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Publication of the Financial Stability Review 2018


- only the French version is binding -

Today, the Banque centrale du Luxembourg (BCL) published the 2018 edition of its Financial Stability Review. This publication contributes to promoting the stability of the Luxembourg financial sector and constitutes a reference document for prudential surveillance and risk analysis specific to the main components of the national financial system.

The following paragraphs outline the main national and international challenges to financial stability in Luxembourg. 

On 11 December 2017, the government submitted a draft law to Parliament on "macroprudential measures on residential mortgages". The text provides for the introduction in legislation of the possibility to define a maximum limit on loan-to-value, loan-to-income, debt-to-income, and debt-service-to-income ratios as well as on the initial maturity of the loan. These limits, which will apply when a loan is granted, may be defined by the designated authority, following the recommendation of the Systemic Risk Committee (Comité du risque systémique - CdRS) and after consultation with the Banque centrale du Luxembourg (BCL) and possibly with the Commissariat aux assurances (CAA), in the event that insurance sector companies are concerned.  

While the draft law responds to the initiative of the European Systemic Risk Board (ESRB), in particular Recommendation ESRB/2016/14 "to fill real estate data gaps" and the warning sent to the government in 2016, the draft law also echoes the vulnerabilities identified by the CdRS and/or its member institutions. The draft law provides the BCL with a leading role in identifying systemic risks, as early as possible, through analyses and studies. In order to further consolidate the BCL’s analytical framework, access to aggregate data available from State administrations and public institutions should thus be facilitated by an amendment to the law of 1 April 2015 establishing the CdRS. The draft law, currently under discussion in the Finance and Budget Commission, should therefore offer national authorities new macroprudential instruments to mitigate, if not contain, the vulnerabilities associated with the housing market and the sustainability of household debt. 

In addition, in 2017, Luxembourg contributed to the work of the Financial Stability Board (FSB) as part of the Shadow Banking Monitoring Report published on 5 March 2018. The report, which covers non-bank financial activities in 29 jurisdictions representing 80% of global GDP, provides an assessment of the extent of "credit intermediation activities involving entities and activities outside the banking system". This initiative reflects regulators' desire to increase oversight of systemic risks associated with non-bank activities conducted by "other financial intermediaries".  

For Luxembourg, the BCL published in April 2017, on behalf of the CdRS, a report on parallel banking activities carried out by captive financial companies. In line with the FSB's "narrow definition of the shadow banking sector", the report found that out of a total of almost 7 trillion euros in assets, only 53 billion fall within the scope of the "shadow banking sector". The risks for financial stability are therefore contained, as the vast majority of the activities of these companies cannot be qualified as parallel banking intermediation activities, insofar as they are mainly dedicated to the management of intra-group liquidity on behalf of affiliated companies.  

The financial stability issues in Luxembourg associated with other financial intermediaries relate more to the interconnections between investment funds and credit institutions, in particular custodian banks. Half of their liabilities consist of deposits from collective investment schemes and they hold almost 3,700 billion euros of securities off-balance sheet on behalf of their clients. Custodian banks could therefore be vulnerable in the event of unfavorable developments in the financial markets leading to massive redemption requests, forced asset sales and/or deposit withdrawals. 

In order to guarantee the resilience of custodian banks, the BCL, in cooperation with the CSSF, has proposed an enhanced methodology for identifying other systemically important institutions by adding a new criterion consisting of two variables to assess the extent of these interconnections.  

The methodology, adopted by the CdRS for the 2018 financial year (CRS/2017/005), made it possible to identify two additional credit institutions, which should help to increase the resilience of the Luxembourg financial system. It should be noted that in December 2017 the ESRB published an Opinion on structural capital buffers (cushion for systemic risk and for systemically important institutions) in response to the public consultation initiated by the European Commission in 2016 on the review of the macroprudential framework in the European Union. As a result, the amount of regulatory capital and how it is applied may change in the future.

The financial stability issues associated with non-bank financial activities were also described by the ESRB in February 2018 through Recommendation ESRB/2017/6, which made several proposals to develop a unified legal framework at the EU level, offering additional tools for managing the liquidity of funds. In particular, the ESRB recommended that the European Commission clarify the role of the competent national authorities and the European Securities and Markets Authority (ESMA) regarding the suspension of redemptions of investment funds where the risks to financial stability are potentially cross-border in nature. The ESRB therefore recommends tightening the limits associated with liquidity mismatches in the alternative investment fund sector, improving the quality of regulatory reporting on leverage and liquidity, and finally publishing guidelines by ESMA for the implementation of liquidity stress tests. The liquidity of financial intermediaries is at the heart of financial stability issues because of the persistent uncertainty of the exit horizon from the low interest rate environment. In the euro area, the Eurosystem started a new stage in reducing its quantitative easing program in January 2018, although inflation remains below the target despite a strong recovery in the European economy in 2017. Thus, although the Governing Council chose to reduce the monthly rate of net asset purchases from 60 billion to 30 billion, the key interest rates will remain at their current levels for an extended period of time, and well beyond the horizon set for net asset purchases. In the United States, the Federal Reserve continued its monetary policy normalisation strategy by combining a planned reduction in its balance sheet with a gradual increase in interest rates.  

