This article was first published in the 23rd edition of the Fact Book on 24 June 2025.
Financial stability is a public good. One that benefits all, including the industry. A system prone to frequent and deep crises requires that financial institutions be prepared for extreme market conditions, which implies particularly stringent risk management policies and exceptionally well-trained risk managers. Moreover, the 2008 financial crisis is most likely one of the primary causes of citizens’ distrust in the financial system, resulting in many households stockpiling cash. According to Mario Draghi's recent report, Europeans keep an estimated EUR 33 trillion in their bank accounts.1
This poses a number of fundamental questions: Which are the risks that most deserve our attention (for example, bank solvency, real estate valuation, fund liquidity management, derivative markets or non-bank leverage)? How do we mitigate systemic risks while still allowing capital markets to grow to meet the EU objectives under the SIU (Savings and Investments Union) strategy (through macroprudential requirements or through regulatory reforms)? EFAMA explored these exact questions in its response to the European Commission’s consultation on the adequacy of macroprudential policies in the Non-Bank Financial Intermediation, better defined in our view as Market-Based Finance (MBF).2
As a starting point, the Commission should develop a holistic and empirically driven macroprudential framework for identifying systemic risks. At its core, the GFC (Great Financial Crisis) was a solvency event in which markets no longer knew which banks were still solvent. This resulted in a liquidity crisis for banks most exposed to the sub-prime real estate market. Basel III has addressed this issue, by ensuring that banks finance their activities through more equity. It also introduced margin requirements to reduce the counterparty risks associated with derivative transactions. As a result, attention is now on (hidden) MBF leverage and the interlinkages between banks and capital markets.3 This is usually justified by the failure of a significantly leveraged Family Office, Archegos Capital Management, which ultimately contributed to Credit Suisse's downfall.
However, financial institutions with such leverage and concentrated exposures are probably rare in European capital markets.4 The vast majority of European insurance companies, pension funds and investment funds are unlikely to default due to leverage. They usually do not borrow, and engage in derivative transactions to hedge their physical portfolios. While there is probably insufficient data on MBF leverage, what data that is available is reassuring. For example, in the AIF (Alternative Investment Fund) sector, only 500 funds of 35,000 are significantly leveraged.5 Their EUR 700 bn assets under management pale in comparison with the total assets in the AIF sector (EUR 9 trillion) and the total assets in the euro area financial sector (EUR 70 trillion). If exposed to a 300-basis point interest rate shock - one twice as large as the interest rate change during the GFC - and assuming that this shock is not correlated with other shocks (such as foreign exchange and equity shocks), only EU LDI (Liability-Driven Investment) funds would face significant losses (approximately 26%). Among these, only a few would default. Other substantially leveraged AIFs would remain mainly unscathed, with relative value hedge funds facing the most significant losses (approximately 10%).6 Moreover, a stringent default scenario, in which 77 (unspecified) non-banks would fail, shows that banks could absorb the losses associated with such an event. Losses would be concentrated among investment banks and wholesale lenders, with only five of them facing losses higher than 300 basis points in CETI 1 (Common Equity Tier 1).7 While clearly not negligible, these losses remains moderate, because universal and retail banks would broadly be spared. The impacted banks could, moreover, absorb these losses if they have CETI 1 close to the banking average of 15%.8
Recent market disruptions were not solvency events but rather pure liquidity events. In its holistic review of March 2020, the FSB (Financial Stability Board) correctly highlighted that it was an imbalance between liquidity demand and supply that drove these ‘dashes for cash’.9 While authorities should seek to prevent such crises, their consequences are nothing close to those of a solvency crisis. For example, although volatility spiked during March 2020, trading volumes remained high, indicating that market participants did not rush for the exit. Instead, price volatility reflected the uncertainty associated with value chains breaking down across the globe due to the pandemic.10
