## cr17122

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### FSAP mission, scope, and participants
- FSAP team led by Peter Breuer; included Bradley Jones (deputy mission chief), Richard Berkhout, Antoine Bouveret, Jana Gieck Bricco, Giovanni Cucinotta, Ender Emre, Ziya Gorpe, Cyril Pouvelle, Nadine Schwarz, Thierry Tressel, Froukelien Wendt (all IMF staff), and external experts Michael Deasy, David Scott, Richard Stobo; assistance from Christie Chea (IMF).
- Mission meetings: Minister of Finance; Governor of the Banque centrale du Luxembourg (BCL); Directeur Général of the Commission de Surveillance du Secteur Financier (CSSF); Directeur Général of the Commission aux Assurances (CAA); ECB; European Systemic Risk Board; Single Resolution Board; banks, investment firms, insurance companies, auditors, accountants, lawyers.
- Report prepared by Peter Breuer and Bradley Jones; draws on six Technical Notes and one Detailed Assessment Report. Date: April 17, 2017.
- Scope: FSAP assesses stability of the financial system as a whole; Luxembourg deemed to have a systemically important financial sector; assessment part of bilateral surveillance under Article IV.

### Executive summary — main findings
- Financial soundness indicators: have remained relatively robust.
- Investment fund industry: strong growth in assets under management (AuM); exposure to liquid assets steady.
- Banking sector: high levels of profitability, capital, liquidity, and asset quality; significant liquidity and revenues from private banking and fund management.
- Insurance industry: relatively less exposed to guaranteed products than regional peers; high profitability and capitalization; adjusted to new regulatory regime.
- Authorities: adoption of key recommendations from the 2011 FSAP; strengthening of AML/CFT regime.

### Structural vulnerabilities and contagion channels
- System features and cross-border size:
  - Financial industry accounts for one quarter of GDP, 18 percent of tax revenues and 12 percent of employment.
  - Investment and money market fund AuM: €3.6 trillion, 67 times GDP.
  - Bank assets: €764 billion, 14 times GDP.
  - Insurance industry assets: €219 billion, 4 times GDP.
  - Investment funds domiciled in Luxembourg: 14,065 entities; AuM doubled since spring 2010.
- Intragroup exposures and parent relationships:
  - Some 35 percent of Luxembourg bank assets comprise intragroup claims (77 percent of which now fall under ECB supervision).
  - Luxembourg subsidiaries aggregate liquidity from investment fund and wealth management operations and ‘upstream’ it to parents abroad; subsidiaries may be exposed to maturity and currency transformation at parent level.
- Investment fund liquidity risk:
  - If liquidity buffers fail under large redemption shocks, asset fire sales and drawdown of local bank deposits could occur; operational deposits broadly stable in past stress periods.
- Clearstream (CBL) risk:
  - Daily average settlement value in 2015: €480 billion; securities held in accounts with CSDs around €6 trillion.
  - Shock to Clearstream could disrupt numerous institutions and markets it serves.
- Real estate risk:
  - Real home prices have risen 22 percent since the marginal decline in 2009; easing in lending standards and increased household indebtedness pose key domestically-originated vulnerability.

### Stress testing and resilience assessment — banks, insurers, funds
- Overall assessment: a good deal of resilience, with some risks.
- Banking solvency (system-wide, fully-loaded Basel III):
  - CET1 ratio decline from 18.6 percent to 15.1 percent over three years under adverse scenario.
  - CAR declines by 3.6 percentage points to 15.8 percent in 2019 from 19.4 percent in 2016.
  - System-wide leverage ratio declines from 5.9 to 5 percent.
  - One bank falls below the CET1 hurdle; three banks (comprising less than 10 percent of industry assets) fall below CAR hurdle by 0.1 and 0.8 percent of GDP respectively.
  - Six banks would experience a decline below the 3 percent leverage hurdle rate in 2019 by an amount equivalent to 1.6 percent of GDP.
- Banking liquidity:
  - System-wide LCR (standard): 109.4%
  - LCR (retail scenario): 107.6%
  - LCR FX (USD): 16.7%
  - LCR FX (EUR): 161.8%
  - LCR FX (GBP): 9.8%
  - NSFR: 101.1%
  - LCR shortfalls: 4 out of 16 banks (various scenarios); NSFR shortfalls: 2 out of 8 banks (modest).
  - Cash-flow analysis: 6 out of 8 banks would face funding gaps over a seven-day shock; all but one affected bank hold sufficient central bank eligible securities to cover such shortfall.
- Household solvency:
  - Household debt default probabilities increase from 2.5 to 6.4 percent (multiplier of 2.6) under the adverse macro-financial shock.
  - Household debt-to-income ratio referenced as 120 percent in one section (offset: high household net worth: financial assets exceed household debt by 2.4 times).
- Insurance solvency:
  - Bottom-up stress test covering 10 life insurers and one reinsurer: aggregate Eligible Own Funds (EOF) declines by 27 percent in the third year of the adverse scenario; each insurer remains above the 100 percent Solvency II requirement.
- Money market funds (CNAV MMFs):
  - Sample of 5 CNAV funds (accounting for 75 percent of CNAV MMF AuM): combination required to ‘break the buck’—130 basis point shock to risk-free rates and 150 basis point widening in credit spreads for shadow NAV to deviate substantially (by 0.2 percent or more) from par.
- Investment fund liquidity stress tests:
  - Around 70 percent of HY funds would face a shortfall in both historical and forward-looking scenarios.
  - Under forward-looking adverse scenario, simultaneous severe redemptions equal 20–24 percent of investment fund bank deposits in the sample (equivalent to €4.9–5.3 billion).
  - Across sample depositary banks, these outflows would equal 3 percent of total deposits, or 4 to 10 percent of wholesale or operational deposits respectively.

### Stress-test design, scenarios, and methodologies
- Banking sector coverage: top-down covering 16 banks (15 SIs and 1 LSI) accounting for 73 percent of industry assets; horizon 3-years (2017–2019).
- Adverse scenario numeric outcomes (bank stress):
  - GDP growth rate declines to -3.7, -2.6 and +1.8 percent, in 2017, 2018 and 2019 respectively; cumulative deviation of 14.7 percentage points with respect to baseline (equivalent to a 2 standard deviation shock).
- Investment fund testing:
  - Sample: 191 investment funds (mostly UCITS); latest data March 2016; redemption shock historical: 1st percentile net outflow over 2007–2016 and forward-looking stress calibrated to adverse macro scenario.
- Contagion and network analysis:
  - Balance-sheet and market-data models show generally benign domestic contagion indices (e.g., failure of highest contagion entity causes losses of less than 0.5 percent of counterparties’ capital).
  - Cross-border modeling shows vulnerability to parent failures; example: Bank 3 suffers average hit to capital of around 25 percent across individually triggered failures of all parent entities; failure of Parent of Bank 9 results in average loss to other entities above 100 percent of their capital.
  - Model assumptions explicitly include loss-given default of 40 percent; funding shortfall of 35 percent; discount for asset firesales of 50 percent.

### Key quantitative financial soundness metrics (selected figures)
- Regulatory capital to risk-weighted assets: 19 17 16 19 21 20 22 23
- Regulatory Tier 1 capital to risk-weighted assets: 17 15 14 17 18 19 21 23
- Return on assets: 0.6 0.7 0.3 0.6 0.6 0.7 0.8 0.7
- Return on equity: 12 13 5 10 10 12 11 10
- Household debt to GDP: 50.0 49.0 54.0 55.0 55.0 60.0 59.0 62.0
- Nonperforming loans to total gross loans: 0.7 0.2 0.4 0.2 0.2 n.a. n.a. n.a.
- Liquid assets to total assets: 56 56 59 58 60 60 58 n.a.
- Customer deposits to total (non interbank) loans: 138 131 119 129 147 154 144 118
- Foreign currency denominated liabilities to total liabilities: 29 33 32 34 35 36 40 40
- Investment funds' AuM (Table 3 snapshot): investment funds (entities) = 14,065 with assets 3,350.0 (€ billions); money market funds = 167 with assets 290.6 (€ billions)
- Bank assets (Table 3): total bank assets = 763.7 (€ billions); banks as multiple of GDP = 14.0
- GDP per head (memorandum): €90,400; population in 2016 = 576,000; land area = 2,586 sq. km.
- Selected Real GDP percent change (Table 2, 2014–22): 2014 = 4.7, 2015 = 3.5, 2016 = 4.0, 2017 = 3.7, 2018 = 3.5, 2019 = 3.3, 2020 = 3.1, 2021 = 3.1, 2022 = 3.0
- GDP (billions of euro) projections (Table 2): 2014 = 49.3, 2015 = 51.2, 2016 = 53.7, 2017 = 56.5, 2018 = 59.3, 2019 = 62.4, 2020 = 65.5, 2021 = 68.8, 2022 = 72.3
- Nonfinancial private sector credit (eop, percent change) 2014–22 (Table 2): 2014 = 4.9, 2015 = 15.7, 2016 = 5.7, 2017 = 5.1, 2018 = 3.9, 2019 = 3.4, 2020 = 2.7, 2021 = 2.8, 2022 = 2.6
- Current account (percent of GDP) projections 2014–22: 2014 = 5.1, 2015 = 5.2, 2016 = 4.8, 2017 = 5.1, 2018 = 5.1, 2019 = 5.4, 2020 = 5.5, 2021 = 5.6, 2022 = 5.8

### Prudential oversight — strengths and recommended enhancements
- Cross-cutting recommendations:
  - Continue pivot to risk-based supervision and increase resources for BCL, CSSF, CAA.
  - Enshrine operational independence and accountability of the CSSF and CAA in law; update codes of conduct for board members.
  - Introduce a formal framework to govern the relationship between the government and banks with state involvement.
  - Increase engagement with supervisors in jurisdictions where Luxembourg’s funds and banks are most active.
- Banking supervision specifics:
  - Increase frequency of on-site inspections, particularly for subsidiaries availing of waiver to large exposure limits; require periodic demonstration of continued eligibility for waiver.
  - Harmonize data reporting standards for loan-to-value and debt-to-income ratios.
  - Monitor FX funding stresses and examine merits of a foreign currency liquidity requirement at group level.
- Investment fund supervision:
  - CSSF to issue guidance on liquidity management tools and liquidity stress testing modalities; develop internal liquidity stress testing capacity.
  - Strengthen guidance on substance in delegated activities; issue guidance on fund directorships; assess depositary independence safeguards.
  - Increase frequency and comprehensiveness of on-site inspections.
- Insurance supervision:
  - Implement revised early warning system under Solvency II (as planned); increase resources; subject board members to formal code of conduct; limit government dismissal powers over Executive Committee.

