DNB contributes to development of risk monitoring framework
Due to these concerns, the ESRB has recommended that the European Markets and Securities Authority (ESMA) develops a risk monitoring framework for alternative investment funds (AIFs), which include hedge funds, private equity funds and real estate funds. With the aim to contribute to European policy development, DNB and ECB staff members have cooperated to create an example of such a risk monitoring framework. Incidentally, the use of leverage in AIFs under Dutch management is limited.
Leverage in alternative investment funds not limited by regulation
In Europe, the assets of alternative investment funds have tripled in value to EUR 5,723 billion over the past decade. This strong growth in investment funds creates new risks. The main systemic risk is a scenario in which large numbers of investors decide to exit these funds (a run). Decisions by investors to sell their investments in such funds can force fund managers into selling assets in less liquid markets, and therefore at substantial discounts (fire sales). This in turn can amplify the impact of price shocks in the financial markets – in particular when funds are highly leveraged – and lead to losses for banks, insurers and pension funds. New findings reveal that leveraged funds, as well as low-liquidity funds, are more sensitive to investor outflows following negative returns.
AIFs are not bound by regulatory leverage limits, but competent authorities in Europe, including DNB, are authorised to impose a leverage limit in the interest of financial stability. This policy instrument has not yet been used. As a result, AIFs can in principle employ unlimited levels of leverage via loans or derivatives in order to generate higher returns.
International analysis and policy required
DNB favours an analysis and adequate management of the risks at European level, as investment funds can easily move beyond national borders and the inherent risks are therefore of an international nature. By working with ECB staff to create a new risk framework for AIFs, DNB contributes to the development of such a framework for Europe. This is a task that in the coming years will be taken up by the ESMA, at the recommendation of the ESRB. In this context, DNB also stresses the importance of considering how the authority to limit leverage in AIFs could potentially be implemented in the future.
Limited use of leverage in alternative investment funds under Dutch management
Around 8% of AIFs under the management of Dutch asset managers employ leverage. The total underlying value of investments held by this group of funds amounted to EUR 97.5 billion at the end of 2016. However, the majority of these funds use limited leverage, and several factors limit their potential contribution to systemic risk. There are for example no indications of a structural liquidity mismatch. This means that under normal market circumstances, exposures can be promptly liquidated to meet investor outflows. Moreover, leveraged AIFs are strongly interconnected with Dutch insurers and pension funds. Although this forms a direct transmission channel for shocks to the financial system, the generally longer investment horizons of insurers and pension funds reduce the risk of an acute run on these funds.
A small group of hedge funds under Dutch management does however employ substantial leverage, which is defined under the EU Directive as net exposure exceeding three times the fund's net asset value (Figure 1). Notably, the use of leverage in these hedge funds is highly volatile, and in 2016 ranged between 25 to 46 times the underlying net asset value. This volatility is indicative of the ease with which funds can adjust net exposures via derivatives, revealing their ability to amplify market shocks if adjustments are procyclical.
Figure 1. Volatile leverage in small group of hedge funds