What do the European Supervisory Authorities see as the current risks in the financial system?

The Joint Committee of the European Supervisory Authorities (ESAs) has released its latest report, highlighting risks of a no-deal Brexit and search for yield.

Its Risks and Vulnerabilities in the EU Financial System report explores uncertainties of Brexit, the pressure place on profitability and returns due to low interest rates and flattening yield curves, and  transition to a more sustainable economy and environmental, social and governance related risks.

As a result, the regulators have issued policy actions which European and national competent authorities (NCAs) and financial institutions should take.

Its first advice is that financial institutions and supervisors should continue contingency plans and assurances of business continuity following a no-deal Brexit. Following the work of the ESA and NCAs, it believes the EU financial sector should be well informed and prepared to manage risks from a micro-perspective.

The ESA will continue to monitor political and market developments and decide if further communication is needed.

Another recommendation from the ESA is that supervisors and financial institutions should continue taking into account a “low-for-long” interest rate scenario and associated risks.

Low interest rates are a key component of low bank profitability and are a main risk for the insurance and pension fund sectors. It contributes to a build-up of valuation risks in the securities markets as well as to a move into less liquid and more leveraged investments via a search-for-yield strategy.

The ESA believes that convergent application of rules on liquidity management and eligible assets, and consistent use of stress testing are important supervisory tools.

Also outlined in its report is that there is further need to address the unprofitable banks and their business orders to improve the resilience of financial institutions during turbulent times. Increasing investments into FinTech and exploring opportunities of bank sector consolidation are some of the responses to this.

Aspects such as transparency, consistent application of common prudential requirements and supervisory rules across jurisdictions are preconditions of what cross-border consolidation could offer.

The ESA also stated that risks around the leveraged loan market and collateralized loan obligations (CLOs) should be explored further. It feels there is a lack of clarity around the total volume of leveraged loans outstanding and about ultimate holders of risks for many CLO tranches.

Finally, the ESA believes supervisory authorities and financial institutions should continue identifying exposures to climate related risks and facilitate access of investors to sustainable assets. Scenario analysis and stress testing are great tools for supervisors looking to increase sustainability considerations into risk assessments, it said.

The ESA believes all financial institutions should incorporate climate risk and other Environmental, Social, and Governance (ESG) factors into their risk management framework. The regulators will begin to take a proactive stance in fulfilling mandates on sustainable finance. This includes exploring how ESG could be incorporated into regulatory and supervisory frameworks.

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