### Macroprudential policy — framework and tools
- Framework introduced in 2015 appears to work well; enhancements suggested:
  - Remove unanimity requirement in the CRS to reduce inaction bias.
  - Enshrine BCL lead role in law and award BCL formal powers to issue recommendations; publish BCL risk reports and dashboard.
  - Expand toolkit to include borrower-based limits (loan-to-value and debt-service-to-income) with legal basis.
  - Surveillance priorities: real estate market and bank-investment fund interlinkages; close remaining data gaps.

### Clearstream Banking Luxembourg (CBL) and FMIs — findings and priorities
- Assessment: CBL broadly observes international standards (PFMI) though 8 out of 21 PFMI principles found to be in broad observance.
- Systemic profile:
  - Average daily settlement value in 2015: €480 billion; client base >1,400 institutions from over 110 countries; links to 56 markets; securities held ~€6 trillion.
- Key risks and recommended mitigants:
  - Concentration in cash correspondent banks (CCBs) in U.S. and U.K.: diversify CCB base and seek direct links with CSDs and central banks.
  - Uncollateralized credit: ensure full collateralization, apply validated haircuts to cash collateral, and implement collateral concentration limits.
  - Operational resilience: invest in a third, more distant data center; conduct a full failover test.
  - Governance and risk management: ensure CRO focuses solely on risk management; independent validation of haircut and other models; acknowledge dependence on Deutsche Börse AG in recovery planning.
  - Oversight: formalize cooperation arrangements between BCL and CSSF; strengthen cooperation with Belgian authorities regarding Euroclear Bank; consider SSM designation for CBL and SRB remit.

### Crisis resolution, safety nets, and contingency planning
- Institutional changes: participation in Banking Union; SRB and ECB share competencies; BRRD and DGSD transposed; Resolution Board and Depositor Protection Council established within CSSF.
- Recovery and resolution planning:
  - Recovery advanced; resolution planning early-stage—more guidance needed from ECB and SRB to identify critical functions and treatment of large intragroup exposures.
  - Recommend operationalize bail-in complemented by sale of business and bridge bank tools; ensure adequate liquidity funding in resolution.
  - Address intragroup exposure policies and transfer of custodian functions in recovery and resolution.
- Deposit insurance and back-stop funding:
  - New deposit insurance targets fund balance twice EU requirement and advanced payout timetable; no backstop funding arrangements in place—should be pursued.
- Emergency liquidity assistance (ELA) and FX contingency:
  - BCL has market and BIS access but no bilateral FX swap arrangements; examine additional contingent FX funding arrangements and finalize modalities of ELA provision.
- Crisis management coordination:
  - MoF to streamline coordination modalities with SRB and ECB; develop and test contingency plans via crisis simulations.

### Risk Assessment Matrix (RAM) — selected risks and likelihoods
- Sharp rise in financial market risk premia and renewed Euro area recession:
  - Relative likelihood: Medium; Impact if realized: High.
  - Transmission: trapped upstreamed liquidity, large synchronized fund redemptions, operational stresses at CBL.
- Political fragmentation/protectionism and post-Brexit uncertainty:
  - Relative likelihood: Medium; Impact if realized: Medium.
  - Transmission: reduced trade/financial flows; potential relocation of activity to Luxembourg.
- Downturn in residential housing market (following 22 percent price rise since 2009, easing lending standards, increased household indebtedness):
  - Relative likelihood: Medium; Impact if realized: Medium.
  - Transmission: increased NPLs for domestically-oriented banks; household net worth decline; contingent fiscal liabilities.
- Structural/operational risks and nonbank financing adaptation challenges:
  - Relative likelihood: Medium; Impact if realized: High.
  - Transmission: shrinkage in financial system assets; erosion of tax base (financial sector = one quarter of GDP).

### STeM (Stress Testing Matrix) — institutional coverage and methodologies (high-level)
- Banking solvency: 16 banks; 73 percent market share; horizon 3-years (2017–2019); satellite models for credit losses and pre-impairment income; adverse scenario with GDP growth -3.7, -2.6, +1.8 percent in 2017–19.
- Banking liquidity: 16 banks for LCR; 8 banks for NSFR and cash-flow; LCR latest data September 2016; NSFR/cash-flow baseline date June 2016; methodologies include Basel III-LCR and NSFR type proxies and cash-flow maturity buckets.
- Contagion: 16 banks, 12 insurers, 5 investment fund groups; network models and market-data connectedness methodologies applied.
- Investment funds liquidity: 191 funds (including 42 EM bond funds; 32 HY bond funds; 50 largest bond funds; 5 CNAV MMFs); latest data March 2016; redemption shock = 1st percentile historical net flows (2007–2016) and model-based forward-looking shocks.
- Insurance solvency: bottom-up by CAA; 10 life insurers and one reinsurer; market share 71.5 percent of gross life technical provisions; baseline date June 2016; horizon 2017–2019.

### Selected policy recommendations (condensed action items)
- Continue resource allocation toward risk-based supervision at BCL, CSSF, and CAA (¶25).
- Increase engagement with supervision and resolution authorities in jurisdictions where Luxembourg’s LSIs and investment funds conduct significant activities (¶25, 30, 33).
- Enshrine operational independence of CSSF and CAA in law; update board codes of conduct (¶25, 30, 39).
- Examine merits of a regulatory LCR requirement in FX at the group level and step up monitoring of FX liquidity risk (¶17, 31).
- CSSF to issue guidance on liquidity management tools and liquidity stress testing modalities for investment funds; develop internal stress testing capacity (¶21, 34).
- Strengthen macroprudential institutional framework (revoke unanimity requirement, enshrine BCL lead role); expand toolkit to include borrower-based limits (¶26, ¶27).
- Reduce CBL’s deposit exposure to select commercial banks; tighten collateralization arrangements; establish third, distant data center and conduct full failover test (¶41).
- Operationalize bail-in and develop sale of business and bridge bank tools; ensure adequate resolution liquidity; agree policies on intragroup exposures and custodian function transfers in recovery/resolution (¶47).
- Pursue contingent FX funding arrangements to complement BCL’s ELA facility (¶52).

*Source: IMF Financial Sector Assessment Program Update — Luxembourg (FSAP chapter and annexes), April 17, 2017.*

### 2016. The FSAP findings were discussed with the

### cr17122 - 2016. The FSAP findings were discussed with the

### FSAP mission and preparation
- The FSAP team was led by Peter Breuer and included Bradley Jones (deputy mission chief), Richard Berkhout, Antoine Bouveret, Jana Gieck Bricco, Giovanni Cucinotta, Ender Emre, Ziya Gorpe, Cyril Pouvelle, Nadine Schwarz, Thierry Tressel, and Froukelien Wendt (all IMF staff), as well as Michael Deasy, David Scott, Richard Stobo (external experts) with assistance from Christie Chea (IMF).
- The mission met with the Minister of Finance, the Governor of the Banque centrale du Luxembourg (BCL), the Directeur Général of the Commission de Surveillance du Secteur Financier (CSSF), the Directeur Général of the Commission aux Assurances (CAA) and their staffs, and representatives of the European Central Bank (ECB), the European Systemic Risk Board and the Single Resolution Board.
- The mission also met with representatives of banks, investment firms, insurance companies, other financial institutions, industry associations, as well as auditors, accountants, and lawyers.
- This report was prepared by Messrs. Peter Breuer and Bradley Jones, with inputs from the Luxembourg FSAP team members. The report draws on six Technical Notes and one Detailed Assessment Report.
- April 17, 2017

### Purpose and scope of FSAP
- FSAPs assess the stability of the financial system as a whole and not that of individual institutions.
- FSAPs are intended to help countries identify key sources of systemic risk in the financial sector and implement policies to enhance its resilience to shocks and contagion.
- Certain categories of risk affecting financial institutions, such as operational or legal risk, or risk related to fraud, are not covered in FSAPs.
- Luxembourg is deemed by the Fund to have a systemically important financial sector and the stability assessment under this FSAP is part of bilateral surveillance under Article IV of the Fund’s Articles of Agreement.

### Executive summary — main findings
- Financial soundness indicators for Luxembourg’s financial system have remained relatively robust in recent years.
- Investment fund industry: strong growth in assets under management; exposure to liquid assets has remained steady.
- Banking sector: high levels of profitability, capital, liquidity, and asset quality; relatively large share of liquidity and revenues derive from private banking and fund management activities.
- Insurance industry: relatively less exposed to guaranteed products than regional peers; maintained high profitability and capitalization levels; adjusted to the new regulatory regime.
- Authorities: adoption of key recommendations from the 2011 FSAP and a strengthening of the Anti-Money Laundering/Combating the Financing of Terrorism regime.

### Structural vulnerabilities and channels of contagion
- Size and interconnectedness of the financial system, and elevated real estate valuations, give rise to potential vulnerabilities.
- Banks’ foreign parent relationships:
  - Many Luxembourg foreign bank subsidiaries aggregate liquidity from investment fund and wealth management operations and ‘upstream’ it to their parents abroad.
  - Subsidiaries may be exposed to maturity and currency transformation at the parent level—where exposures can be large (relative to subsidiaries capital) and oversight by the Luxembourg authorities may be limited where parents are not regulated under the Single Supervisory Mechanism.
- Investment fund liquidity risk:
  - Should investment fund liquidity buffers struggle to accommodate large redemption shocks, asset fire sales and a drawdown of local bank deposits could occur.
  - Operational deposits have been broadly stable in past stress periods.
- Clearstream risk:
  - A shock to Clearstream, which has a central role in worldwide securities depositary and settlement services, could disrupt numerous institutions and markets it serves.
- Real estate risk:
  - After a strong run up in prices and easing in lending standards, the real estate market, to which domestically-oriented banks are most exposed, poses the main home-grown vulnerability.

### Stress testing and resilience assessment
- Overall assessment: a good deal of resilience, albeit with some risks.
- Banks:
  - High starting levels of capital allow most banks to absorb a large shock in the adverse stress test scenario while retaining substantial buffers.
  - Bank liquidity displays broad resilience, though some banks could be exposed to wholesale funding drying up or foreign exchange (FX) funding stresses.
  - Recommendation: closely monitor FX funding stresses and examine the merits of a foreign currency liquidity requirement at the group level.
- Insurance:
  - Stress test results indicate that strong initial levels of capital and low guaranteed product exposure offer insulation against market shocks.
- Money market funds:
  - Liquidity and solvency risk appears muted.
  - Continued monitoring of liquidity and concentration risk among select bond funds is warranted.
- Spillovers:
  - Spillover analysis confirms material cross-border exposures for banks and investment funds, underscoring the need for ongoing vigilance.

### Prudential oversight — strengths and areas for improvement
- General/cross-cutting:
  - System of prudential oversight seems to function well, though several cross-cutting themes warrant attention.
  - A continued pivot towards risk-based supervision and further increase in resources for entities engaged in financial stability oversight would be consistent with rising industry assets and regulatory demands.
  - Introduce a formal framework to govern the relationship between the government and banks with state involvement.
  - Enshrine the operational independence of the CSSF and CAA in law.
  - Increase intensity of engagement with supervisors in countries where Luxembourg’s investment funds and banks are most active.
- Banking supervision:
  - More frequent on-site inspections, particularly for subsidiaries availing of the waiver to large exposure limits for intragroup transactions, should be introduced.
  - Banks should be required to periodically demonstrate their continued eligibility for the waiver.
  - Authorities are encouraged to harmonize data reporting standards (as intended), and remain vigilant in monitoring real estate vulnerabilities.