During periods of stress, demand for liquidity spikes because investors face sizeable margin calls and adopt a risk-off attitude, exiting riskier markets such as corporate and EM bond markets. However, despite significant concerns for the liquidity demand from funds during these challenging times, the System-Wide Exploratory Scenario - conducted by the Bank of England in 2023-2024 - demonstrated that liquidity demand in government bond markets stems mainly from (variation) margin calls.11 At the same time, liquidity supply stagnates - and sometimes even decreases - during these market stress episodes. GFC reforms have resulted in lower intermediary capacity in core bond and repo markets; this is because fewer banks are willing to operate as market dealers, and those that do tend to have lower balance sheet capacities than before. The situation worsens further during periods of stress, because increasing numbers of market dealers stop intermediating under these conditions. Principal Trading Firms and all-to-all trading platforms have grown in importance as liquidity providers during normal market conditions. However, their business models make it challenging to act as an intermediate during periods of stress (for example, dealing algorithms may no longer work due to price uncertainty, or other investors might not be able to buy assets because they also face a liquidity shock).12
As a result, EU policy interventions should reduce the imbalance between liquidity demand and supply rather than attempt to tackle ‘excessive’ MBF leverage. Yet, despite the growing interest in (macro-)prudential requirements (including capital/liquidity, buffers, leverage limits or margin requirements), regulatory reforms are better suited for addressing this imbalance. Historically, prudential frameworks were developed for the banking sector because removing the solvency and liquidity risks inherent to banking activities was impossible. It would require that banks only hold high-quality and short-term assets, something that would be commercially impossible. In contrast, removing the vulnerabilities that may arise in capital markets from specific sectors, such as investment management, is possible without introducing (macro-)prudential requirements. For instance, to the extent that it exists, it would be possible to remove the ‘first-mover’ advantage in the fund sector by ensuring that investment funds charge investors who are redeeming the transaction costs borne by the fund.13
That said, in capital markets, (macro-)prudential requirements may be necessary under specific circumstances (for example, to prevent selling spirals like the one in the UK gilt market in 2022). Nevertheless, one must remember that (macro-)prudential requirements can result in over-insurance if not adequately calibrated to reflect the risks associated with a specific entity or transaction. In such a situation, market participants would have to hold cash (in the form of deposits or short-term bonds), which could have been used to finance more-socially beneficial activities. For this reason, legislators tend to prefer micro-prudential rules, as these provide financial institutions with sufficient flexibility to adapt the prudential requirements to their specific situations while ensuring that supervisors retain sufficient scrutiny over these firms’ prudential positions. For example, in capital markets, central clearing counterparties and clearing members can adapt margin requirements based on their counterparty credit risks (for example, is the counterparty significantly leveraged, or does it invest in a concentrated market?). In contrast, macroprudential requirements are less prevalent because these entail authorities setting minimum resilience requirements (such as countercyclical buffers for banks or yield buffers for LDI funds). As these only introduce a floor, they are less risk-sensitive than micro-prudential requirements and are more likely to result in over-insurance. To continue with the above example, introducing minimum margin requirements would face this precise problem. A minimum margin requirement calibrated on an ‘extreme but plausible’ stress scenario would result in creditworthy counterparties having to post more cash to prepare for a crisis. However, that crisis may never materialise, either because the stress scenario is not relevant for this specific entity or because that entity may exit its derivative positions ahead of such a shock materialising.
Given these limitations, there are several regulatory reforms that would be more effective and proportionate for reducing the imbalance between liquidity demand and supply during periods of stress. Under the condition of applying sufficiently conservative haircuts, using non-cash collateral in variation margin calls would significantly reduce the liquidity demand during market stress episodes. Instead of selling assets such as government bonds, market participants could simply post them as collaterals when a variation margin call arises. Similarly, allowing market participants such as UCITS funds to access repo markets could ensure that they do not have to sell assets when faced with significant spikes in margin calls. Through repo transactions, market participant can transform their assets into cash, which can in turn be posted as collateral when there is a margin call. Last, allowing market dealers to hold more assets on their balance sheets would ensure that these liquidity providers can absorb larger trades when the liquidity supply ascribed to buy-side investors weakens, including in repo markets.
Notes to Editors
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