ESRB: Systemic Risk Oversight under AIFMD and MiFID for NBFI

ESRB’s December 2024 Update and Its Regulatory Context

On December 4, 2024, the European Systemic Risk Board (ESRB) released a critical update outlining its macroprudential approach to managing risks in the expanding non-bank financial intermediation (NBFI) sector. This report, in response to the European Commission’s targeted consultation, underscores the need for a robust regulatory framework under the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive (MiFID) to address systemic vulnerabilities and ensure financial stability.

NBFIs, including investment funds, pension funds, and insurers, now account for over 40% of the EU's financial assets, complementing traditional banks by providing market-based financing and risk diversification. However, their growing prominence also introduces systemic risks, such as liquidity mismatches and excessive leverage, which demand coordinated regulatory oversight under frameworks like AIFMD and MiFID.

Source

[1]

ESRB publishes report on system-wide approach to macroprudential policy

The European Central Bank (ECB) is the central bank of the 19 European Union countries which have adopted the euro. Our main task is to maintain price stability in the euro area and so preserve the purchasing power of the single currency.

European Central BankEuropean Central Bank

[2]

Commission launches consultation on macroprudential policies for Non-Bank Financial Intermediation

The objective of the consultation is to gather further insight into the markets and business models of NBFI, and the interconnectedness among them and with banks.

Finance

Role of AIFMD and MiFID in Regulating NBFI

The AIFMD governs alternative investment funds (AIFs), such as hedge funds and private equity funds, focusing on transparency, risk management, and investor protection. It mandates reporting requirements, risk mitigation measures, and leverage caps to ensure that these funds operate responsibly and contribute to financial stability. With NBFIs increasingly adopting complex investment strategies, the AIFMD framework is critical for addressing systemic risks posed by these entities.

Meanwhile, the MiFID regulates trading activities, including those involving derivatives and structured financial products. It emphasizes investor protection, market transparency, and the orderly functioning of financial markets. MiFID’s focus on trading platforms and market infrastructure directly impacts NBFIs, especially as they increasingly engage in activities traditionally dominated by banks, such as market-making and securities trading.

Systemic Vulnerabilities and Key Risks

The European Systemic Risk Board (ESRB) identifies critical vulnerabilities in the non-bank financial intermediation (NBFI) sector, underscoring the need for enhanced regulation under the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive (MiFID). These vulnerabilities, including liquidity mismatches, excessive leverage, interconnectedness, and inconsistent oversight, threaten both individual institutions and the broader financial system.

1. Liquidity Mismatches

Investment funds, particularly open-ended ones governed by AIFMD, frequently face liquidity mismatches when asset liquidity does not align with redemption terms. This was starkly evident during the COVID-19 pandemic, when money market funds (MMFs) experienced significant redemption pressures, requiring central bank intervention. Real estate and fixed-income funds, with their reliance on illiquid assets, are similarly vulnerable to forced asset sales during market stress, which can further destabilize markets.

Impact: Liquidity mismatches not only disrupt individual funds but can trigger broader financial instability. The 2022 UK liability-driven investment (LDI) crisis highlighted how such imbalances force asset sell-offs, amplifying market volatility and necessitating external intervention. Enhanced liquidity buffers, stress testing, and harmonized redemption controls under AIFMD are critical to addressing these risks.

2. Excessive Leverage

Despite leverage caps outlined under AIFMD, hidden leverage remains a significant concern in the NBFI sector. The Archegos Capital collapse in 2021 demonstrated the dangers of opaque derivative exposures, which, when unwound, caused widespread market disruptions and losses to global banks. MiFID’s transparency requirements, supported by the European Market Infrastructure Regulation (EMIR), help monitor derivatives trading, but gaps in real-time oversight hinder proactive risk management.

Impact: Excessive leverage amplifies systemic risks, leading to abrupt market sell-offs and cascading financial instability. The ESRB emphasizes stricter enforcement of leverage limits under AIFMD and enhanced monitoring of derivatives trading under MiFID to reduce these vulnerabilities.

3. Interconnectedness

The growing interconnectedness between NBFIs, traditional banks, and financial markets increases the risk of contagion. The 2022 UK gilt crisis illustrated how sudden margin calls led to widespread bond sell-offs, destabilizing both NBFIs and banks. MiFID’s regulations on securities financing transactions and repo markets are designed to manage these risks, but the ESRB highlights the need for stronger safeguards to prevent systemic spillovers.

Impact: Interconnectedness enables localized risks to propagate across the financial system, threatening stability. Strengthening MiFID’s oversight of interlinked markets and improving clearing mechanisms are critical to mitigating these risks.

4. Inconsistent Regulatory Oversight

Disparities in how AIFMD and MiFID are implemented across EU member states create an uneven regulatory landscape. Variations in national enforcement of leverage and liquidity requirements under AIFMD, coupled with inconsistent application of MiFID’s transparency rules, encourage regulatory arbitrage. This allows NBFIs to shift operations to jurisdictions with less stringent oversight, undermining macroprudential policies.