### Macroprudential policy framework
- The new macroprudential policy framework appears to be working well in practice and could be strengthened further.
- Institutional enhancements recommended:
  - Remove potential inaction bias arising from unanimous decision making.
  - Enshrine in law the lead role of the Banque centrale du Luxembourg (BCL).
  - Award BCL formal powers to issue recommendations.
- Surveillance priorities:
  - Surveillance of real estate and bank-investment fund vulnerabilities is appropriate.
  - Closing related data gaps is a priority.
- Instrument toolkit:
  - Expand to include borrower-based limits, as further macroprudential tightening may be required.

### Investment funds and insurance — regulatory and supervisory recommendations
- Investment funds:
  - CSSF should issue industry guidance on liquidity management tools and liquidity stress testing modalities, and develop internal stress testing capacity.
  - Increase the frequency of on-site inspections; introduce comprehensive inspections.
  - Engage with regulators in jurisdictions where delegated activities are prominent.
  - Ensure custodian banks are independent of funds for which they have oversight functions.
  - Issue guidance on fund directorships.
- Insurance:
  - Introduce a revised early warning system and increase resources.

### Clearstream Banking Luxembourg (CBL) and Financial Market Infrastructures
- Clearstream is assessed as broadly observing international standards for safe and efficient settlement and custody of securities transactions, though further risk mitigation measures are warranted.
- Priorities:
  - Reduce CBL’s deposit exposure to select commercial banks (preferably through direct links with Central Securities Depositories and central banks).
  - Tighten collateralization arrangements.
  - Further invest in a more distant data center.

### Crisis resolution and safety nets
- Single Resolution Mechanism and European directives have reconfigured Luxembourg’s bank resolution framework.
- Legal powers: authorities now have adequate legal powers to resolve failing banks, but more work is required to finalize credible resolution plans.
- Recommended actions:
  - Operationalize bail-in complemented by developing sale of business and bridge bank resolution tools.
  - Ensure adequate liquidity funding in resolution.
  - Address policies on intragroup exposures and the transfer of custodian functions in recovery and resolution.
  - Pursue additional contingent FX funding arrangements to complement the BCL’s emergency liquidity assistance facility.

*Source: IMF Financial Sector Assessment Program Update — Luxembourg, April 17, 2017*

### 1.      Continue resource allocation toward risk-based supervision at BCL, CSSF and CAA (¶25)

### 1.      Continue resource allocation toward risk-based supervision at BCL, CSSF and CAA (¶25)

### Summary of Key Policy Recommendations
- Continue resource allocation toward risk-based supervision at BCL, CSSF, and CAA (¶25). Responsible: BCL, CSSF, CAANT.
- Increase engagement with supervision and resolution authorities in countries where Luxembourg’s LSIs and investment funds conduct significant activities (¶25, 30, 33). Responsible: CSSFNT.
- Enshrine in legislation the operational independence of the CSSF and CAA, and introduce (CAA, CAA) or update (BCL) board member codes of conduct (¶25, 30, 39). Responsible: MoF, BCL, CAA, CSSF NT.

### Risk Analysis Recommendations and Actions
- Examine merits of a regulatory LCR requirement in FX at the group level and step up monitoring of related FX liquidity risk (¶17, 31). Responsible: EC, ECBMT.
- Provide industry guidance on liquidity stress test modalities and liquidity management tools for investment funds, and develop internal liquidity stress testing capacity (¶21, 34). Responsible: CSSFNT.

### Macroprudential Policy
- Strengthen the institutional framework in order to increase the willingness to act (¶26). Responsible: MoF, CRSMT.
- Expand the macroprudential policy toolkit to include borrower based lending limits (¶27). Responsible: MoF, CRSI.
- Continue to strengthen risk-based monitoring of the residential real estate market and bank-investment fund interlinkages, and close remaining related data gaps (¶28). Responsible: CRS, BCL, CSSFI.

### Banking Regulation and Supervision
- Increase the intensity of supervision over intra-group exposures, with banks required to demonstrate continued eligibility in their use of large exposure limit waivers (¶9, 24, 30). Responsible: CSSFNT.
- Continue monitoring ability of banks to absorb a real estate market price decline (¶10, 30). Responsible: CSSF, ECBC.
- Increase frequency of on-site inspections of subsidiaries of SIs (¶30). Responsible: CSSF, ECBC.
- Harmonize data reporting standards for loan-to-value and debt-to-income ratios (¶30). Responsible: CSSF, ECBI.

### Investment Fund Regulation and Supervision
- Strengthen guidance on substance in the context of delegated activities and actively engage with regulators in jurisdictions where such activities are prominent (¶33). Responsible: CSSFNT.
- Issue guidance on the holdings of directorships of funds and their managers (¶33). Responsible: CSSFNT.
- Assess whether safeguards to ensure depositary independence are adequate (¶35). Responsible: CSSFNT.

### Insurance Regulation and Supervision
- Implement revised early warning system under Solvency II regime (¶39). Responsible: CAANT.

### Financial Market Infrastructure Oversight
- Reduce CBL’s exposure to commercial banks vis-à-vis CSDs and central banks (¶41). Responsible: CSSF, BCLNT.
- Require establishment of third data center and conduct a full failover test (¶41). Responsible: CSSF, BCLNT.

### AML/CFT
- Ensure the 2016/2017 national risk assessment focus adequately on TCSP risks (¶45). Responsible: MoFI.

### Contingency Planning and Financial Safety Nets
- Develop policies on intragroup exposures and the transfer of custodian functions in recovery and resolution (¶47). Responsible: CSSF, SRB, ECBI.
- Agree on the roles and responsibilities in dealing with a system-wide crisis (¶53). Responsible: MoFNT.
- Finalize the operational modalities of emergency liquidity assistance provision (¶52). Responsible: BCL MT.

### Major Findings and Systemic Features (Selected Data Points)
- The financial industry directly accounts for one quarter of GDP, 18 percent of tax revenues and 12 percent of employment.
- Investment and money market fund AuM: €3.6 trillion, 67 times GDP.
- Bank assets: €764 billion, 14 times GDP.
- Insurance industry assets: €219 billion, 4 times GDP.
- Investment funds domiciled in Luxembourg: 14,065 entities; investment fund AuM doubled since spring 2010.
- Clearstream Banking S.A., Luxembourg (CBL): daily average settlement value of €480 billion in 2015; value of securities held in accounts with CSDs around €6 trillion.
- Memorandum items and selected macro figures (latest available data, 2016): GDP per head = €90,400; population in 2016 = 576,000; land area = 2,586 sq. km.
- Table 3 snapshot (Latest Available Data 2016): Number of banks = 142; total bank assets = 763.7 (€ billions); banks as multiple of GDP = 14.0; investment funds (entities) = 14,065 with assets 3,350.0 (€ billions); money market funds = 167 with assets 290.6 (€ billions); insurance companies = 292 with assets 219.0 (€ billions).
- Selected projections and historical macro figures (Table 2, 2014–22): Real GDP 2014 = 4.7, 2015 = 3.5, 2016 = 4.0, 2017 = 3.7, 2018 = 3.5, 2019 = 3.3, 2020 = 3.1, 2021 = 3.1, 2022 = 3.0 (percent change). GDP (billions of euro) 2014 = 49.3, 2015 = 51.2, 2016 = 53.7, 2017 = 56.5, 2018 = 59.3, 2019 = 62.4, 2020 = 65.5, 2021 = 68.8, 2022 = 72.3.
- Household debt-to-disposable income: noted increase to moderate levels (figure-based discussion).
- Nonfinancial private sector credit (eop, percent change) series (Table 2): 2014 = 4.9, 2015 = 15.7, 2016 = 5.7, 2017 = 5.1, 2018 = 3.9, 2019 = 3.4, 2020 = 2.7, 2021 = 2.8, 2022 = 2.6.
- Current account (percent of GDP) projections 2014–22: 2014 = 5.1, 2015 = 5.2, 2016 = 4.8, 2017 = 5.1, 2018 = 5.1, 2019 = 5.4, 2020 = 5.5, 2021 = 5.6, 2022 = 5.8.

*Source: IMF staff compilation from the Luxembourg FSAP chapter and tables included in the provided content.*

### 8.      Luxembourg’s financial soundness metrics have remained relatively robust in recent

### 8.      Luxembourg’s financial soundness metrics have remained relatively robust in recent

### Financial soundness overview
- Bank profitability, capital, liquidity and asset quality has been high (Table 5; Figure 8).
- Net interest margin compression has been relatively less problematic due in part to fee and commission income from private banking and fund management activities (Figure 3).
- Across money market funds and the expanding investment fund industry, liquid asset holdings have remained broadly steady (Figure 9).
- The Luxembourg insurance industry has stayed profitable and well capitalized (Figure 10), reflecting a relatively modest asset-liability duration mismatch and the relatively modest exposure of life insurers to guaranteed rate products.

### Key bank financial soundness statistics (from Table 5)
- Regulatory capital to risk-weighted assets: 19 17 16 19 21 20 22 23
- Regulatory Tier 1 capital to risk-weighted assets: 17 15 14 17 18 19 21 23
- Capital to assets: 65 56 66 67 78
- Return on assets: 0.6 0.7 0.3 0.6 0.6 0.7 0.8 0.7
- Return on equity: 12 13 5 10 10 12 11 10
- Interest margin to gross income: 37 31 34 31 29 27 27
- Trading income to total income: 6.0 -1.0 -9.0 -1.0 3.0 1.0 2.0 1.0
- Noninterest expenses to gross income: 56 64 74 65 65 66 76 69
- Personnel expenses to noninterest expenses: 39 36 35 33 33 31 29 28
- Residential real estate loans to total loans: 3.0 3.0 3.0 4.0 4.0 4.0 4.0 4.0
- Household debt to GDP: 50.0 49.0 54.0 55.0 55.0 60.0 59.0 62.0
- Nonperforming loans to total gross loans: 0.7 0.2 0.4 0.2 0.2 n.a. n.a. n.a.
- Liquid assets to total assets: 56 56 59 58 60 60 58 n.a.
- Liquid assets to short-term liabilities: 65 66 69 69 70 70 67 n.a.
- Customer deposits to total (non interbank) loans: 138 131 119 129 147 154 144 118
- Foreign currency denominated loans to total loans: 28 30 29 31 34 36 36 37
- Foreign currency denominated liabilities to total liabilities: 29 33 32 34 35 36 40 40
- Net open foreign exchange to capital: -10 20 0 n.a. n.a. n.a. (table entry)

