Financial institution focus: risks and vulnerabilities in the EU financial system - ESA policy actions

In their recently published joint committee report, the European Supervisory Authorities (EBA, EIOPA and ESMA – ESAs) advise a number of policy actions for national competent authorities (NCAs), financial institutions and market participants. The ESAs advise these policy actions in light of perceived risks and vulnerabilities in the EU financial system, arising principally from increased inflation, the COVID-19 pandemic and the Russian invasion of Ukraine. Financial institutions should consider this succinct report and factor it into their horizon scanning and compliance risk frameworks. Key highlights from the report are collected below for ease of reference.

Sanctions

Against the background of ongoing geopolitical developments and, in particular the Russian invasion of Ukraine, the ESAs advise that financial institutions should be prepared for potential further detrimental implications.  Financial institutions should ensure compliance with the sanctions regimes implemented both at the EU and global level. Where possible, NCAs should effectively coordinate on the scope and implementation of sanctions by authorities and financial markets participants.

Asset quality

The ESAs advise that financial institutions and NCAs should continue to be prepared for a possible deterioration of asset quality in the financial sector. In light of persisting risks, and a build-up of medium-term risks with high uncertainties, NCAs should continue to closely monitor asset quality, including in real estate lending, and in particular assets which have already benefitted from support measures.

Inflation

The ESAs advise that potential further increases in yields and sudden reversals of risk premia should be closely monitored in terms of their impacts for financial institutions as well as for investors. Rising yields could result in higher funding costs for banks and higher credit risks, but it is acknowledged that banks' profitability outlook could improve given their interest rate sensitivity. Rising yields could also increase credit risks for corporate lending via higher borrowing costs. Credit risks related to the corporate and banking sector remain a main concern also for insurers as well as for the credit quality of bond fund portfolios. Fund liquidity also needs to be closely monitored should market liquidity deteriorate in case of wider market stress. The ESAs further advise that NCAs, policy makers and financial institutions should continue to develop mitigants to guard against the risks arising from rising inflation.

Retail investors

The ESAs advise that retail investors are of particular concern, in light of their increased participation in financial markets in recent years and, whilst this diversification offers opportunities, it also comes with risks. The ESAs advise that NCAs should monitor risks to retail investors who buy assets with expectations of significant price growth, and without realising the high risks involved. Where disclosures are ineffective, these risks are compounded. 

The recently published Central Bank of Ireland (CBI) Consumer Protection Outlook Report highlights a number of risks for consumers arising from changing business practices and ineffective disclosure on investment products, as well as CBI's expectations of regulated firms to deal with those risks. In addition, CBI has today written to MiFID investment firms outlining the findings from a series of targeted reviews of Structured Retail Products (SRPs), and setting out CBI's expectations of regulated firms to take action to identify a sufficiently granular target market for SRPs, and to drive improvements in the quality and transparency of disclosures to investors of the risks relating to these products. 

The ESAs also advise that, as the crypto-asset market continues to expand, risks to investors and financial stability are considered to have grown and, pending the entry into force of the proposed Markets in Crypto-Assets (MiCA) regulation, consumers typically do not benefit from any safeguard or legal protection. Both the ESAs and CBI's concerns in respect of retail investors/consumers investing in crypto-assets are reflected in their recent warning to consumers on the risks of investing in crypto-assets. 

ESG

The ESAs advise that financial institutions need to further incorporate ESG considerations into their business strategies and governance structures. They should consider ESG risks in their risk appetite and internal capital allocation process. Financial institutions should continue to develop methodologies and approaches to test their long-term resilience against ESG factors and risks.  

The ESAs further advise that data gaps continue to challenge the incorporation of ESG considerations into financial institutions' risk management, investment processes and investment advice and emphasise the importance of public disclosures, as well as data collections through bilateral engagement with counterparties, as relevant data sources for ESG risk assessment and monitoring.

Cyber resilience

The ESAs advise that financial institutions should strengthen their cyber resilience measures and prepare for a potential increase in cyber-attacks and their consequences going forward. This need for strengthened resilience measures arises from both the COVID-19 pandemic and its continued spurring of the digital transformation of the financial sector, and geopolitical tensions, in particular, the Russian invasion of Ukraine. In this regard, the ESAs welcomed the European Systemic Risk Board's recommendation for the establishment of a pan-European systemic cyber incident coordination framework. 

Next steps

These policy actions closely align with the CBI's financial regulation priorities for 2022, as highlighted in our recent insight. There is particular alignment with the CBI's focus on cyber resilience, driving fair outcomes for consumers and investors, strengthening the EU regulatory framework to capture crypto-assets, and climate change, thus placing increased emphasis on the need for regulated firms to bring these policy actions into their horizon scanning board updates and their regulatory and compliance plans.

For further information in relation to this topic, please contact Patrick Brandt, Partner, Kevin Allen, Partner, Christopher Martin, Of Counsel, Sian Langley, Knowledge Lawyer or any member of ALG's financial regulation team.

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Date published: 22 April 2022