Impact: Regulatory inconsistencies weaken the overall stability of the financial system. The ESRB calls for harmonized supervision, reciprocity mechanisms, and standardized reporting under AIFMD and MiFID to address these gaps and ensure effective oversight across jurisdictions.

ESRB’s System-Wide Approach to Regulation

The European Systemic Risk Board (ESRB) advocates a comprehensive system-wide approach to managing systemic risks in the non-bank financial intermediation (NBFI) sector. This approach integrates entity-based regulation (EBR) and activity-based regulation (ABR), leveraging the frameworks of the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive (MiFID).

Entity-Based Regulation (EBR)

EBR focuses on addressing risks specific to financial institutions, such as investment funds, insurers, and pension funds. Under AIFMD:

• Leverage Caps: Limits are imposed to prevent excessive risk-taking that could destabilize markets.
• Liquidity Management: Fund managers are required to implement tools like stress testing and redemption controls to align asset liquidity with investor demands.

The ESRB recommends enhanced supervisory powers under AIFMD to strengthen enforcement. For instance, monitoring derivatives exposure and off-balance-sheet risks can ensure comprehensive oversight of complex strategies.

Activity-Based Regulation (ABR)

ABR targets systemic risks linked to financial activities, regardless of the entity performing them. Under MiFID:

• Margin Requirements: Stricter controls are proposed for derivatives trading to mitigate liquidity shocks, as evidenced by the UK gilt crisis.
• Transparency Standards: MiFID ensures trading activities, such as repo and securities financing transactions, are adequately monitored and reported to minimize spillover risks.

The ESRB stresses that ABR is critical for managing risks that transcend individual institutions, such as interconnectedness and excessive credit growth. By focusing on activities, ABR ensures consistent risk management across the financial system.

Integration of AIFMD and MiFID

The ESRB’s approach leverages the strengths of AIFMD and MiFID:

• AIFMD addresses fund-specific risks, including leverage and liquidity, critical to ensuring the stability of investment funds.
• MiFID enhances market transparency, protects investors, and provides robust oversight of trading platforms and financial instruments.

By aligning these frameworks, the ESRB aims to create a cohesive regulatory environment that reduces systemic risks and promotes financial stability.

Priority Reforms and Legislative Action

The European Systemic Risk Board (ESRB), in coordination with the European Commission, has outlined immediate and medium-term reforms to address systemic risks in the non-bank financial intermediation (NBFI) sector. These reforms enhance regulatory oversight under the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive (MiFID), with a focus on resilience, transparency, and harmonization.

Immediate Actions

1. Reform Money Market Funds (MMFs):
   • Strengthen liquidity buffers and redemption controls to reduce vulnerability to market stress.
   • Implement advanced stress-testing tools to monitor MMFs under adverse scenarios.
2. Enhance Investment Fund Resilience:
   • Introduce stricter leverage controls and harmonized liquidity management tools under AIFMD.
   • Ensure consistent application of risk-monitoring frameworks to reduce regulatory arbitrage.
3. Harmonize Crypto-Asset Regulation:
   • Define a clear regulatory perimeter for crypto-assets under the Markets in Crypto-Assets Regulation (MiCAR).
   • Align transparency and reporting standards for crypto activities with MiFID’s requirements.
4. Strengthen Supervisory Collaboration:
   • Improve data sharing among national and EU regulators to enable cross-sectoral risk assessments and coordinated crisis responses.

Medium-Term Actions

1. Develop Reciprocity Mechanisms in AIFMD:
   • Ensure uniform enforcement of leverage and liquidity requirements across member states to prevent regulatory arbitrage.
2. Establish Borrower-Based Measures (BBMs):
   • Implement activity-based regulations for loan-to-value (LTV) and debt-to-income (DTI) limits to manage credit risks.
   • Introduce exposure concentration limits for highly indebted firms.
3. Encourage Central Clearing:
   • Incentivize central clearing of government bonds and repo markets to improve market liquidity during stress periods.
   • Leverage MiFID’s trade reporting data to monitor systemic risks in these markets.
4. Harmonize Data Collection and Reporting:
   • Align AIFMD and MiFID reporting frameworks to improve transparency and enable seamless regulatory cooperation.

By embedding these reforms into AIFMD and MiFID, the ESRB seeks to create a resilient macroprudential framework that reduces systemic risks while fostering stability and transparency in Europe’s financial ecosystem.

ESRB Reforms on AIFMD, MiFID, and Financial Institutions

The ESRB’s proposed reforms will significantly influence the regulatory frameworks of the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive (MiFID). By addressing systemic vulnerabilities in the non-bank financial intermediation (NBFI) sector, these changes will reshape operational practices across financial institutions, enhancing resilience and stability in the European Union’s financial markets.