### Structural features and cross-sector metrics
- Some 35 percent of Luxembourg bank assets comprise intragroup claims (77 percent of which now fall under ECB supervision; Figure 12).
- Luxembourg bank exposures to intragroup entities (principally EU parents) often amount to several times their capital.
- Luxembourg risk density (ratio of risk-weighted to total assets) is 31 vis-à-vis 39 percent euro area average.
- Investment funds’ exposures to banks (Table 6):
  - Investment funds' assets: 104 (€ billions) in Banks in Luxembourg; 691 (€ billions) in Banks abroad
  - Of which: Debt securities: 1 (€ billions) in Banks in Luxembourg; 330 (€ billions) in Banks abroad
  - Of which: Stocks: 0 (€ billions) in Banks in Luxembourg; 72 (€ billions) in Banks abroad
  - Of which: Derivatives: 1 (€ billions) in Banks in Luxembourg; 134 (€ billions) in Banks abroad
  - Deposits & loans: 101 (€ billions) in Banks in Luxembourg; 155 (€ billions) in Banks abroad
  - Investment funds' liabilities: 8 (€ billions) in Banks in Luxembourg; 175 (€ billions) in Banks abroad
  - Of which: Derivatives (liabilities): 2 (€ billions) in Banks in Luxembourg; 126 (€ billions) in Banks abroad

### Vulnerabilities arising from structure and interconnectedness
- Banks:
  - Deposits from private wealth management and investment fund activities are frequently “upstreamed” to foreign parents for centralized treasury management.
  - Luxembourg subsidiaries may be exposed to maturity and currency transformation risk at the parent level, where oversight by Luxembourg authorities may be limited (risk materialized during the global financial crisis; mitigants introduced since).
  - Large holdings of zero-weighted sovereign bonds contribute to a low measured risk density.
- Investment funds:
  - If investment funds have inadequate liquid asset holdings and liquidity management tools (LMTs) prove ineffective, an unexpectedly large redemption shock could result in a drawdown of bank deposits (Figure 13, Table 6) and fire sales in markets where such funds account for a large share of tradeable securities.
  - This would primarily include but need not be limited to operational deposits (such as those held for clearing, custody, and cash management) as defined per Article 27 of the EU’s Delegated Regulation 2015/61.
- FMIs:
  - A shock to the functioning of CBL (Clearstream Banking Luxembourg) could disrupt the vast number of international institutions and markets it serves, leaving participants unable to access or trade some or all of the securities held in CBL, resulting in credit and liquidity pressures with potentially significant repercussions for the international financial system.

### Domestically-originated vulnerability: residential real estate and household sector
- Real home prices have risen 22 percent since the marginal decline in 2009, while real disposable income has been flat, impairing affordability (Figure 14; Box 1).
- Mortgage lending standards have eased recently, with an uptick in the share of high loan-to-value (LTV) mortgages; household indebtedness has increased (Figure 1).
- Floating rate mortgages raise borrower interest rate risk.
- Offsetting factors:
  - Modest share of mortgages in domestically-oriented bank assets: 16 percent.
  - Industry-wide loan-to-value (LTV) ratio: 52 percent.
  - Below average household indebtedness (household debt-to-income ratio at 120 percent, 0.4 standard deviations below the OECD average of 146 percent).
  - High household net worth: financial assets exceed household debt by 2.4 times.
- Box 1 model results:
  - Econometric models of annual real house price growth over 1981Q1–2015Q4 do not point to a significant misalignment of prices with fundamentals, although housing affordability has deteriorated.
  - Model coefficients (selected):
    - Disposable income growth (t-1): 0.691*** 0.825*** 0.878*** 0.791*** 0.588** 0.511**
    - Mortgage credit growth (t-1): 0.330** 0.350**
    - Dummy euro (1998-1999): 0.0388*** 0.0407*** 0.0357*** 0.0288** 0.0471*** 0.0492***
  - Observations: 140 (for each model reported)
  - Note: models estimated with a newey west estimator with 4 lags.

### Risks, resilience and spillovers; major risk scenario
- Principal risks relate to interruptions to real and financial cross-border flows, and second round effects for real estate and domestically-oriented banks.
- Primary acute external shock (as described in RAM, Annex II): a surge in global financial market volatility, a renewed euro area recession, and spillover to the housing market.
- Stress-test design and coverage:
  - Banking sector stress tests: top-down, covering 16 banks (15 SIs and 1 LSI) accounting for 73 percent of industry assets.
  - Scenarios: baseline (WEO October 2016 projections) and an adverse scenario spanning three years (to 2019).
  - Adverse scenario specifics:
    - A V-shaped GDP profile with a cumulative decline larger than that experienced following the global financial crisis.
    - Resulting in a 1.5 percent per annum decline in GDP averaged over 2017–2019.
    - Leading to a cumulative deviation of 14.7 percentage points with respect to the baseline (equivalent to a 2 standard deviation shock).
- Integrated approach:
  - Unique feature: integration of bank and investment fund stress tests via common adverse shock scenario, transmission of investment fund redemption shock to bank deposits, market-based spillover analysis, and network analysis of intersectoral balance sheet exposures.

### Stress-test methodologies and instruments
- Banking sector:
  - Macro tests: external and domestic shocks; forecasts of credit losses and other profit/loss sources based on satellite models.
  - Sensitivity tests: domestic shocks; Household Stress Test based on micro data and macro scenarios.
  - Contagion: pure interbank, banks-insurers and cross border contagion models; market data-based network model inspired by Segoviano-Goodhart (2009) and Diebold-Yilmaz (2014).
  - Liquidity: LCR-type liquidity stress test variants; NSFR-type liquidity stress test; cash flow-based liquidity stress test using maturity buckets; reverse liquidity sensitivity test.
- Insurance sector:
  - Bottom-up by companies, coordinated by the CAA; three-year projections of undertakings’ available own funds and coverage of the solvency capital requirement (SCR).
- Investment funds:
  - Top-down: macro tests (external and domestic shocks); three-year projections of available own funds and SCR coverage.
  - For CNAV MMFs: increase in risk-free rate and credit spreads.
  - Redemption shock calibrated on i) 1% highest outflows and ii) the adverse macro scenario.
  - Liquidity assets measured by i) cash and short-term securities, and ii) HQLA.

*Source: IMF.*

### 14.      Stress test results suggest system-wide bank capital would display a good deal of

### 14.      Stress test results suggest system-wide bank capital would display a good deal of 

### System-wide bank solvency: top-line findings
- High starting levels of capital allow the banking system to absorb a large adverse shock while retaining substantial buffers.
- Based on fully-loaded Basel III regulatory requirements, the ratio of Common Equity Tier 1 capital to total risk-weighted assets (CET1 ratio) would decline over three years from 18.6 percent to 15.1 percent.
- One bank would experience a decline in capital below the CET1 hurdle rate.
- Three banks (comprising less than 10 percent of industry assets) would experience a decline in capital below the capital adequacy ratio (CAR) hurdle by 0.1 and 0.8 percent of GDP respectively.
- The CAR declines by 3.6 percentage points to 15.8 percent in 2019 from 19.4 percent in 2016.
- The system-wide leverage ratio (Tier 1 capital to total assets) would decline from 5.9 to 5 percent.
- Six banks would experience a decline below the 3 percent leverage hurdle rate in 2019 (after which time it becomes binding) by an amount equivalent to 1.6 percent of GDP.
- This leverage result reflects in part the aforementioned low risk density of Luxembourg banks.

### Drivers of capital changes (stress decomposition)
- Contributions to net profit and changes in capitalization ratio are driven by:
  - Net interest income
  - Loss provisions (Credit Risk)
  - Net non-interest income
  - Trading income (HFT portfolio)
  - Other comprehensive income (AFS portfolio)
  - Others and Taxes
- Contribution to change of capitalization ratio (points of RWA) include:
  - Net Profit (before losses due to stress)
  - Loss provisions (Credit Risk)
  - Credit spread risk
  - Other market risk
  - Other comprehensive income
  - Change in Risk-weighted assets
  - Net effect

### Comparison with other exercises and methodological notes
- Results differ from banks' own estimates in a recent exercise coordinated by the EBA, ECB, and national authorities due to methodological differences:
  - Lack of historical credit loss data led to conservative credit risk benchmarks based on the recent Ireland financial crisis.
  - Risk mitigants including economic hedges and financial guarantees were not incorporated because their granular characteristics could not be assessed and harmoniously applied.
  - Growth assumptions for RWA under the adverse scenario exceeded those estimated by the authorities and banks in recent stress tests.

### Concentration risk
- Sensitivity tests indicate vulnerability to simultaneous default of largest nonfinancial corporate exposures.
- The simultaneous default of the five largest exposures, after application of exemptions and credit risk mitigation, would lead three banks to be undercapitalized by 1.6 percent of GDP with regard to the Tier 1 capital ratio hurdle of 6 percent.
- Exempted exposures refer to non-financial corporates benefitting from an explicit state guarantee.
- Banks hold most of their credit risk mitigation measures in the form of financial collateral, debt instruments and third party financial guarantees.

### Bank liquidity: overall outcomes
- Stress tests confirm general strength in bank liquidity, with intragroup treasury activities potentially contributing to liquidity mismatches in a highly stressed scenario.
- Liquidity Coverage Ratio (LCR):
  - Under the standard scenario, all banks comfortably meet the 80 percent LCR requirement currently effective.
  - All but 4 of the 16 banks in the sample meet the 100 percent LCR requirement effective January 2018.
  - Separate retail and wholesale deposit withdrawal scenarios show that 4 and 7 banks respectively would struggle to maintain an LCR above the 100 percent requirement.
  - Shortfalls in the LCR in USD terms reflect subsidiaries’ reliance on their parent to manage FX assets on their behalf.
- Net Stable Funding Ratio (NSFR):
  - 6 out of 8 banks pass the 100 percent NSFR threshold ahead of its January 2018 implementation, with modest shortfalls in the remaining two.
- Cashflow analysis:
  - 6 out of 8 banks would face funding gaps over a seven-day shock.
  - All but one of the affected banks hold sufficient central bank eligible securities to cover such a shortfall.
- Data availability issues meant the NSFR and cashflow analysis could only be conducted on 8 (rather than 16) banks.

### Bank liquidity: quantitative snapshots (selected figures from Table 7)
- System-wide Liq. ratio (LCR standard): 109.4%
- LCR (retail scenario): 107.6%
- LCR FX (USD): 16.7%
- LCR FX (EUR): 161.8%
- LCR FX (GBP): 9.8%
- NSFR: 101.1%
- Liquidity shortfall (EUR billion) examples: 3.5; 1.9; 12.7; 0.3; 1.3; 8.9; 18.9; 0.7
- Liquidity shortfall (% GDP) examples: 6.4%; 3.4%; 23.2%; 0.6%; 2.4%; 16.2%; 34.6%; 1.3%
- Short/out of sample in % of banks' assets in sample: 1.6%
- LCR shortfalls: 4 out of 16 banks (various scenarios); NSFR shortfalls: 2 out of 8 banks (modest)
- Cash-flow stress: 7 out of 16 banks show seven-day funding gaps in sample reporting

### Household solvency stress test
- Household debt default probabilities increase from 2.5 to 6.4 percent (a multiplier of 2.6) under the adverse macro-financial shock.
- The low share of households in default reflects:
  - Many households either do not hold or have repaid part of their mortgage.
  - High household net worth.
  - Large holdings of liquid assets which could be used for debt service payments.

