Macroprudential supervision

The entry into force of Capital Requirements Directive (CRD) (2013/36/EU) and Capital Requirements Regulation (CRR) (575/2013) for banks and large investment firms marked a turning point at the European level in the context of macroprudential policy for banks. This section describes the macro-prudential measures implemented in Luxembourg and which mainly affect the banking sector. The CSSF is the national designated authority under the CRD and, as such, responsible for implementing macro-prudential supervision and policy for Luxembourg banks. In the context of its missions, the CSSF, takes decisions after consultation and exchange with the Banque centrale du Luxembourg (BCL) and based upon recommendation or after requesting the opinion of the Comité du Risque Systémique (CdRS). The CSSF also acts in close cooperation with the relevant European institutions. The CSSF disposes of a policy toolkit to perform its duties, including the possibility of requiring banks to build additional capital buffers because of their systemic importance, the state of the financial cycle or because of structural risks. The CSSF can also set up risk weight floors. As macroprudential policy has an international dimension due to possible cross-border spillover effects and leakages, the CSSF is also led to recognise macroprudential policy measures taken by other countries and apply them to the entities falling under its supervision.

At the international level, the CSSF cooperates in several fora in the context of its macroprudential policy and supervision. The most frequent interaction takes place in the context of the Financial Stability Committee of the Eurosystem in SSM composition. Furthermore, the CSSF is represented in the ESRB General Board. Lastly, the CSSF participates in the regional consultative group for Europe of the Financial Stability Board.

The Countercyclical Capital Buffer (CCyB) is a key macro-prudential instrument of the Basel III framework designed to counter the pro-cyclicality of the financial system. The CCyB is introduced into EU law by the Capital Requirements Directive (CRD) (2013/36/EU) and by the Capital Requirements Regulation (CRR) (575/2013), both of which came into effect on 1 January 2014. Two regulatory sources determine the CCyB regime in Luxembourg: the Law of 5 April 1993 on the financial sector (LFS) transposing the CRD, and, the Law of 1 April 2015 establishing a Comité du Risque Systémique (CdRS Law). Article 59-7 of the LFS provides that the CSSF is responsible for setting the countercyclical buffer rate applicable in Luxembourg. As such, the CSSF, as designated authority shall take the decisions after consultation with the Banque centrale du Luxembourg (BcL) and by taking into account the recommendations of the Comité du Risque Systémique (CdRS). CSSF Regulation N° 15-05 exempts small and medium-sized investment firms from the application of the CCyB. In accordance with the recommendation of the European Systemic Risk Board (ESRB) (ESRB/2014/1), the CSSF calculates a quarterly guide for the capital buffer, intended to guide the judgement on the adequacy of the countercyclical buffer rate. This guide reflects the credit cycle and the risks associated with excessive credit growth in Luxembourg and takes due account of the specificities of the Luxembourg economy. It is based on the deviation of the credit-to-GDP ratio from its long-term trend. The countercyclical buffer rate is set based on a “guided discretion”-approach, whereby the CdRS for its recommendation takes into account a set of data when it assesses the level of systemic risk and sets the buffer rate accordingly.

Article 131 of the Capital Requirements Directive (CRD) (2013/36/EU) deals, among others, with the identification methodology for other systemically important institutions (O-SIIs). O-SIIs can either be an EU parent institution, an EU parent financial holding company, an EU parent mixed financial holding company or an institution. Such provisions have been transposed into Luxembourg by the Law of 23 July 2015 amending the Law of 5 April 1993 on the financial sector (LFS). Under Article 59-3 of the LFS, the CSSF is the national designated authority in charge of identifying O-SIIs. The CSSF takes its decisions after consultation with the Banque centrale du Luxembourg (BCL) and after requesting the opinion of the Comité du Risque Systémique (CdRS). The CSSF and the BCL have jointly developed a calibration methodology designed to translate the systemic importance of the institutions into O-SII buffer rates. Their assessments follow the European Banking Authority (EBA) O-SII Guidelines (the Guidelines) with which the CSSF has committed to comply. The Guidelines more particularly establish a mandatory scoring process for assessing systemic importance based on the following indicators: size, importance, complexity, and interconnectedness. In 2017, the CSSF in collaboration with the Luxembourgish central bank for the first time applied an extended methodology for the identification of O-SIIs. This methodology adds to the standard indicators a scoring category which picks up the importance of an institution with respect to connections with the domestic investment fund industry. This extended framework specifically acknowledges the importance of the wider financial sector for the Luxembourgish banking sector.

