Remarks at the Irish Funds Annual Global Funds Conference - Director General Derville Rowland

Speech delivered at the Irish Funds Annual Global Funds Conference

Good afternoon.

Today’s virtual Irish Funds conference takes place amidst great uncertainty. The Covid-19 pandemic represents a threat to people’s lives first and foremost, and the necessary public health response has, in turn, had a significant impact on the economy, on businesses and on livelihoods.

It was John F Kennedy who famously said that: “When written in Chinese, the word ‘crisis’ is composed of two characters - one represents danger and one represents opportunity.”¹

While the technical accuracy of the remark has been disputed, Kennedy was of course addressing a wider theme about how we view – and react to – crises.

In my remarks today², I want to focus on the challenges Covid poses to the funds, asset management and the wider non-bank sector; the response of the Central Bank to date; and the regulatory concerns we have going forward which regulated entities will need to address – the danger, if you like.

However, I will also touch upon the capacity of the sector to contribute to the post-Covid recovery, to increased resilience of the financial system as a whole, and other fundamental global challenges, such as climate change – the opportunity, as such.

In terms of the initial economic shock, the financial system held up well. The reforms implemented following the financial crisis were a contributory factor in this. So too was the action taken by the Central Bank, at national level and as part of the Eurosystem, seeking to ensure that the system absorbed the shock. This included action to mitigate liquidity issues in financial markets, including the funding stress in money market funds.³

Yet it is also fair to say it was a period of extreme volatility. And with the path of the virus and the economic outlook remaining uncertain, we need to assess the vulnerabilities, identify the lessons to be learned, and further enhance the resilience of the system. There is significant work taking place in international fora analysing these issues, and we are actively contributing to these considerations. Today, the Central Bank publishes new research as part of that process, examining the behaviour of Irish-domiciled funds during the Covid-19 crisis, and the persisting effect of the pandemic on money market funds and money markets.⁴

As the Governor of the Central Bank has noted, the pandemic will, undoubtedly, also leave a legacy of structural change.⁵ Some of this will be an acceleration of trends already in motion and some of it is, as yet, unclear. “These times of disruption can pose significant challenges, but they can also be an impetus for progress” – this is as true for regulated entities as it is for regulators.

In that respect, the funds and asset management sector has a vital role to play in (i) the post-Covid recovery, (ii) addressing climate change and (iii) deepening capital markets.  These are all substantial challenges.  

We are therefore at an inflection point in terms of the dangers and the opportunities. I will turn to these matters in more detail now. 

Role of the sector:

To have the appropriate context for this discussion, we must first consider the role that funds, asset management and the wider non-bank sector plays in our economy.  Since the global financial crisis, the world’s market-based finance sector has more than doubled in size.  This is reflected in Ireland where the non-bank sector now amounts to approximately €4.5 trillion in assets under management, with funds accounting for roughly two-thirds of total assets.  This sector plays a vital role in the functioning of the financial system and the financing of the real economy.  It will also be critical in determining how successful the global economy is in overcoming some of the very real challenges I cited above, from systemic resilience to the post-Covid recovery and more. 

When examining a sector of this importance there are many different perspectives to consider.  The Central Bank’s mandate includes monetary and financial stability and ensuring that the financial system operates in the interests of consumers, investors, and the economy as a whole.⁶ The breadth of our mandate gives us both strength and insight, enabling the Bank to harness its collective, wide-ranging and deep policy and technical expertise to tackle complex issues. That breadth has a significant bearing on how we organise our approach to the regulation of the funds sector – examining macro, micro and conduct issues in the round.

Covid-19 – Assessing the impact and remaining vulnerabilities

Given the size and role played by the funds sector, it is important that we take stock of recent events, consider vulnerabilities identified and address how these should be mitigated. The financial sector as a whole broadly demonstrated operational resilience throughout the last number of months.  The funds industry, generally speaking, was no different.  However, issues did arise in certain segments of the sector and they warrant specific consideration. 

The focus of regulatory authorities, at EU and international level, has largely been on two particular segments of the industry, namely money market funds and those funds which have short redemption periods but hold less liquid assets.  In the immediate aftermath of the crisis, from both our analysis of the sector and our supervisory engagements, we supported this prioritisation.  Indeed, the Central Bank played a leading role in the work of the European Systemic Risk Board (ESRB) looking at market illiquidity following the March/April period of intense market turbulence and considering its implications for asset managers and insurers.  Throughout this work, we were able to provide both the central banking and regulatory perspectives I mentioned earlier.

In terms of money market funds specifically, the sector is sizeable with approximately $6.9 trillion in assets under management at year-end 2019, with Irish money market funds accounting for about 9.1% of this and about 45% of MMFs in the euro area. The sector plays an important role in supporting the real economy, both as a cash management tool for investors and as a source of funding for governments and corporates.  Following the onset of Covid, money market funds were affected to varying extents, with different dynamics apparent. During this period, central bank support played an important role and had a positive impact on market sentiment and functioning generally and on money markets in particular, though there were differences across regions.  The research we are publishing today notes that the return to pre-crisis conditions in money markets has been very slow and liquidity ratios within Irish-resident MMFs remain elevated even as liquidity returns to money markets, reflecting concerns that this liquidity could suddenly disappear again if stress in other markets were to emerge. Looking more widely, money markets improved at a faster pace in the US than in Europe.