### Insurance sector solvency
- Bottom-up solvency stress test covering 10 life insurers and one reinsurer (roughly three quarters of respective markets) shows:
  - Aggregate Eligible Own Funds (EOF) declines by 27 percent in the third year of the adverse scenario.
  - Each insurer in the sample would maintain its capital well above the 100 percent Solvency II requirement.
  - Insurers with a relatively larger share of unit-linked business are more severely hit, reflecting exposure to reduced AuM-related fee income.
- Cross-sectional indicators:
  - Solvency II Capital Ratio: distribution by insurer (capital-weighted industry averages and percentiles shown in source figures).
  - Stress test induced decline in EOF for life insurers correlated with Unit Linked Product Share of Technical Provisions (R² = 0.42 in source figure).

### Money Market Funds (CNAV MMF) solvency risk
- A very large increase in risk-free interest rates and credit spreads would be needed to ‘break the buck’ in Luxembourg’s CNAV MMF industry.
- Sample of 5 CNAV funds (accounting for 75 percent of CNAV MMF AuM):
  - Combination required: 130 basis point shock to risk-free interest rates and 150 basis point widening in credit spreads for the shadow NAV to deviate substantially (by 0.2 percent or more) from par value.
- Market risks are mitigated by large holdings of cash and short duration, high quality assets.

### Investment fund and MMF liquidity stress tests
- Funds exposed to asset classes with lower liquidity/higher credit risk are more vulnerable to severe but plausible redemption shocks.
- Around 70 percent of HY funds would face a shortfall in both historical and forward-looking scenarios.
- EM, mixed and other bond funds encounter problems only under the conservative assumption that liquidity comprises cash and short-term debt.
- Liquidity risk in MMFs appears muted.
- Under the forward-looking adverse scenario where all funds face simultaneous severe redemption shock, outflows amount to 20–24 percent of investment fund bank deposits in the sample (equivalent to €4.9–5.3 billion).
- Across the sample of depositary banks, these outflows would amount to 3 percent of total deposits, or 4 to 10 percent of wholesale or operational deposits respectively.

### Fund stress test details (selected table figures)
- Redemption shock (historical, 1st percentile net outflow) and simulated (forward-looking) reported as share of TNA for fund types.
- Examples (share of TNA and percent of funds with shortfall):
  - Short Term CNAV: 19% historical; 0% of funds with shortfall (HQLA not applicable)
  - Short Term VNAV: 23% historical; 0% shortfall
  - Other MMFs: 18% historical; 0% shortfall
  - EM funds: 18% historical; 71% HQLA(short-term debt) / forward-looking 2% with HQLA 9% (50% of funds with shortfall)
  - HY funds: 19% historical; 78% HQLA / forward-looking 75% with HQLA 11% (66% and 69% of funds with shortfall)
  - Mixed funds: 9% historical; 28% HQLA / forward-looking model indicates net inflows under adverse scenario in the sample (model note)
  - Other bond funds: 18% historical; 52% HQLA / forward-looking 8% with HQLA 6% (30% of funds with shortfall)
- Notes: HQLA measure is not applicable for MMFs. Estimated model significance varies by fund type. Under the adverse forward-looking scenario, mixed funds experience net inflows in the sample.

### Implications for banks and depositary banks
- In the absence of adequate liquid security holdings and effective liquidity management tools (LMTs), select bond funds may need to draw on bank deposits.
- The forward-looking adverse scenario outflows (€4.9–5.3 billion) represent 20–24 percent of investment fund bank deposits in the sample.
- These outflows equal 3 percent of total deposits, or 4 to 10 percent of wholesale or operational deposits respectively, across the sample of depositary banks.
- Caveats:
  - Tests assume managers cannot avail of LMTs and embed restrictive assumptions on the ability of funds to liquidate long-term securities, notably for HY funds.
  - Manager surveys recently introduced by the CSSF point to a more benign assessment of liquidity risk for HY funds.
  - HY fund AuM account for only 5 percent of Luxembourg’s investment industry.
  - Data limitations require the assumption that the entire liquidity shortfall is borne by a single depositary bank in Luxembourg, while in practice fund deposits are typically spread across several banks in and outside Luxembourg.

*Source: IMF staff calculations and Luxembourg authorities as presented in the source content.*

### 24.      Network analysis and other modelling of supervisory and market data confirm that

### 24.      Network analysis and other modelling of supervisory and market data confirm that

### Domestic interconnectedness: findings from balance sheet and market-data models
- Aggregate indices of contagion and vulnerability (based on balance sheet data) record benign readings. For example:
  - Failure of the entity with the highest contagion index causes losses of less than 0.5 percent of counterparties’ capital.
  - The failure of Bank 1 results in the average loss to other entities of just 0.4 percent of capital.
  - Insurer 5 suffers an average hit to capital of 2 percent across individually triggered failures of all other entities (i.e. 27 independent failures).
- Market data-based analysis suggests Luxembourg banks are not strongly interconnected (excepting Bank 2 and 4).
- Note: recent internal analysis by the CSSF suggests a more benign outcome under different assumptions. These results pertain only to a sample of depositary banks comprising 9.3 percent of system wide bank deposits.

### Cross-border interconnectedness: banks
- Quantitative analysis confirms a high degree of cross-border interconnectedness for Luxembourg-domiciled banks and investment funds.
- Bank network modeling (based on gross original exposures, before credit risk mitigation, and under standard model assumptions) indicates:
  - An unexpected increase in the defaulted share of cross-border claims through the failure of a parent poses a threat to the capital of Luxembourg subsidiaries, reflecting large intra-group exposures (diagonal cells in Figure 25).
  - Vulnerability and contagion risk emanating from foreign parents is more prominent through credit rather than funding channels (blue columns, Figure 26).
- Model assumptions (explicit):
  - loss-given default of 40 percent;
  - funding shortfall of 35 percent;
  - discount for asset firesales of 50 percent.
- Results should be interpreted with caution as underlying data are based on gross (rather than net) exposures.
- Examples from indices:
  - Bank 3 suffers an average hit to capital of around 25 percent across individually triggered failures of all parent entities.
  - The failure of Parent of Bank 9 results in the average loss to other entities of above 100 percent of their capital.

### Cross-border interconnectedness: investment funds
- Luxembourg-domiciled investment funds appear interconnected with select global banks and EM bond markets.
  - Mixed and bond funds are connected with U.S. and UK banks, evidenced by their central location in the global network (red/orange nodes).
  - Some fixed income investment funds have large and concentrated holdings in select frontier/EM bond markets (beyond capitalization-weighted benchmarks).
- Concentration and market share metrics:
  - Exposure to a single sovereign issuer is around 30 percent of assets for a number of funds.
  - UCITS fund exposures to a single issuer are capped at 5 percent, though this cap is waived for sovereign issuers.
  - Collectively, Luxembourg bond funds hold more than 10 percent of outstanding tradable debt in six frontier/EM bond markets.
  - Frontier markets could be more susceptible to liquidity risk than EMs.
- Implication: Luxembourg funds could act as a conduit of shocks for these markets.

### Prudential oversight: cross-cutting themes and recommendations
- Risk-based supervision and resources:
  - Continue pivot towards risk-based supervision and increase resources for the CSSF, CAA, and BCL (where planned capital increases should also proceed).
- Governance:
  - Agree a formal framework to govern the relationship between the government and banks with state involvement to ensure arm’s-length operation and commercial terms.
  - Enshrine the operational independence and accountability of the CSSF and CAA in law.
  - CSSF and CAA board members should be bound by codes of conduct; concurrent updating of the BCL’s code of conduct would be welcome.
- International engagement:
  - Increase engagement with supervisors in countries where Luxembourg’s financial institutions, particularly investment funds, are most active.
- Dampening residual risks:
  - Consider supervisory measures that go beyond the minimum prescribed by European legislation where justified by Luxembourg-specific idiosyncrasies and compatible with the EU Single Rule Book.
  - Reinforce oversight of nonbank holding companies of banks to improve risk monitoring and advocate coordinated approaches at the European level.

### Macroprudential policy framework: assessment and enhancements
- The macroprudential framework introduced in 2015 is working well in practice, though some elements could be strengthened.
- Institutional enhancements recommended:
  - Revoke the unanimity voting requirement in the CRS to eliminate potential inaction bias arising from veto power.
  - Strengthen the independence of each member of the CRS.
  - Enshrine in law the BCL’s de facto lead role in financial stability analysis.
  - Publish the BCL’s risk reports and dashboard to increase transparency and accountability.
  - Award the BCL powers to make formal policy recommendations to the CRS.
- Real estate macroprudential toolkit:
  - Measures enacted since 2012 include: higher risk weights where loan-to-value ratios exceed 80 percent; stricter stress test requirements for IRB bank mortgage books; pillar II capital add-ons; and a higher risk weight floor for IRB bank exposures to domestic real estate.
  - In December 2016, the authorities transposed the EU Mortgage Credit Directive into law, strengthening consumer information requirements and obligations to assess creditworthiness.
  - Further macroprudential tightening may be required should real estate price growth outpace that of incomes, and lending standards continue to ease.
  - Operational capacity would be enhanced by providing a legal basis for borrower-based macroprudential tools, notably limits on loan-to-value and debt-service-to-income.

### Data gaps, monitoring priorities, and bank-investment fund linkages
- Monitoring by the BCL and CSSF appropriately focuses on real estate vulnerabilities and bank-investment fund linkages, but closing data gaps is a priority.
  - Real estate data gaps: residential market (including rental market and loan-to-value distribution across borrowers and banks) and commercial market (no data besides a commercial survey every five years).
  - Bank-investment fund surveillance is hampered by data gaps regarding individual investment fund exposures to depository banks; data typically gathered at the asset management company level.
  - Authorities encouraged to deepen analysis of investment fund liquidity risk, use of synthetic leverage and securities financing transactions, and concentration and categorization of beneficial investors.