The Luxembourg real estate market has been buoyant for many years. A strong growth in the population combined with a limited supply in housing has driven up the residential property prices. So far, banks have contributed to the real estate demand through a strong increase in housing credit which has driven up the global level of household indebtedness. At the macroprudential level, these developments generate financial stability concerns. The repayment capacity of households is strongly linked to the evolution of interest rates and the value of household wealth depends on the continuous growth of real estate prices. Borrower-based measures contribute to contain indebtedness and to stabilise real estate mortgage credit prices. In November 2016, the ESRB issued public warnings for eight countries, including Luxembourg, on medium-term residential real estate vulnerabilities. Moreover, in May 2017, the IMF published its Financial System Stability Assessment for Luxembourg following the Financial Sector Assessment mission that took place in September and December 2016. Among the several IMF findings and recommendations, the IMF recommended the Luxembourg authorities to “enhance the macroprudential policy toolkit to include borrower-based lending limits”, to “continue to strengthen risk-based monitoring of the residential real estate market”, and to “close remaining related data gaps”. Also, in September 2019, the ESRB issued a follow up recommendation to Luxembourg, to introduce a legal framework for borrower based measures, and, activate measures as soon as a legal framework becomes available. As a follow-up of the ESRB warning and the IMF and ESRB recommendations, the Luxembourgish Parliament passed a law on borrower-based measures (BBM) in November 2019. This law enables the CSSF upon request by the CdRS to enact borrower-based measures such as loan-to-value (LTV) and debt service-to-income limits (DSTI).

In 2016, the Comité du Risque Systémique (CdRS) provided an opinion and a recommendation regarding the risk weights applied to retail exposures (non-SME) secured by residential property in Luxembourg. In its opinion (CRS/2016/004), the CdRS expresses its view that risk weights that are based on internal models (“IRB Approach”) for loans secured by residential real estate should not produce an average risk weight for residential property in Luxembourg below 15%. Also the CdRS recommendation (CRS/2016/004) invites the CSSF to take any appropriate measure to ensure that credit institutions respond to the CdRS’ opinion. The CSSF is following up on banks’ compliance in the context of macroprudential supervision.

The commercial real estate sector plays an important role in the economy and its developments can have a material influence on the financial system. In recent years, increasing efforts have been devoted to identify and monitor potential vulnerabilities that may arise from the interplay between this sector and the financial system.

The European Systemic Risk Board (ESRB) wishes to establish a harmonised framework for monitoring developments in both the residential and the commercial real estate sector. This implies the collection of data and indicators that help identifying the build-up of systemic risks and assessing the potential need for macroprudential intervention. Granular and consistent data are necessary to capture market developments and analyse systemic risks adequately.

In this context, the ESRB issued a recommendation in 2016 on closing real estate data gaps (ESRB/2016/14), which was amended in 2019 by ESRB recommendation 2019/03. These two recommendations were followed by another one focussing specifically on vulnerabilities in the commercial real estate sector (ESRB/2022/9). The recommendation on closing real estate data gaps contains a set of indicators that need to be collected by national authorities as part of the risk monitoring framework for their domestic real estate sector, while the recommendation specific to CRE aims at improving the monitoring of systemic risks stemming from the CRE market, at ensuring sound financing practices, and at increasing the resilience of financial institutions.

In Luxembourg, the Comité du Risque Systémique is coordinating work among several authorities to comply with the ESRB recommendations. In this context, the CSSF implemented two recurrent data collections focusing on the financing of the commercial real estate (CRE) sector by banks and investment funds.

Article 458 of the Capital Requirements Regulation (CRR) (575/2013) allows national authorities to impose stricter prudential requirements to address systemic risks with the potential to have serious negative consequences to the financial system and that are considered to be better addressed by stricter national measures. The instruments in Article 458 CRR serve different purposes and target different dimensions of systemic risk. These measures can be applied for up to two years, with a possibility of extension. It can target own funds requirements, capital conservation buffer, intra-financial sector exposures, large exposures requirements, public disclosure requirements but also liquidity and real estate-related systemic risks. Where the CSSF acts in accordance with Article 458 of Regulation (EU) No 575/2013, it shall take its decisions after consultation with the Banque centrale du Luxembourg (BCL) and after requesting the opinion or recommendation of the Comité du Risque Systémique (CdRS). So far, no measure under Article 458 CRR has been taken.

The Capital Requirements Directive (CRD) (2013/36/EU) provides additional capital requirements for systemically important banks, i.e. banks that may pose systemic risks to the global financial system given their size, market importance and global interconnectedness. The global systemically important institutions (G-SII) buffer is a mandatory capital surcharge built up of Common Equity Tier 1 capital and applied at the consolidated level of the identified banking groups. The main aim of the measure is to increase the resilience of the banking sector at the global level by compensating for the higher risk that G-SIIs represent and the potential impact of their failure. The capital surcharge may vary between 1% and 3.5% depending on the degree of systemic importance of the bank. It is being gradually phased-in from 1 January 2016 until 1 January 2019. The legal provisions that provide for the identification of G-SIIs and the application of the buffer requirement are contained in Article 131 of the CRD IV which have been transposed into national law through Articles 59-3 and 59-8 of the Law of 5 April 1993 on the financial sector (LFS). The CSSF, as designated authority, is in charge of identifying G-SIIs in Luxembourg. It takes the decisions after consultation with the Banque centrale du Luxembourg (BCL) and by taking into account the opinion of the Comité du Risque Systémique (CdRS). There is no bank established in Luxembourg identified as a G-SII.

