ESMA Assesses Trends, Risks, and Vulnerabilities in Financial Sector
ESMA published the second trends, risks, and vulnerabilities report for 2020. The report analyzes the impact of COVID-19 on financial markets during the first half of 2020 and highlights the risk of a potential decoupling of financial market performance and underlying economic activity, which raises the question of the sustainability of the current market rebound. In context of the impact of pandemic, the report also discusses securitization market, including collateralized loan obligations (CLOs), and developments in the areas of ESG (environmental, social, and governance) and cyber risks.
As highlighted in the report, in terms of the initial impact of COVID-19 on financial markets, ESMA saw the financial market go through three stages. First stage was a liquidity and volatility period (mid-February to end-March) where markets, investment funds, and infrastructures faced high levels of stress. Then, in the rebound period (early to end-April) markets grew swiftly on the back of policy actions and, finally, in the differentiation stage (starting early May), where credit and solvency risk came to the fore, investors started to differentiate between issuers and asset classes amid ongoing deterioration of economic fundamentals. During the recovery, there have been signs of differentiation across sectors. As of end-June, EU banking sector index is still 30% below its early January level, against 11% for the EU aggregate index. Bank lending increased by almost 10% with respect to the previous quarter and the increase in bank loans is linked to government guarantee schemes for new loans, which are granted by financial institutions to non-financial corporates so that they can support their businesses throughout the crisis.
As the market environment remains fragile, ESMA sees a prolonged period of risk, to institutional and retail investors, of further—possibly significant—market corrections and sees very high risks across the whole of the ESMA remit. The extent to which these risks will further materialize will critically depend on two drivers: the economic impact of the pandemic and any occurrence of additional external events in an already fragile global environment. The impact on EU corporates and their credit quality, and on credit institutions, are of particular concern, as are growing corporate and public indebtedness, along with the sustainability of the recent market rebound. The report also contains an article that explores the approaches to modeling CLO credit risk adopted by the three main Credit Rating Agencies. The article emphasizes that benefits of securitization depend on its ability to effectively engineer and limit credit risk, in addition to discussing the differences and limitations in approaches and how these might potentially affect credit rating accuracy.
The report highlights that ESG-oriented assets such as benchmark equity indices and funds have outperformed their non-ESG peers again in the first half of 2020. Investor appetite for ESG funds remained high, with net inflows in the first half of 2020 compared with large net outflows for the rest of the equity fund industry. The green bond market continued to expand, even as some agency and supranational issuers shifted their focus to social bonds to tackle the socio-economic consequences of COVID-19 pandemic. Green bond liquidity is improving despite a deterioration in corporate bid-ask spreads in March and April, in line with the broader bond market developments. Additionally, COVID-19 lockdowns are expected to accelerate digitalization of financial services. While positive from an efficiency perspective, this may accentuate risks, such as cyber risk, high market concentrations among data service providers, and fragilities in the fintech sector. Crypto assets were not spared from the COVID-19 turmoil and “global stablecoins” continue to be under close scrutiny by central banks and regulators.
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Keywords: Europe EU Banking Insurance Securities COVID-19 Credit Risk Market Risk Fintech Cyber Risk Collateralized Loan Obligations, ESG, Sustainable Finance, ESMA
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