for the policy to be effective. So I am pleased that we are seeing progress in this regard: in the 2 Member States with no macroprudential authority the legislative process is ongoing. The macroprudential authorities actively used the available instruments in 2016, in particular to meet the requirements of the CRD IV/CRR package, but also to address the vulnerabilities in the residential real estate sector, which I talked about when we last met. The ESRB’s recently published review of macroprudential policy takes stock of the measures adopted in the EU in 2016.[5]

Thank you for your attention. I am now available for questions.

[1] ESRB (2017), EU Shadow Banking Monitor.

[2] ESRB (2017), The macroprudential use of margins and haircuts.

[3] See Abad J., I. Aldasoro, C. Aymanns, M. D'Errico, L. Fache Rousová, et al. (2016), Shedding light on dark markets: First insights from the new EU-wide OTC derivatives dataset, ESRB Occasional Paper Series No 11.

[4] These figures refer to representative sub-samples of the three derivative markets as of 2 November 2015. See ESRB (2017), EU Shadow Banking Monitor for further details.

[5] ESRB (2017), A Review of Macroprudential Policy in the EU in 2016.