At the global level, financing conditions, which remain very favourable, should thus continue to support the economic recovery. For the banking sector, which has been in decline since the crisis, this recovery should constitute an opportunity. The low interest rate environment is putting pressure on the profitability of credit institutions, especially those that depend most on interest income as their main source of profit, such as retail banks. Also, the limited size of their securities portfolios makes them less sensitive to financial market movements, for which leaving the low rate environment can mean short-term losses.  

Indeed, these structures are exposed to sudden reversals in investor risk aversion that have become very sensitive to inflation risk and monetary policy decisions in a context where protectionist tendencies are exacerbated. In bond markets, although long-term interest rates gradually incorporate higher inflation expectations, yields and their dispersion remain compressed. In 2017, debt instruments have remained attractive for both issuers and investors seeking yields in a low interest rate environment. Equity markets also benefited from particularly compressed volatility and continued to rise despite signs of overvaluation, particularly in the United States. The fall in the markets observed in February 2018, although significant in terms of increased volatility, did not resolve underlying imbalances. 

The consolidation of economic activity and the exit from the low interest rate environment will benefit from a well-articulated policy mix with international, European and national dimensions. In particular, macroprudential policy, through the diverse instruments at its disposal, makes it possible to act with precision on identified vulnerabilities without hindering the economic recovery.  

The Financial Stability Review 2018 also analyses recent developments in the Luxembourg financial sector and its outlook. While the latter appears more favorable in view of the acceleration in economic growth in Europe, this expansion phase requires the national authorities to remain vigilant as regards the emergence of cyclical systemic risks.

The macroeconomic environment reflects the renewed dynamism of the global and European economies. In Luxembourg, the macroeconomic outlook remains favorable for 2018. Residential property prices, supported in part by the favourable conditions of the domestic economy, are expected to remain at a high level given the existence of underlying structural imbalances that have not been fully addressed. The demand for dwellings, fueled by a positive net migration and favorable borrowing conditions, is is characterized by limited supply and the low price elasticity does not allow for a proper adjustment. In the face of rising housing prices, the increase in disposable income did not lead to the consolidation of households' balance sheets, which would have helped attenuate the potential vulnerabilities identified by the BCL regarding the sustainability of household debt. 

In the financial markets 2017 had been characterized by relatively good performance, despite experiencing a sudden increase in volatility. Following these developments, 2018 could be a pivotal year for investors who, as monetary policies normalize, are encouraged to change the structure of their portfolios. For the time being, the risk aversion measures used by the BCL reveal investors' pronounced appetite for risk and the transitory nature of the increase in volatility at the beginning of 2018. 

The analysis of the Luxembourg financial sector allows us to observe its evolution since the crisis. On the one hand, the strong momentum in the investment fund sector, which is certainly conducive to growth for the domestic economy, calls for further study of its systemic involvement. From this point of view, the reduction in bond funds' exposure to interest rate risk reflects prudent behavior in the context of the normalisation of monetary policies. On the other hand, credit institutions demonstrate certain resilience capacities with regard to regulatory ratios (solvency and liquidity), stress tests, theoretical probabilities of default (z-score index) and the systemic banking fragility indicator. Nevertheless, the contraction in total assets and net banking income confirms their gradual adaptation to an unfavorable profitability environment and increased regulatory requirements.  

Finally, the Financial Stability Review proposes, as an annex, two specific analyses. The first examines the risks to financial stability associated with the growth of the "parallel financial intermediary" sector in a context where banking regulation can provide an incentive to transfer credit risk to less regulated segments of the financial system. The optimality of macroeconomic stabilization macroprudential policy is assessed through a New Keynesian stochastic dynamic general equilibrium (DSGE) model, in which the traditional banking sector can use debt securitization to reduce its regulatory capital burden. This study suggests that, following the risk transfer from the traditional banking system to the "parallel system" allowed by securitisation, it returns to the first sector through the interbank market and in the productive sector through the allocation of loans to enterprises. Moreover, the results indicate that the complementarity of macroprudential instruments, such as the leverage ratio or the securitisation ratio, enables macroprudential authorities to successfully achieve macroeconomic stabilisation, measured by the volatility of gross domestic product, following a shock.  

The second study shows how a measure of systemic risk, constructed from each line of the balance sheet of financial intermediaries, can potentially identify different aspects of the aggregate level of systemic risk. In the same way that it is possible to allocate a market price to an asset according to the Mark-to-Market rule, it is possible to associate to each balance sheet line with an aggregate "Mark-to-Systemic-Risk" risk contribution by considering it for each financial institution simultaneously. The "Mark-to-Systemic-Risk" approach then provides an analysis of each financial entity's contribution to overall risk according to the importance of each balance sheet item. 

In order to show how the "Mark-to-Systemic-Risk" concept can be put into practice, the study characterises systemic risk and transmission risks for 33 Luxembourg banks, their respective banking groups and 232 investment funds over the period 2003-2016. A so-called "dynamic grouped t-copula" approach, relevant for modelling large dynamic distributions, is proposed in order to estimate several prospective measures constructed on the basis of the balance sheet data of each financial institution in the system. The study suggests in particular that Luxembourg subsidiaries are more sensitive to adverse events conveyed by investment funds than to those transmitted by European banking groups and that investment funds were more sensitive to adverse events from European banking groups than from Luxembourg subsidiaries. 

The Financial Stability Review is available upon request, subject to availability, from the BCL ( and can also be downloaded from the BCL website