In light of Covid events, there are then issues for both central banks and securities regulators to consider. There is the overall question concerning the functioning of the money market system during this period and the vulnerabilities that emerged in this regard. It is important to look at a range of factors that interacted, giving rise to stress in the framework and the risk of negative amplification of shocks, in advance of market interventions by central banks.  The configuration of the regulatory framework will also need to be looked at further in this context.  The performance of money markets and lessons to be learned in that regard is something that the international regulatory community is rightly focused on given the importance of these funds to the wider market ecosystem. 

The other area which we believe warrants regulatory attention following the crisis is funds with short redemption periods holding less liquid assets.  This is important in our view as redemptions from funds throughout this period were not necessarily correlated with asset returns.  Equity funds experienced less redemptions compared to corporate bond funds although equity price falls were much larger than the falls in corporate bond prices.  Corporate bond funds, in particular those holding less liquid high yield corporate bond funds, saw significant redemptions. These redemptions were at a level and of a nature which is consistent with there being a “first mover advantage” dynamic at play.⁷ And funds collectively responded to those redemption pressures partly by seeking to sell less liquid securities.  Such a dynamic would suggest that liquidity mismatch in certain areas of the fund sector can give rise to a shock amplification rather than shock absorption in times of stress. This is why, during the Covid-related ESRB work on market liquidity which I mentioned earlier, we advocated for investigation of the topic by ESMA through coordinated supervisory activity with national competent authorities (NCAs).

ESMA is in the process of finalising its report to the ESRB.  At a national level, this supervisory exercise has provided us with important insights including in relation to the availability and deployment of liquidity management tools by these funds.  From an Irish perspective, the sample of funds examined showed the most commonly available liquidity management tools were swing pricing (with 36% of funds providing for this and 25% deploying it during the crisis) and anti-dilution levies (with 58% of funds providing for this and 27% of funds deploying the measure).  Increases in redemptions were largely managed without recourse to suspensions or gating, which occurred in a limited number of cases only. Within Europe and domestically, we will need to consider all the findings of this initiative to consider what enhancements to the regulatory framework are warranted.

It is also important to look at the collective action question and see what improvements should be made. While the actions of one entity or fund when faced with stress may be rational and appropriate when looked at on an individual basis, the collective impact can be materially suboptimal when replicated across a large number of entities. This is where the macroprudential question arises. Again as the Governor has noted, the macroprudential framework for market-based finance is currently incomplete and not operational. Indeed, compared to the banking sector where the tools are already in place, macroprudential policy for the market-based finance sector remains at an early stage of development.^[viii] This is why we are assessing what steps need to be taken to complete the macroprudential framework for the market-based finance sector. Our view is that a considered and completed framework would be good for the sector as a whole as well as for the stability of the financial system and ultimately the real economy. We therefore need to address the gaps in the macro-prudential framework for the non-bank sector so as to make it fully operational. We look forward to continuing to work with international counterparts, including at fora such as the FSB, ESRB, ECB, ESMA and IOSCO, to further that objective.

 Effectiveness of firms in responding to these events

Let me now turn to how regulated firms responded to these events and their effectiveness more generally.  I would like to share some perspectives on engagements with firms throughout this period.  Firstly, it is important to recognise the considerable efforts undertaken by staff within firms and the wider industry to respond this crisis.  I would highlight that, in our engagements, on the whole we have found firms to be responsive to requests for additional data to enable us to assess the market wide situation, and I want to acknowledge this.  I appreciate this can be burdensome for firms but the provision of good quality, timely, information is critical when calibrating the regulatory response to an unfolding crisis.

The period of market turbulence showed up areas of vulnerability in how well firms were resourced and organised to meet their obligations to investors and the market during this period. It was a challenging time, as firms grappled with an extreme set of circumstances that were not of their making. Nevertheless, it was striking the extent to which the issues that emerged fell squarely within the priority areas we have been engaged with the sector on for some time now.

Issues of over-reliance on group policies and expertise, lack of defined triggers and processes for escalation and a paucity of operational play books for worst case scenarios are all too familiar to us. And, had the market turbulence continued, I fear they would have become all too apparent in their impact. 

This leads me to our recent work to review CP86.

Review of CP86

In 2019, the Central Bank embarked on a significant body of work to assess how firms have incorporated the CP86 framework into their businesses. “CP86” is the name given to the body of rules and guidance introduced over the course of three separate consultations and which came into full effect in 2018. Its aim was to put in place a detailed framework for fund management companies to follow to ensure they are appropriately organised and resourced to meet their regulatory obligations and run their funds to the highest standards. There can be no compromise on these objectives. Investment funds are the repository of the enormous trust of their investors who place their savings and investments for the future with them. Fund management companies and their management and staff are responsible for fulfilling that trust.