### Banking regulation and supervision: status and actions
- Regulatory changes and supervisory structure:
  - The EU Capital Requirements Directive (CRD IV) has been transposed into national law.
  - Following the introduction of the SSM in 2014, 61 of the 140 banks in Luxembourg are now supervised by the ECB, representing 77 percent of Luxembourg bank assets.
  - The ECB has replaced Luxembourg’s Finance Minister as the body responsible for bank licensing.
- Further recommended measures to safeguard banking system stability:
  - Enshrine the operational independence and accountability of the CSSF in law, consistent with the Basel Core Principles.
  - Increase frequency of on-site inspections, particularly for foreign subsidiaries availing of the waiver to large exposure limits for intragroup transactions, and require banks to periodically prove continued eligibility for the waiver.
  - Continue monitoring mortgage lending standards and harmonize data reporting standards for loan-to-value and debt-service-to-income ratios across banks.
  - The BCL should work closely with the ECB to ensure households are included in the euro area credit registry initiative, given the recent uptick in household indebtedness.

*Source: IMF staff report (chapter text).*

### 31.      Liquidity stress test results suggest risks relating to short term funding and foreign

### 31.      Liquidity stress test results suggest risks relating to short term funding and foreign

### Liquidity stress test findings and recommendations
- Liquidity stress test results suggest risks relating to short term funding and foreign currency arrangements with parent groups should be addressed.
- Banks should lengthen the maturity of unsecured funding beyond seven-days.
- Implementation of an FX LCR framework at the group level would help manage the risk of FX-related liquidity mismatches for Luxembourg subsidiaries.
- The authorities should work with the EBA to close liquidity reporting gaps and expand harmonized EU bank reporting.

### Investment Fund Regulation and Supervision
- The CSSF applies a strong and comprehensive regulatory and supervisory framework to the investment fund industry.
- Since the 2011 FSAP, the CSSF has bolstered resources devoted to fund management oversight and gives due priority to monitoring the sizable UCITS sector.
- Delegation practices and the concentration of fund directorships merit increased attention:
  - Guidance on the ‘substantial presence’ threshold would be welcome given the extent to which Luxembourg funds avail of delegated activities such as portfolio and risk management.
  - The CSSF should engage more actively with regulators in jurisdictions where delegated activities are frequently performed.
  - The CSSF should review data on fund directorships held by individuals and issue guidance on limits accordingly, framed in terms of aggregate time commitments.
- Liquidity management tools (LMTs) and stress testing:
  - Authorities should issue guidance on the use of LMTs and the modalities of liquidity stress tests—focused initially on fixed income funds—and develop liquidity stress testing capacity.
  - The CSSF should leverage its extensive experience with LMTs in conducting an assessment of their effectiveness to inform industry guidance.
  - To strengthen surveillance and management of system-wide liquidity risk, the CSSF should provide industry guidance on the modalities of liquidity stress tests (e.g., frequency, fund coverage, scenarios), and develop system-wide stress testing capacity, consistent with recent Financial Stability Board (FSB) and European Systemic Risk Board guidance.
- Depositaries and UCITS V:
  - The CSSF should assess the impact of changes on depositary independence introduced under UCITS V, and identify whether risks remain.
  - Appropriate safeguards should be introduced to address any residual concerns.
  - Luxembourg benefits from a large and diverse depositary sector, which gives greater scope for intra-group depositary arrangements to be adjusted if necessary.
- Supervisory resources and inspections:
  - While the CSSF’s supervisory approach is sound, enhancements to its inspection program and better data access would further improve the effectiveness of risk-based supervision.
  - Efforts should be made to further increase the number of thematic on-site inspections, and to introduce comprehensive on-site inspections as another element of the supervisory toolkit.
- Nonbank financing and OFIs:
  - Analysis of nonbank financing and special purpose vehicles should continue.
  - The BCL is encouraged to continue its analysis of the OFI sector and examine whether some entities should be brought under the regulatory perimeter.
  - Authorities are encouraged to fully participate in international fora on nonbank finance, including initiatives led by the FSB.

### Insurance Regulation and Supervision
- The CAA has worked diligently to ensure the insurance industry has adjusted smoothly to the introduction of Solvency II.
- The FSAP assessed the CAA’s regulatory and supervisory compliance with selected Insurance Core Principles (ICPs), notably those concerned with cooperation with other supervisory jurisdictions, risk management, internal controls, and supervisory review reporting.
- Observations and recommendations:
  - Luxembourg’s supervisory framework demonstrates an adequate level of consistency with IAIS standards, though the CAA’s resources and governance arrangements could be enhanced.
  - The CAA has a modest staff of about 40 to oversee nearly 300 insurance companies with assets approaching €220 billion.
  - A revised early warning system, calibrated to new Solvency II parameters, should be prioritized (as planned) once the requisite data become available.
  - The CAA’s governance structure would benefit from:
    - subjecting board members to a formal code of conduct;
    - having board activities periodically reviewed by an independent committee;
    - limiting the government’s power to dismiss the Executive Committee, thus safeguarding the CAA’s operational independence.

### Financial Markets Infrastructure — Clearstream Banking Luxembourg (CBL)
- Assessment summary:
  - An assessment of CBL’s risk management practices and supervisory treatment against the CPSS-IOSCO Principles for Financial Market Infrastructures (PFMI) reveals it to be in broad observance.
  - CBL offers a relatively safe and efficient system for the settlement and custody of securities transactions.
  - Luxembourg’s implementation of European directives provides a solid statutory basis for netting, finality of settlement, and securities lending.
  - CBL uses an effective risk management framework to manage operational and liquidity risks, has developed a comprehensive business continuity plan, and has in place a detailed counterparty default management framework.
  - CBL’s oversight and supervision is conducted prudently by the BCL and CSSF.
- Recommended risk mitigation priorities:
  - Reducing the large deposit-based exposure of CBL to a small number of commercial banks—this could be mitigated through an increase in the number of contracted banks, or the establishment of direct links with local CSDs and central banks, where possible.
  - Tightening collateralizing arrangements—though CBL has a process for managing credit risks (exposure limits, partial collateralization), residual risks could be mitigated with full collateralization and applying (independently validated) haircuts to cash collateral.
  - Strengthening operational risk management—investment in a third (more distant) data center is warranted given the close proximity of existing contingency facilities and CBL’s systemic importance; a full failover test is also advised to assess the efficacy with which remote locations can assume critical operations.
  - Enhancing supervisory cooperation arrangements—formalizing modalities between the BCL and CSSF would support efficiency and accountability; authorities should engage with international colleagues when conducting their assessment of CBL against the PFMI.
  - Cooperation between the Belgian and Luxembourg authorities with respect to Euroclear Bank should also be strengthened as planned.
- Systemic importance and supervision:
  - Notwithstanding effective national level supervision, the sheer scale and scope of CBL’s activities suggest CBL should be designated as a SI under SSM supervision, alongside Belgium’s Euroclear Bank.
  - Although harmonization of national supervisory approaches is expected to increase with the implementation of the EU CSD Regulation, this does not address CBL as a bank.
  - SSM-level supervision would ensure a level playing field and better facilitate monitoring of cross-border group level spillover risks.

### Anti-Money Laundering and Combating Financing of Terrorism (AML/CFT)
- Progress since 2010 mutual evaluation:
  - Luxembourg has strengthened its AML/CFT regime since the 2010 mutual evaluation.
  - As of January 1, 2017, aggravated tax evasion and tax fraud constitute predicate offenses to money laundering (ML).
  - Earlier progress includes strengthening the ML offense and the licensing and supervision of financial institutions, increasing mutual legal assistance in CFT efforts, and dematerializing bearer shares.
  - Luxembourg is currently conducting its first national risk assessment (NRA) and seeking to increase transparency of beneficial ownership information.
  - AML/CFT supervision of the financial and nonfinancial sectors has been strengthened, though remains relatively weak with respect to lawyers.
- Tax transparency:
  - The government’s push for tax transparency constitutes material progress.
  - Luxembourg is amongst the first countries to implement the OECDs Common Reporting Standard, which should greatly facilitate the exchange of information between tax administrations.
  - The number of suspicious transaction reports and the exchange of financial information with foreign counterparts have increased over recent years.
- Remaining challenges and priorities:
  - Ensure that the ongoing NRA adequately focuses on risks related to trust and company services providers across all relevant professions.
  - Provide guidance on the identification of suspicions of tax crimes and related ML to reporting entities not supervised by the CSSF.
  - Further intensify AML/CFT monitoring of lawyers.
  - Continue to ensure resources for risk-based AML/CFT supervision of the financial sector remain sufficient.

### Crisis Resolution and Safety Nets
- Institutional changes since 2011 FSAP:
  - As a participant in the Banking Union, the CSSF shares intervention and recovery planning competencies with the ECB, and resolution competences with the Single Resolution Board (SRB).
  - By transposing the Bank Recovery and Resolution Directive (BRRD) and Deposit Guarantee Scheme Directive (DGSD) in late 2015, the authorities introduced a new resolution framework and public deposit insurance scheme.
  - The Resolution Board and the Depositor Protection Council were established within the CSSF to carry out resolution work and administer the deposit insurance scheme respectively.
  - A further increase in staffing would better equip the CSSF’s new Resolution Department.
- Recovery and resolution planning:
  - Recovery planning is advanced while resolution planning is at an early stage.
  - Both would benefit from additional guidance from the ECB and SRB on identification of critical functions (e.g., custodian functions) and the treatment of large intragroup exposures.
  - Guidance on the use of the sale of business and bridge bank tools would help strengthen resolution plans, including developing fall-back resolution strategies where bail-in is the preferred strategy.
  - Under SRB policy, resolution planners cannot contemplate the use of the Single Resolution Fund (SRF) in their plans—and thus plans do not address how the SRF access requirements would be met; the policy should be reconsidered.
  - The goal should be to establish credible and feasible resolution plans for the most important Luxembourg banks as soon as possible.
- Specific challenges for Luxembourg:
  - Ambiguities include whether excluding investment fund bank deposits from the scope of bail-in would give rise to “No Creditor Worse Off” claims should other creditors in the same creditor hierarchy class be bailed-in.
  - Ensuring continuity of custodial functions through the sale of business tool may necessitate advance preparations to overcome operational challenges in selling such business lines.
  - Bail-in of large intragroup (typically foreign parent) claims held by Luxembourg subsidiaries may adversely affect their viability; these issues should be factored into resolution plans.
- Cross-border cooperation:
  - There is scope for improvement in cross-border cooperation.
  - The recent conversion of several Luxembourg subsidiaries into branches raises questions as to how member states hosting branches that are not “significant branches” but that provide “critical functions” can be engaged in reviewing group-wide recovery and resolution plans.
  - With respect to third country relations, there is a need for the SRB to continue, and the CSSF to seek, to establish cooperation arrangements with relevant resolution authorities.
- Insolvency regime and creditor hierarchy:
  - The insolvency regime applying to banks should be strengthened to complement the newly established bank resolution regime.
  - The introduction of explicit asset and liability transfer powers during winding-up proceedings may help achieve an orderly liquidation with reduced costs to the Fonds de Garantie des Dépôts Luxembourg.
  - The creditor hierarchy in Luxembourg is determined by different laws, making it difficult to interpret; the authorities are assessing these rules and could leverage the recent Commission proposal to harmonize aspects of creditor hierarchy across the EU.
- Deposit insurance and back-up funding:
  - New deposit insurance arrangements are in place but should be supported with back-up funding.
  - They target a fund balance twice that required in EU legislation, and the timetable for rapid payouts is advanced.
  - However, no backstop funding arrangements are in place and should be pursued swiftly, with the private sector where possible.
  - As a last resort, public funding in compliance with State Aid rules may be necessary.
- Emergency liquidity assistance (ELA) and foreign exchange:
  - While a contingent framework is in place for the provision of ELA, efforts to operationalize it quickly when needed should continue.
  - BCL has access to foreign exchange from market sources and the Bank for International Settlements, but has no bilateral foreign exchange swap arrangements with relevant central banks.
  - BCL should continue examining additional contingent foreign exchange funding arrangements, possibly by collaborating with the ECB.
  - The terms and conditions of state guarantees for the extension of ELA should be determined.
- Crisis management coordination:
  - Arrangements for the management of a system-wide financial crisis should be put in place.
  - The MoF should take the lead to streamline and clarify the modalities of coordination arrangements between domestic authorities and the SRB and ECB.
  - Contingency plans should be developed and tested via crisis simulation exercises.

