ESRB published the fifth issue of the EU Non-bank Financial Intermediation Risk Monitor 2020 (NBFI Monitor). This issue considers a range of cyclical and structural risks and vulnerabilities in the non-bank financial intermediation sector, including those stemming from interconnectedness, liquidity, and leverage. This issue of the NBFI Monitor focuses on data up to end-2019, but also considers market developments at the onset of COVID-19 pandemic in early 2020. These developments include the use of liquidity management tools in EU investment funds, developments in money market funds and developments in corporate bond exchange-traded funds.
The NBFI Monitor assesses risks and vulnerabilities using an entity-based monitoring framework, which considers both investment funds and other financial institutions such as financial vehicle corporations, security and derivative dealers, and financial corporations engaged in lending. The analysis is complemented by an activity-based assessment considering risks and vulnerabilities in securities financing transactions, derivatives, and securitizations, which are used across entities and where risks can arise from the use and reuse of financial collateral. The key cyclical risks that will require close monitoring include:
- Sharp contraction of economic activity in the EU and globally and an uncertain economic outlook
- Rising indebtedness, increased credit risk, and an expected rise of rating downgrades
- Increased share of negative yielding assets and interest rates that are expected to stay low for longer
- Subdued liquidity and increased volatility in some markets
In addition, several structural risks require ongoing monitoring and these include:
- Risk-taking, liquidity risk, pricing uncertainty, and risks associated with leverage among some types of investment funds and other non-bank financial institutions
- Domestic and cross-border interconnectedness and the risk of contagion across sectors and within the non-bank financial sector, including domestic and cross-border linkages
- Activities-related risks—procyclicality, leverage, and liquidity risk—created through the use of derivatives and securities financing transactions
- Data gaps, including the need to develop new and improved risk metrics as new datasets become available
The NBFI Monitor highlights that the use and reuse of financial collateral in derivatives and securities financing transactions can create intermediation chains through which funding liquidity shocks can spread. In the event of an abrupt fall in the value of securities used as collateral, lenders can be prompted to demand additional collateral, possibly forcing borrowers to sell assets to post the additional collateral. Investment firms and credit institutions dominate the EU derivatives market and large volumes of derivative transactions have created a complex and interdependent network of exposures that ultimately may contribute to a build-up of systemic risk. Derivatives exposures increase liquidity needs for investment funds and the rapid decrease in asset prices and increased volatility in early 2020 following the COVID-19 shock resulted in a sudden increase in initial and variation margins.
Keywords: Europe, EU, Banking, Securities, Insurance, NBFI, Liquidity Risk, NBFI Monitor, Systemic Risk, Procyclicality, COVID-19, ESRB
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