The review we carried out was wide ranging, both in terms of the scope of firms included and the elements of the framework that it encompassed. First, a questionnaire was issued to 358 in-scope firms in order to gather data in a wide range of areas such as delegate oversight, organisational effectiveness, directors’ time commitments and managerial functions. The second step involved an in-depth review of certain documentation held by a subset of those firms focussing on three specific elements - (i) the investment management function (ii) the risk management function and (iii) the organisational effectiveness role. The final step involved detailed interviews with representatives of some of those firms.

From our in-depth analysis, this review found that when applied correctly by firms, the rules and guidance provide a framework of robust governance, management and oversight arrangements.  Firms who were able to demonstrate that they were largely compliant with the framework had a considered, well-planned approach to its implementation supported by appropriate resourcing.  These findings align with our experience in respect of the large number of recent applications for authorisation, where the application of the framework has provided a strong basis for firms to identify and retain the level and nature of resources required.

However, the review found that a significant number of previously authorised firms have not yet fully implemented the CP86 framework. This is disappointing and concerning. In particular, we found that a large number of these firms had not appropriately increased resources to ensure effective implementation of the framework. The Central Bank expects that the number of FTE should reflect the nature, scale and complexity of the firm and that sufficient resources are in place.

 On the basis of these findings, as well as requiring specific mitigation programmes in each of the firms where we identified deficiencies, we have issued a general letter to the industry. This letter is a call to action and requires all fund management companies (regardless of whether they are the subject of specific findings from us) to critically assess their operations against CP86 and our findings, and to implement a time specific plan for making the necessary changes.

As well as our supervisory work to pursue firms’ implementation of the framework, in 2021, we will consider whether enhancements are necessary to the rulebook to hold firms duly to account to ensure they are resourced and organised to meet their obligations.

CP86 was intended to bring about a step change in the sector. Our findings are that this has not been achieved to date. It now needs to be.

Brexit

Turning to Brexit, 31 December marks, of course, the end of the transition period.  While attention may have focused on the unforeseen risk of Covid, we must not lose sight of the Brexit risks which may materialise over the coming months - risks arising both from the change in legal paradigm and from the potential further shock to the economy.  The pathway to the end of the transition point and makeup of the future relationship remains uncertain.  Despite extensive preparations under way for a considerable period of time, not all these risks have been, or can be, mitigated. Additionally, I am in no doubt that new risks and unforeseen consequences may also emerge over the coming months as we approach 31 December.  For this reason it is essential that firms remain proactive and vigilant in their planning and mindful of the risks that remain. Given the length of time leading into Brexit, and the extent to which the issues have been well-flagged, investors will expect no less from you.   

Future challenges:

I am conscious that for many regulated entities, regulatory obligations can be significant, and it may sometimes appear as if we focus only on the risks, on the gaps in the framework, or the improvements we require firms to make. This is not simply about stability, regulatory or conduct concerns, however. It is also because we recognise that effective markets which operate in a fair, orderly and transparent manner have a significant contribution to make to common challenges facing us – post-Covid recovery, deepening capital markets, addressing climate change. In a recent speech, ECB board member Isabel Schnabel set out the pathway between the three: how Covid has intensified the debate about the role that monetary policy should play in addressing the risks of climate change; how collective action of policymakers, firms, investors and households is required; and how a critical component of that collective action will be a functioning capital market to fund green investments.⁹ I believe we share these objectives, and a view of the positive role the funds, asset management and non-bank sector can make in delivering on them. I hope we can further delve into these issues in our panel discussion.

Thank you.

[1] Kennedy, J.F. 1989. Remarks at the Convocation of the United Negro College Fund, Indianapolis, Indiana

[2] My thanks to James O’Sullivan, Aoife Medlar and Rebecca O’Mahony for their contribution to these remarks.

[3] de Guindos, L. 2020. "Improving funding conditions for the real economy during the COVID-19 crisis: the ECB's collateral easing measures"

[4] Golden, B. 2020. "The persisting effect of the pandemic on Money Market Funds and money markets" Economic Letter, Vol 2020, No. 9. Calò, S., Emter, L., and Galstyan, V., 2020. "Repricing of risk and EME assets: the behaviour of Irish-domiciled funds during the COVID-19 crisis" Financial Stability Notes, Vol 2020, No. 9

[5] Makhlouf, G. 2020. "COVID-19 and the future of monetary policy" Remarks delivered at the Institute of International and European Affairs on 14 September 2020.

[6] See more about the Central Bank’s mandate here: https://www.centralbank.ie/about/role-of-the-central-bank

[7] ESRB 2020. "Issues notes on liquidity in the corporate bond and commercial paper markets, the procyclical impact of downgrades and implications for asset managers and insurers"

[8] Makhlouf, G, 2020. "Making the case for macroprudential tools for the market-based finance sector: lessons from COVID-19" Speech prepared for Bruegel online event on "The need for market-based finance after COVID-19" on 29 June 2020

[9] Scnabel, I. 2020. "When markets fail - the need for collective action in tackling climate change" Speech by Isabel Schnabel, Member of the Executive Board of the ECB at the European Sustainable Finance Summit on 28 September 2020.