The Joint Committee of the European Supervisory Authorities (the “Committee”) has recently published a report on risks and vulnerabilities in the EU financial system.
The UK’s decision to leave the EU highlights uncertainties in the EU financial systems. For banks, low interest rates are linked with no/low profitability and income remains under pressure. Pension funds and life insurers are seeing increases in their liabilities due to low interest rates, and they are finding it more of a challenge to generate high investment returns, that are low risk. Non-banking entities have continued to grow ie. through new technological innovations in investment funds, but with this comes the need for increased supervisory measures and potentially greater risks for investors.
The financial services industry is finding it increasingly difficult to offer an adequate level of profitability to investors and so is looking for different and often riskier ways to achieve it. Therefore, it is important that the supervisory community adopts a forward-looking perspective that helps the industry adapt its business models. The report suggests a number of measures that will help supervisors address the identified risks.
Low growth and low yield environment
Economic growth, although subdued has not been dominated by the fear of entering recession, and in fact, stress tests in the banking sector published by the EBA show there is resilience to any potential adverse economic scenarios. However, it cannot be ignored that share prices have decreased since the start of the year and profitability is affected.
Pension funds liabilities are more expensive to fund and the low interest rate increases reinvestment risk. In the future, it could significantly lower pension benefits for participants in pension schemes. The Committee note that to mitigate against this, they are considering carefully monitoring financial industries, carrying out stress testing and preparing resolution arrangements for undesirable scenarios.
Search for yield
As financial institutions seek to increase their yield, higher returns are sought through more riskier investments ie. less liquid ones. This trend is likely to promote the further growth of the fund industry, as yields are sought in areas such as unit-linked and market-based products. However, with this comes the need to ensure that fund managers manage their liquidity carefully.
In the banking sector, there has been a relaxation of credit standards, which although has been necessary to promote lending, can increase risks and increase the likelihood of financing borrowers with lower ability to pay.
The above concerns raise the need for more supervisory oversight and possibly stress testing for investment funds.
Profitability of financial institutions
- Banks: low quality assets and competition from non-banking financial institutions are factors affecting profitability. So far banks have not been able to offset falling interest income with higher fees and commissions but reducing their costs is proving difficult. The Committee point out that one solution could be for banks to make changes quickly and decisively. Adjustments to current business models must be made in order to ensure that banks remain viable in the long term.
- Insurance sector: the sector is likely to face increased competition due to innovations in IT, ie. peer to peer insurance, which will lead to increased consumer choices, but potentially reduced profitability in the longer term. However, technological advances could offer insurance firms a strategic opportunity to improve products and engage more with customers.
- Asset managers: investment returns are subdued and returns rates for most fund categories have entered negative territory. Such profitability trends reduce the attractiveness of the industry to investors. The rise of Fintech through automated financial advice and crowdfunding is likely to challenge the sustainability of current asset management business models. Technological innovations increase competition and lower costs for consumers, but the Committee is considering what levels of investor protection are needed in context of technical innovations.
Interconnectedness within the financial system
The use of market infrastructures continued to intensify and in the financial system outside of banks, insurers and pension funds, continued to grow. Whilst market infrastructures serve to connect financial markets, their role in contributing to a stable financial economy requires careful management of their risk profiles.
The majority of asset managers is dominated in most EU markets by parent companies belonging to the banking or insurance industry, while in several member states the biggest five incumbents of the asset management sectors control more than 50% of respective national markets. Whilst such consolidation may increase diversification, it can also increase risks such as public relationship incidents and technological issues. Supervisory approaches to tackle related risks include the ESAs’ identification of financial conglomerates throughout the EU and the ESAs’ joint efforts on consistency of supervisory practices for financial conglomerates.
With the increase in financial institutions managing funds outside the remit of banks, pension funds and insurers, comes the challenge for supervisory bodies to ensure that they adequately stress test and scrutinize such financial institutions to ensure that any risks to the consumer are mitigated.
To access the full report please click here. For any assistance on any of the issues raised, Cleveland & Co, your External In-house Counsel, are here to help.