ESA Report Highlights Risks of No-Deal Brexit in EU Financial System
ESAs published a Joint Committee report on risks and vulnerabilities in the EU financial system. The 2019 Autumn report highlights certain risks, such as the uncertainties around Brexit, low interest rate environment risk, and climate change risks, as potential sources of instability. The need to prepare for the impact of a no-deal Brexit on financial activities continues to require attention from the public and private sector in light of the postponement of the Brexit date to October 31, 2019. Although there seems to be a “Brexit fatigue” in the financial sector, supervisors continue to encourage institutions to prepare contingency plans for a no-deal Brexit and have themselves set further steps in motion to minimize the negative impact of Brexit on financial markets.
In light of the ongoing uncertainties, especially those around Brexit, supervisory vigilance and cooperation across all sectors remains key. Therefore, ESAs call for the following key policy actions by European and national competent authorities as well as financial institutions:
- Contingency planning. Financial institutions and supervisors should continue their work on contingency planning and assurance of business continuity in the case of a no-deal Brexit. Contingency plans should be implemented by October 31, 2019 at the latest. Considering the variety of measures undertaken by ESAs and national supervisory authorities and other competent authorities, the EU financial sector should be well-informed and prepared to manage risks from a micro-perspective. ESAs will continue to closely monitor the ongoing political and market developments and will consider the need for further communications on that basis.
- Low-for-long interest rate scenario. Supervisors and financial institutions should continue taking into account a "low-for-long" interest rate scenario and the associated risks. Low interest rates are an important driver of low bank profitability and remain the main risk for the insurance and pension fund sectors. They contribute to the further buildup of valuation risks in securities markets as well as to a move into less liquid and more leveraged investments through search-for-yield strategies.
- Bank profitability. There is a need to further address unprofitable banks and their business models to increase the resilience of institutions to a more challenging economic environment. Further investments into financial technologies and exploring opportunities for bank sector consolidation are among responses to low profitability. Transparency and a consistent application of common prudential requirements and supervisory rules across jurisdictions are the preconditions that could contribute to the use of opportunities that cross-border consolidation may offer.
- Leveraged lending market. Risks related to the leveraged loan market and collateralized loan obligations (CLOs) in the financial sector should be further explored and identified. There is a lack of clarity about the total volume of leveraged loans outstanding and about the ultimate holders of risks of many CLO tranches. Supervisors have raised concerns about a possible under-pricing of risks.
- Sustainable finance and Environmental, Social, and Governance (ESG) risks. Supervisory authorities and financial institutions should continue their work on identifying exposures to climate related risks and facilitate access of investors to sustainable assets. Scenario analysis and stress testing are important tools that can be implemented by supervisors, with a goal to incorporate sustainability considerations into risk assessment. Financial institutions should incorporate climate risk and other ESG factors into their risk management framework and should play a stewardship role by taking into account the impact of their activities on ESG factors. Going forward, ESAs should take a proactive stance in fulfilling mandates on sustainable finance, including on how ESG considerations can be incorporated into the regulatory and supervisory framework of EU financial institutions.
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Keywords: Europe, EU, Banking, Insurance, Securities, Pensions, Brexit, Interest Rate Risk, Climate Change Risks, ESG, ESAs
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