Impacts on AIFMD

The AIFMD governs the operations of alternative investment funds (AIFs), focusing on transparency, risk management, and investor protection. ESRB’s recommendations propose enhanced measures under AIFMD to mitigate systemic risks, including:

1. Leverage Monitoring and Limits:
   • Current AIFMD provisions on leverage require fund managers to report their use of leverage and ensure compliance with national-level caps. ESRB proposes strengthening these measures by introducing stricter EU-wide leverage limits and enhanced oversight of derivatives exposures.
   • Fund managers will need to adopt real-time leverage tracking tools to prevent the buildup of excessive risk, particularly in high-leverage funds such as private equity and hedge funds.
2. Liquidity Management Enhancements:
   • ESRB’s reforms align with AIFMD’s requirements for stress testing and liquidity management tools. However, it recommends introducing additional safeguards, such as mandatory redemption fees during periods of market stress, to prevent investor runs.
   • Real estate funds and fixed-income funds, which often hold illiquid assets, will need to implement stricter liquidity buffers and longer redemption notice periods.
3. Expanded Supervisory Coordination:
   • ESRB suggests harmonizing supervisory practices across member states under AIFMD to eliminate regulatory discrepancies. This includes establishing reciprocity mechanisms to ensure that funds operating across borders comply with uniform leverage and liquidity standards.

Impacts on MiFID

The MiFID framework regulates trading practices and market transparency, with a focus on investor protection and the orderly functioning of financial markets. ESRB’s proposed reforms will enhance MiFID’s role in mitigating risks linked to market-based activities:

1. Transparency in Securities Financing Transactions: MiFID’s transparency requirements will be extended to include comprehensive reporting on repo markets and securities lending, activities that NBFIs frequently engage in. This will provide regulators with better visibility into interconnected risks and potential contagion channels.
2. Derivatives and Margining Practices: ESRB recommends revisiting MiFID rules on derivatives trading to incorporate stricter margining requirements. This will mitigate liquidity risks, especially during periods of heightened market volatility, as seen during the UK gilt crisis.
3. Enhanced Reporting Obligations: MiFID-regulated entities will face expanded reporting requirements for trading activities, enabling regulators to assess systemic risks more effectively. This includes standardized data submissions to ensure consistency across member states.

Impact on Financial Institutions

The ESRB’s reforms under AIFMD and MiFID will have far-reaching implications for financial institutions, including investment funds, asset managers, insurers, and trading firms:

1. Investment Funds: Funds must enhance liquidity management frameworks and adopt advanced risk-monitoring systems to comply with stricter AIFMD requirements. Real estate and fixed-income funds, in particular, must adjust redemption policies and maintain higher liquidity buffers.
2. Asset Managers: Asset managers operating under AIFMD will need to invest in technological tools for real-time leverage and liquidity tracking. They must also ensure compliance with harmonized reporting standards across jurisdictions.
3. Insurers: As participants in securities lending and repo markets, insurers will need to align their practices with MiFID’s enhanced transparency requirements, providing detailed data on transactions and exposures.
4. Trading Firms: Trading entities subject to MiFID will face tighter controls on derivatives and margining practices. They must implement robust systems to manage collateral requirements and report trading activities comprehensively.

What Financial Institutions Must Do

To adapt to these changes, financial institutions must:

• Upgrade Reporting Systems: Ensure compliance with AIFMD and MiFID’s expanded reporting obligations by adopting advanced data collection and submission tools.
• Implement Risk Mitigation Strategies: Strengthen liquidity management, leverage monitoring, and stress testing frameworks to align with ESRB’s recommendations.
• Enhance Cross-Border Compliance: Coordinate with regulators across jurisdictions to meet harmonized AIFMD and MiFID standards, particularly for funds operating in multiple EU countries.

Challenges in Implementation

While the ESRB’s proposals are ambitious, implementation challenges persist:

1. Regulatory Fragmentation: Variations in how AIFMD and MiFID are implemented across member states complicate harmonization efforts.
2. Data Gaps: Despite progress, discrepancies in data availability and quality hinder comprehensive risk assessment.
3. Resource Constraints: Supervisory authorities require additional resources, both in terms of skilled personnel and technological capabilities, to analyze complex datasets and oversee cross-border activities.
4. Adapting to Innovation: Emerging technologies, such as decentralized finance, pose regulatory challenges as they blur the lines between traditional and non-traditional finance.

The ESRB’s December 2024 update underscores the urgency of reforming NBFI regulation under a system-wide framework. By aligning the objectives of AIFMD and MiFID with its macroprudential goals, the ESRB seeks to build a resilient financial system capable of withstanding future shocks. While challenges remain, the outlined reforms offer a clear pathway to achieving greater financial stability and fostering a robust Capital Markets Union.