*International Monetary Fund — Luxembourg: Selected Financial Sector Assessment findings and recommendations (excerpts).*

### Annex II. Risk Assessment Matrix (RAM)

### Annex II. Risk Assessment Matrix (RAM)

### Macro-financial and Political Risks
- Sharp rise in financial market risk premia and renewed Euro area recession
  - Relative likelihood: Medium
  - Transmission channels:
    - Cross-border financial intermediation would contract abruptly, increasing the risk that liquidity ‘upstreamed’ from Luxembourg bank subsidiaries to parents abroad could be trapped.
    - An unexpectedly large and synchronized redemption shock experienced by investment funds could result in asset fire sales in international markets and a drawdown of local bank deposits.
    - Operational stresses at Clearstream (CBL) could leave international financial market participants unable to access or trade some or all of the securities held in CBL.
  - Impact if realized: High
    - The internationally-oriented financial industry could encounter liquidity stress and experience a substantial hit to profitability should the shock be sustained, thus leading to reduced employment, economic activity and fiscal revenues in Luxembourg.

- Protracted uncertainty associated with political fragmentation in advanced economies (including post-Brexit arrangements) and rising protectionism
  - Relative likelihood: Medium
  - Transmission channels:
    - Protectionism and economic isolationism would detrimentally impact the trade and financial flows contributing to the openness of the Luxembourg economy.
    - New Brexit arrangements could lessen London’s appeal as a financial center as UK-based banks and investment funds could lose “passporting” rights to the rest of the EU.
    - Luxembourg’s investment funds have large exposures to US capital markets.
  - Impact if realized: Medium
    - A negative outcome from upcoming elections would have substantial effects on financial flows and economic confidence.
    - Luxembourg’s small open economy and internationally-oriented financial system will be adversely impacted by any interruption to the free movement of capital and services.
    - However, the departure of the UK from the EU may also result in some financial activity relocating to Luxembourg.

### Domestic Real Estate and Household Risks
- Downturn in Luxembourg’s residential housing market following substantial earlier increase in valuations, easing in mortgage lending standards and increase in household indebtedness
  - Relative likelihood: Medium
  - Transmission channels:
    - Domestically-oriented banks are the principal mortgage originators and would be most exposed to an increase in non-performing mortgages and possible hit to bank capital.
    - Household net worth would decline, impacting consumption.
  - Impact if realized: Medium
    - A hit to profitability and possibly capital at domestically-oriented banks could trigger a tightening in domestic lending conditions.
    - A capital shortfall in a domestically-oriented bank in which the state holds a key ownership stake could realize a contingent liability for the government.
    - Negative wealth effects in the household sector could result in second-round impacts on the economy.

### Structural and Operational Risks to the Financial System
- Structural outflows from the financial system initiated by adverse hits to bank and investment fund operating conditions; challenges adapting to regulatory demands and innovative technologies (including Fintech)
  - Relative likelihood: Medium
  - Transmission channels:
    - Prolonged problematic operating business conditions for Luxembourg’s banks and investment funds could result in a shrinkage in financial system assets.
    - A large share of fiscal revenues depends on cross-border operations.
  - Impact if realized: High
    - One quarter of Luxembourg’s GDP is directly generated by the financial sector, with additional contributions from ancillary professions (law, technology, etc.). An important component of the tax base could be eroded.

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### Annex III. Stress Testing Matrix (STeM)

### Banking Sector: Solvency Risk (Top-down by FSAP Team)
- Institutional perimeter and data
  - Institutions included: 16 banks
  - Market share:
    - 73 percent of the banking sector’s assets
    - 94 percent of residential mortgage loans
    - 68 percent of exposures to foreign banks
  - Data and baseline date:
    - Publically-available and supervisory data
    - Baseline date: June 2016
    - Bank consolidated level data for banks headquartered in Luxembourg and sub-consolidated level data for subsidiaries of foreign banks
    - Market-data

- Channels, methodology and models
  - Methodology:
    - Satellite models developed by the FSAP team
    - Balance sheet-based approach
    - Market data-based approaches
  - Satellite models:
    - Models for credit losses, pre-impairment income, credit growth; expert judgment
    - Models to integrate solvency-funding interactions
    - Methodology to calculate sovereign risk
    - Methodology to calculate losses from bonds and money market instruments (sovereign and other issuers). Haircuts calculated based on a modified duration approach
    - Net fee income and commission income projected based on assumptions on investment funds’ business volume and redemptions

- Stress test horizon
  - 3-years (2017–2019)

- Tail shocks and scenarios
  - Scenario analysis:
    - Baseline macroeconomic scenario and an adverse scenario assessing impact on entire portfolio including loans and trading book
    - TD analysis covered three main sources of risk: domestic real estate; exposures to parent companies and investment funds; and sovereign risks
    - Variables included domestic macro-financial variables and GDP for key trading partners, interest rates, exchange rates and real estate prices
  - Adverse scenario numeric outcomes:
    - GDP growth rate declines to -3.7, -2.6 and +1.8 percent, in 2017, 2018 and 2019 respectively
    - The output gap would be larger than experienced during the last financial crisis
    - Market shocks calibrated to magnitudes close to those observed in 2008/2009

- Sensitivity analysis
  - Evaluated households’ balance sheet sensitivity to increases in borrowing costs, declines in income and residential house prices, rising unemployment, and combinations of these shocks
  - Estimated direct effects of interest rate shocks; exchange rate shocks; decline in sovereign bond prices; and failure of the largest to 10 largest corporate exposures

- Risks and buffers
  - Risks assessed:
    - Credit risk on the banking book and trading book
    - Market risk and bond losses: direct effects of interest rate shocks; direct effects of exchange rate shocks; shocks to sovereign bond yields
  - Behavioral adjustments:
    - Balance sheet grows with nominal GDP
    - Dividends are paid out by banks that remain adequately capitalized throughout the stress

- Regulatory and market-based standards
  - Calibration of risk parameters: Through the cycle and Point-in-time for credit risk parameters or proxies
  - Regulatory/accounting: National regulation; Basel II IRB approach + Basel III

- Reporting format for results
  - Output presentation:
    - System-wide capital shortfall
    - Number of banks and percentage of banking assets in the system that fall below certain ratios

### Banking Sector: Liquidity Risk (Top-down by Authorities and FSAP team jointly)
- Institutional perimeter and data
  - Institutions included:
    - 16 banks for the LCR analysis and eight for the NSFR and cash-flow analysis
  - Market share: 45 to 73 percent of banking sector’s assets
  - Data and baseline date:
    - Latest data: September 2016 for LCR and June 2016 for NSFR and cash flow analysis
    - Source: supervisory data
    - Scope of consolidation: perimeter of individual banks

- Methodology and channels
  - Basel III-LCR and NSFR type proxies
  - Cash-flow based liquidity stress test using maturity buckets by banks
  - Liquidity test in foreign currencies

- Risks and buffers
  - Risks:
    - Funding liquidity (liquidity outflows)
    - Market liquidity (price shocks)
  - Buffers:
    - Counterbalancing capacity
    - Central bank facilities

- Tail shocks and size of shock
  - Run-off rates calculated following historical events, or IMF expert judgment and LCR/NSFR rates
  - Bank run and dry up of wholesale funding markets, taking into account haircuts to liquid assets

- Regulatory standards
  - Basel III standards (revision as of January 2013)
  - European Commission Delegated Act

- Reporting format for results
  - Output presentation:
    - Liquidity gap by bank, and aggregated
    - Survival period in days by bank, number of banks that can still meet their obligations

### Banking Sector: Contagion Risk (Top-down by FSAP Team)
- Institutional perimeter and data
  - Institutions included:
    - 16 banks
    - 12 insurance companies
    - 5 investment fund groups covering 75 percent of the total net assets for HY, EM bond funds, VNAVs and MMFs; 54 percent for mixed funds; 32 percent for bond funds
  - Market share: 73 percent of total banking system assets
  - Data and baseline date:
    - Latest data: June 2016
    - Source: supervisory and market data
    - Scope: individual institutions or sectoral indexes; possible use of indexes

- Methodology and channels
  - Balance sheet and off balance sheet based financial metrics
  - Network interbank model by Espinosa-Vega and Solé (2010)
  - Diebold-Yilmaz variance decomposition connectedness methodology
  - CIMDO/SyRIN approach (Goodhart and Segoviano, 2009)

- Tail shocks
  - Pure contagion: default of institutions
  - Spillover index and transmission

- Reporting format for results
  - Output presentation:
    - Number of undercapitalized and failed institutions, and their shares of assets in the system
    - Evolution and direction of spillovers within the network

### Investment Funds: Liquidity Risk (Top-down by FSAP team)
- Institutional perimeter and data
  - Institutions included:
    - 191 investment funds (all but 1 are UCITS funds): 42 EM bond funds; 32 HY bond funds; 40 mixed funds (investing at least 70 percent of their assets into fixed income instruments); 50 largest bond funds; 5 CNAVs short term MMFs (3 USD, 1 EUR, 1 GBP); 7 VNAV short term MMFs; 15 MMFs
  - Market share:
    - 75 percent of the total net assets for HY, EM bond funds, CNAVs, VNAVs and MMFs
    - 54 percent for mixed funds
    - 32 percent for bond funds
  - Data and baseline date:
    - Latest data: March 2016
    - Source: supervisory data

- Methodology and channels
  - Liquidity measures by:
    - i) cash and short-term debt securities (residual maturity less than one year)
    - ii) cash and high quality liquid assets

- Risks and buffers
  - Risks:
    - Funding liquidity (liquidity outflows) and inability to sell assets to cope with redemptions
  - Buffers:
    - Liquidity buffers
    - Credit facilities and Liquidity Management Tools

