European securities regulators’ new stress-testing framework for the asset management sector finds that certain asset classes could be vulnerable to liquidity pressures, possibly creating knock-on effects for broader financial markets.
The European Securities and Markets Authority (ESMA) released its new stress-testing framework for the investment fund sector on Thursday along with the results of a test on the bond fund sector, which found potential vulnerabilities in certain asset classes, such as high-yield bond funds.
The test, which simulates a redemption shock, found that most funds would be able to accommodate a weekly redemption demand of 5% to 10%, given their liquid asset holdings, but also uncovered vulnerabilities to this sort of shock among high-yield funds.
“Under the severe but plausible assumptions of our simulations, up to 40% of HY bond funds could experience a liquidity shortfall,” the ESMA reported.
Additionally, the regulators’ tests found that forced selling to meet a spike in redemption demand would have a limited impact on most asset classes, “as sales by funds are only a fraction of aggregate trading volumes.”
Yet, for certain less liquid asset classes, such as high-yield and emerging markets (EM) bonds, “fund sales could have a material impact, ranging from 150 to 300 basis points, and generate material second round effects,” the ESMA said.
The ESMA said it will be using its stress-testing framework as part of its routine risk-monitoring efforts, and that it has discussed the results of its work with national regulators to help inform the day-to-day supervision of the sector.
“The stress simulation framework is a key element of ESMA’s stress testing strategy, which also includes guidelines on liquidity stress testing and on money market fund stress testing. The resilience of the fund sector is of growing importance as it accounts for an increasing part of the EU financial system,” Steven Maijoor, chair of the ESMA, said in a statement.
“This framework will be an important tool for supervisors to assess risks in the asset management industry, as the methodology developed by ESMA can be applied across the industry’s different sectors,” he added.