Article 129 of the Capital Requirements Directive (CRD) (2013/36/EU) deals with the set-up of a capital conservation buffer. This article has been transposed into Article 59-5 of the Law of 5 April 1993 on the financial sector (LFS). The capital conservation buffer is a capital buffer of 2.5% of an institution’s total exposures that needs to be met with an additional amount of Common Equity Tier 1 capital. The buffer sits on top of the 4.5% minimum requirement for Common Equity Tier 1 capital. Its objective is to conserve an institution’s capital. The capital conservation buffer is intended to ensure that firms build up buffers of capital outside any periods of stress and is designed to avoid breaches of minimum capital requirements. This capital buffer can then be drawn upon in times when losses are incurred. When an institution breaches the buffer, automatic safeguards apply to limit the amount of dividend and bonus payments it can make.

In Luxembourg, banks must have a capital conservation buffer of 2.5% from 1 January 2014 onwards. There has not been a transition phase for the implementation. Following CSSF Regulation N° 15-05, investment firms qualifying as small and medium-sized enterprises are exempted from the requirements to maintain a countercyclical capital buffer and a capital conservation buffer.

The systemic risk buffer (SRB) is a macro-prudential instrument designed to prevent and mitigate systemic risks of a long-term, non-cyclical nature, which present a potential of contagion to the financial system and the real economy, and are not covered by the Capital Requirements Regulation (CRR) (575/2013). The SRB is introduced into EU law by Article 133 of the Capital Requirements Directive (CRD) (2013/36/EU). At the national level, Article 59-10 of the Law of 5 April 1993 on the financial sector (LFS) establishes the CSSF as the designated authority in charge of setting the systemic risk buffer rate applicable in Luxembourg. The CSSF may only act pursuant to this article after an opinion has been adopted by the Comité du Risque Systémique. The Comité du Risque Systémique (CdRS) shall review this opinion at least every second year. Where the CSSF acts in accordance with this article, it shall take the decisions after consultation with the Banque centrale du Luxembourg (BCL). This systemic risk buffer must be of at least 1% based on the exposures to which the systemic risk buffer applies, which may apply to exposures in Luxembourg as well as to exposures in third countries. No maximum limit applies to this buffer. When requiring a systemic risk buffer to be maintained the CSSF shall comply with the following: (a) according to the assessment of the CdRS, the systemic risk buffer must not entail disproportionate adverse effects on the whole or parts of the financial system of other Member States or of the European Union as a whole forming or creating an obstacle to the functioning of the internal market; (b) the systemic risk buffer must be reviewed by the CSSF at least every second year. So far, the SRB has not been activated yet.

The macroprudential measures implemented in a country may directly or indirectly impact other countries. In order to reduce the potential for arbitrage of financial institutions between Member States, these can reciprocate measures of other authorities. Broadly two reciprocation frameworks can be distinguished: automatic and voluntary reciprocation. Following ESRB Recommendation ESRB/2014/1, Article 137 of the Capital Requirements Directive (CRD) (2013/36/EU), and Article 59-7(8) of the Law of 5 April 1993 on the financial sector (LFS), there is an automatic recognition principle for CCyB below or equal to 2.5% for EU countries. Hence, the CSSF should generally recognise the buffer rates set by other Member States. For this type of reciprocation no decisions need to be taken. Regarding other cases and instruments, the ESRB in its Recommendation on the assessment of cross-border effects of and voluntary reciprocity for macroprudential policy measures (ESRB/2015/2), provides guidance for a systemic assessment of the cross-border effects of macroprudential policy and a coordinated policy response in the form of voluntary reciprocity for macroprudential policy measures when needed. In practice, the activating authority requests a reciprocation of its measure to the ESRB and the latter issues a recommendation to reciprocate the measure taken by the activating authority. The CSSF is not obliged to reciprocate but is required to sufficiently explain why it does not (“comply or explain mechanism”). The decision to reciprocate is taken after consultation with the Banque centrale du Luxembourg (BCL) and after requesting the opinion or recommendation of the Comité du Risque Systémique (CdRS).

Macroprudential measures can be taken by the CSSF under Article 25 of the Alternative Investment Fund Managers’ Directive (“AIFMD”) on the use of information by competent authorities, supervisory cooperation and limits to leverage, as implemented into Luxembourg legislation by Article 23 of the Law of 12 July 2013 on alternative investment fund managers (“AIFM Law”).

It specifically stipulates that the CSSF shall assess the risks that the use of leverage by a Luxembourg alternative investment fund manager (“LU AIFM”) with respect to the AIFs it manages could entail. Where deemed necessary, in order to ensure the stability and integrity of the financial system, the CSSF, after having notified the European Securities and Markets Authority (“ESMA”), the European Systemic Risk Board (“ESRB”) and, if applicable, the competent authorities of the relevant AIF, shall impose limits to the level of leverage that an LU AIFM is entitled to employ or other restrictions on the management of the AIF with respect to the AIFs under its management to limit the extent to which the use of leverage contributes to the build-up of systemic risk in the financial system or risks of disorderly markets.