By Gabriel Makhlouf, Governor, Central Bank of Ireland
Over the last decade, the Central Bank of Ireland (the Central Bank) has continued to develop its approach to macroprudential policy. During this time, the changing nature of financial intermediation, including the increased role of investment funds, has highlighted the need to broaden and develop the macroprudential framework. Today, the Central Bank’s macroprudential-policy framework has three broad pillars, including (i) policies relating to banks, such as macroprudential capital buffers; (ii) policies relating to borrowers, such as mortgage measures; and (iii) policies relating to non-banks, which are currently focused on Irish property funds. However, our recent “Discussion Paper: An approach to macroprudential policy for investment funds”1 aims to advance the international discussion on how to develop and operationalise a comprehensive macroprudential policy framework for the funds sector. Across the three pillars, macroprudential policy strives to ensure that the financial sector is more resilient to stresses and less likely to amplify adverse shocks. In turn, this better equips it to serve as a resilient form of financing and support broader economic activity.
The non-bank financial intermediation (NBFI) sector, and particularly the investment-fund component of it, has grown considerably since the Global Financial Crisis (GFC). The absolute size of the global NBFI sector grew from €72 trillion in 2008 to €212 trillion in 2021, and this growth can largely be attributed to the rise of investment funds. In 2021, the NBFI sector represented approximately half of all global financial assets and just over half of the European Union’s (EU’s). Similar to developments at a global level, the NBFI sector in Ireland has grown significantly over the last decade, driven by the growth in the funds sector. Ireland is now one of the world’s largest hubs for investment funds at the global level and hosts the largest money market fund (MMF) sector in Europe. Ireland is also home to Europe’s largest exchange-traded fund (ETF) sector, accounting for about two-thirds of the total assets of ETFs in the euro area during the same period.
Increased financial intermediation via investment funds brings many benefits. It diversifies the financing channels available to the real economy and enables the diversification of asset portfolios, benefiting investors. In doing so, the funds sector supports broader economic activity and acts as a useful alternative to bank financing. However, like all forms of financial intermediation, the activities of investment funds can also pose risks that, in certain circumstances, can become systemically relevant. The underlying systemic risk posed by the funds sector stems from the potential of cohorts of funds to spread or amplify shocks to other parts of the financial system and the real economy, particularly in times of market stress. This was evident during the COVID-19 shock, when we saw how liquidity mismatches in certain open-ended investment funds exacerbated market shocks. More recently, the stress in the UK gilt (government bond) market last autumn illustrated how leverage-related vulnerabilities in the funds sector can be exposed by rapidly changing market conditions and how such vulnerabilities can amplify shocks to financial markets and the real economy.
Policymakers and regulators in recent years have increased their focus on the role of investment funds and their relevance from a systemic-risk perspective. This includes attention from some quarters on the role of macroprudential policy in the funds sector. In 2022, following significant analysis, the Central Bank announced the phased implementation of new macroprudential measures in “The Central Bank’s macroprudential policy framework for Irish property funds”2 document. The measures reflect the growing importance of these funds in the Irish commercial real estate (CRE) market—a systemically important market for the Irish financial system and the real economy. Likewise, the role of liability-driven investment (LDI) funds in the 2022 gilt-market crisis led the Central Bank to introduce measures to enhance the resilience of these funds in November 2022. While these initial measures were supervisory in nature, they targeted the source of LDI funds’ systemic risk (i.e., leverage). Work is ongoing to develop a macroprudential policy response to ensure the steady state resilience of Irish-resident LDI funds.
More broadly, given the need to further develop the macroprudential policy framework, in 2023, the Central Bank published the aforementioned “Discussion Paper: An approach to macroprudential policy for investment funds”3 (Discussion Paper 11). Discussion Paper 11 (DP11) sets out what the Central Bank considers important elements in developing a comprehensive macroprudential framework for the funds sector. It does not propose specific policy measures or purport to have all the answers. Rather, the purpose of DP11 is to help facilitate the ongoing international regulatory debate on this topic and inform it, based on the Central Bank’s experience as the supervisor of one of the largest investment-fund hubs in the world, as well as our practical experience with the phased implementation of the macroprudential measures announced last year for property funds. The Central Bank will also continue its international and European engagements on this topic in the coming years—for example, through its work with the Financial Stability Board (FSB), the International Organization of Securities Commissions (IOSCO), the European Systemic Risk Board (ESRB) and the European Securities and Markets Authority (ESMA), among others.
From an investor-protection perspective, investment funds are well-regulated vehicles. But while the current regulatory framework addresses some fund-specific elements that can contribute to systemic risk, it does not address them all. A macroprudential perspective is therefore needed in regulating the funds sector. When designing a macroprudential framework for funds, the approach should not be purely an extension or replication of the macroprudential framework applied to the banking sector. Investment funds perform very different economic functions than banks in the financial system, and these differences extend to how each sector contributes to systemic risk. The Central Bank’s Discussion Paper 114 outlines a number of key principles that could underpin the design of a macroprudential framework for funds.
Macroprudential interventions for the funds sector could be structured as repurposing existing regulatory measures and tools or developing new bespoke macroprudential tools. In practice, given the sector’s diversity, a “one size fits all” approach is unlikely to be effective, and a mix of measures to target the underlying vulnerabilities and interconnectedness of the funds sector will likely be required.
Given the global nature of the funds industry, a macroprudential framework would ideally have a high degree of consistency internationally. The phased implementation of the Central Bank’s property-fund measures has highlighted the importance of international coordination, particularly the need for a reciprocation framework to minimise the potential for regulatory arbitrage. Further, the importance of high-quality data to inform macroprudential policymaking should not be underestimated. There should be a framework that facilitates data sharing between national authorities—securities regulators, central banks and other macroprudential or financial-stability authorities—who require access to complete macroprudential risk assessments.
Given that the funds sector is playing an increasingly important role in the wider financial system, the need to develop and operationalise a macroprudential framework continues to be a key priority for the Central Bank. As is true of the banking sector, developing these policies takes time—particularly given the need for international coordination in some instances. The Central Bank will continue its work to build resilience in this sector so that it can proceed to act as an alternative source of financing and support broader economic activity.
1 Central Bank of Ireland (Banc Ceannais na hÉireann): “Discussion Paper: An approach to macroprudential policy for investment funds,” July 2023, Discussion Paper 11.
2 Central Bank of Ireland (Banc Ceannais na hÉireann): “The Central Bank’s macroprudential policy framework for Irish property funds,” 2022.
3 Central Bank of Ireland (Banc Ceannais na hÉireann): “Discussion Paper: An approach to macroprudential policy for investment funds,” July 2023, Discussion Paper 11.