Since the onset of the 2008 financial crisis, global policymakers have been interested in ensuring that those financial institutions “whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity” (FSB, 2011) are identified and appropriately regulated. After systemically important banks were identified by the FSB in 2011, and insurers in 2013, policymakers turned to non-bank, non-insurer systemically important financial institutions (NBNI SIFIs).
On the 14th November, the International Organisation of Securities Commission (IOSCO) released its consultative report on leverage to request feedback on a proposed framework that would help assess leverage used by investment funds. The consultation takes a granular but flexible approach in order to take into account the different practices used worldwide.
The proposed framework is comprised of a two-step process aimed at achieving a meaningful and consistent assessment of global leverage. The first step indicates how regulators could exclude certain funds that are unlikely to create stability risks to the financial system while filtering and selecting a subset of other funds for further analysis. The second step calls for regulators to conduct a risk-based analysis of the subset of investment funds identified in the first step.
As part of Step 1, IOSCO consults on three metrics to assess whether they may be effective, including in combination with each other. These include:
- Gross Notional Exposure (GNE) without adjustment which the consultation describes as a very conservative measure of leverage.
- Adjusted GNE which attempts to limit the overstatement of a fund’s exposure to interest rate derivatives and options.
- Net Notional Exposure (NNE) which could help correct some of the limitations of GNE and Adjusted GNE.
IOSCO states that a further approach is to express the step 1 metrics by asset class, rather than only in a single, aggregate figure. Additionally, regulators could evaluate supplementary data points that are already collected in many jurisdictions e.g. fund portfolio composition and the availability of assets to meet calls for margin or collateral.
For Step 2, regulators will exercise their judgment when determining which funds to analyse and which analysis to perform. In making these decisions, a regulator could consider, among other factors:
- the size and scope of the fund industry;
- the nature of each regulator’s focus and mission; and
- the extent to which other domestic regulations may seek to address leverage-related risks in other sectors of the financial system.
The consultation is in many respects the beginning of a long-term project on leverage in investment funds and it remains to be seen where this work will lead. One area where it may have an impact relatively soon is the upcoming review of AIFMD (expected end-2019/early 2020). The consultation is open until 1 February 2019.