- Tail shocks
  - Monthly Redemption shock equal to the 1th percentile of historical net flows observed over 2007–2016
  - Redemption shock estimated from an econometric model relating funds flows to macrofinancial variables (including the ones used in the bank macroeconomic scenario)

- Regulatory standards
  - European Commission Directive 2010/43/EU Article 45(3): “Where appropriate, management companies shall conduct stress tests which enable the assessment of the liquidity risk of the UCITS under exceptional circumstances”

- Reporting format for results
  - Output presentation:
    - Redemption coverage ratio by investment fund and liquidity shortfall
    - Number of funds and share of funds that cannot meet their obligations

### Investment Funds: Solvency Risk (Top-down by FSAP team)
- Institutional perimeter and data
  - Institutions included: 5 CNAVs short term MMFs
  - Market share: 75 percent of the total net assets for short term CNAVs MMFs
  - Data and baseline date:
    - Latest data: March 2016
    - Source: supervisory data

- Methodology and channels
  - Increase in risk free rates and credit spreads that would result in deviations between shadow Net Asset Value (NAV) and Constant Net Asset Value

- Risks and buffers
  - Risks:
    - Inability to maintain Constant NAV
  - Buffers:
    - Liquidity buffers
    - High credit quality and short duration assets

- Tail shocks
  - Sensitivity analysis with shocks to risk free rates and credit spreads ranging from 10 to 200 basis points

- Regulatory standards
  - According to the IMMFA Code of Practice, draft MMF Regulation and the Ireland FSAP analysis, escalation procedures should exist for deviation between the published price and the shadow NAV above 20 basis points

- Reporting format for results
  - Output presentation:
    - Deviations between constant NAV and shadow NAV
    - Number of funds and share of funds that can still meet their obligations

### Insurance Sector: Solvency Risk (Bottom-up by Authorities (CAA))
- Institutional perimeter and data
  - Bottom-up by companies under the guidance and supervision of the Luxembourg authorities
  - Institutions included: 10 life insurance companies and one re-insurer
  - Market share: 71.5 percent of the Luxembourg insurance market in terms of gross life technical provisions
  - Data and baseline date:
    - Supervisory data
    - Baseline date: June 2016

- Methodology and channels
  - Analysis based on Solvency II requirements using infrastructure developed by the Luxembourg Commission aux Assurances and/or the EIOPA

- Stress test horizon
  - 2017–2019

- Tail shocks and scenarios
  - Macro scenarios included a baseline and an adverse scenario in line with the banking sector stress test

- Risks and buffers
  - Risks/factors assessed: Credit risk and market risk

- Reporting format for results
  - Output presentation:
    - Three-year projections of undertakings’ available own funds
    - The coverage of the solvency capital requirement (SCR)
    - Capital adequacy ratios with and without the “long-term guarantee package”

*Annex II. Risk Assessment Matrix (RAM), cr17122*

### Annex IV. Report on the Observance of Standards and Codes

### Annex IV. Report on the Observance of Standards and Codes (ROSC)––Summary Assessments of CPSS-IOSCO Principles for Financial Market Infrastructures: Clearstream Banking Luxembourg

### A. Introduction — scope and purpose
- Assessment objective: identify potential risks related to Clearstream Banking Luxembourg (CBL) with implications for financial stability in Luxembourg and abroad.
- Context: assessment undertaken in the IMF’s Financial Sector Assessment Program (FSAP) to Luxembourg in December 2016.
- Assessor: Froukelien Wendt, IMF Monetary and Capital Markets Department.
- Scope: CBL and its authorities assessed against PFMI for securities settlement systems (SSS) and Central Securities Depositories (CSDs) — Principles 1–5, 7–13, and 15–23. BCL and CSSF assessed using the five responsibilities for authorities of the PFMI.
- Prior assessment: CBL was earlier assessed as part of the Luxembourg FSAP in 2011.

### B. Information and methodology
- Inputs:
  - Assessments and self-assessments provided by the Banque centrale du Luxembourg (BCL) and the Commission de Surveillance du Secteur Financier (CSSF).
  - Responses to a dedicated questionnaire.
  - Relevant EU directives, national laws, regulations, rules and procedures, legal opinions, and other available material.
  - Discussions with the authorities, CBL, the ECB, banks, and other market participants.
- Methodology:
  - Ratings based on CPSS-IOSCO Disclosure Framework and Assessment Methodology (December 2012).
  - Ratings reflect gravity and urgency of issues and assessors’ judgment; plans for improvements noted but do not influence observance judgments.
  - Cutoff date for considered information: December 10, 2016.

### C. Key facts and systemic profile
- Average daily settlement value in 2015: €480 billion.
- Client base: more than 1,400 financial institutions (including banks, supranationals, central banks, broker/dealers, and CSDs) from over 110 countries.
- Links and currencies: maintains links to 56 markets with settlement in over 40 currencies.
- Securities held on accounts with CBL: approximately €6 trillion.
- Assessment outcome summary: 8 out of 21 PFMI principles found to be in broad observance.

### D. Main findings — systemic risk, dependencies, and risk management
- Systemic significance and concentration of risk:
  - CBL is highly interconnected and systemically important; a failure would cause major market disruption and potential financial losses for participants, reduce availability of secured credit, and affect other FMIs (e.g., CCPs) via loss of access to collateral or financial buffers.
- Dependencies on commercial banks and counterparties:
  - Important dependencies on a limited number of depository and cash correspondent banks, in particular for the U.S. and UK markets.
  - Recommendation: mitigate through increasing number of contracted banks or establishing direct links with local CSDs and central banks where possible.
- Credit exposures and collateralization:
  - CBL offers uncommitted credit lines (mostly secured) and securities lending; not all exposures are fully collateralized because the executive board can extend uncollateralized credit to individual participants.
  - Risks from advancement of income payments and the Bridge with Euroclear Bank may create further uncovered exposures.
  - Recommendations:
    - Ensure all credit exposures are fully collateralized.
    - Apply haircuts to cash collateral, including foreign currencies.
    - Implement ex ante collateral concentration measures.
    - Subject haircut model to independent validation.
- Risk management function independence:
  - The chief risk officer (CRO) should be responsible only for risk management and not for operational activities.
  - Clearstream Holding A.G. board committee on risk management should be chaired by an independent board member.
  - CBL’s dependence on parent funding from Deutsche Börse AG should be explicitly recognized and managed within the recovery plan.
- Operational risk and business continuity:
  - CBL has business continuity plans, two datacenters with regular testing and ability to switch without data loss.
  - Concern: close proximity of the two datacenters; a third, more distant datacenter is justified as contingency against simultaneous impact.
  - CBL has conducted a partial, but not full, failover test; unclear whether remote sites can swiftly assume all critical Luxembourg operations.
- Oversight and supervision:
  - BCL and CSSF conduct oversight and supervision prudently, based on clear and transparent legal framework.
  - CSSF supervises CBL as a bank and has no specific requirements for CBL as a CSD; implementation of the EU CSD Regulation (CSDR) and related regulatory technical standards expected to strengthen day-to-day supervision in line with PFMI.
  - Resources of authorities considered sufficient for the time being; additional resources may be needed in future to meet increased regulatory responsibilities.
  - Authorities have powers to obtain relevant information and enforce corrective action; BCL’s reliance on moral suasion works well but enforcement powers could be strengthened by adopting a general legal sanctioning power in its organic law.
- Cooperation and crisis arrangements:
  - Authorities encouraged to formalize cooperation arrangements domestically and internationally (e.g., MoU between BCL and CSSF, ex ante crisis management arrangements).
  - Authorities should consult international authorities and central banks in the PFMI assessment.
  - Cooperation between Belgian and Luxembourg authorities on the bridge/link with Euroclear Bank needs to be formalized and enhanced with ECB involvement for coordinated parallel implementation of risk measures.
- Supervisory designation recommendations:
  - Strong case for designating CBL as a Significant Institution (SI) under the Single Supervisory Mechanism (SSM) alongside Belgium’s Euroclear Bank to achieve consistent supervision and harmonization benefits.
  - CBL should be under the remit of the Single Resolution Board (SRB).

### E. Summary compliance highlights from Table 1 (Principles 1–8)
- Principle 1 — Legal basis:
  - Legal risk mitigated through a sound and enforceable legal basis for settlement, custody and banking activities.
  - Settlement activities governed by consistent laws, regulations, and contractual arrangements; Luxembourg implementation of European directives provides statutory foundation for finality, netting, and securities lending.
  - Collateral arrangements governed by sound legal framework; securities and payment transfers, when finalized, are protected from ordinary operation of Luxembourg insolvency law.
  - CBL identifies and mitigates cross-jurisdictional legal risks via legal opinions.
- Principle 2 — Governance:
  - Governance arrangements comprehensive; roles of supervisory and executive boards clearly described and publicly disclosed.
  - Audit Compliance and Risk Management Committee (ACRC) chaired by an independent board member.
  - Independence of risk management should be strengthened:
    - CRO should focus solely on risk management (no operational responsibilities).
    - Most risk management issues discussed at Clearstream Holding level (CRCC); CRCC should be chaired by an independent board member.
    - All risk management models, including haircut calculation model, should undergo independent validation by technical experts.
    - Regular review of supervisory board (SB) performance recommended.
- Principle 3 — Framework for comprehensive management of risks:
  - CBL has risk policies, procedures and systems that enable identification, monitoring and management of risks, with effective use of key risk indicators (KRIs) for operational and business risks.
  - Coverage of credit risk could be enhanced; develop KRIs for credit, liquidity and market risks and ensure independent validation of risk models.
  - Dependencies on commercial entities should be actively managed; recovery plan heavily relies on Deutsche Börse AG (DBAG) financial support and this dependency should be explicitly managed.
- Principle 4 — Credit risk:
  - Framework exists to identify, monitor and manage credit risks, but modifications needed to ensure full collateralization.
  - As a bank, CBL is subject to regulatory exposure limits and solvency/liquidity ratios above mandatory thresholds.
  - Executive board can extend uncollateralized credit; advancement of income payments and bridge transactions with Euroclear Bank may create uncovered exposures.
  - Recommendation: invest in a credit risk management tool to automatically collect and display exposures from entities fulfilling multiple roles.
- Principle 5 — Collateral:
  - Collateral policy defines eligibility, haircuts and concentration limits; conservative haircuts applied to securities but not to cash collateral due to technical limitations.
  - Collateral arrangements do not explicitly consider potential pro-cyclical adjustments.
  - Tools to monitor and limit concentration should be strengthened and applied ex ante.
  - Haircut model should be independently validated by technical experts.
- Principle 6 — Margin:
  - Not applicable.
- Principle 7 — Liquidity risk:
  - Comprehensive and generally sound framework to manage liquidity risk from participants, cash correspondent banks, liquidity providers, and depository banks in various currencies.
  - Holds sufficient liquid resources in euros and U.S. dollars; can obtain liquidity in other currencies through reverse repo contracts with a range of counterparts.
  - Conducts daily, monthly and quarterly stress tests, including default of the two participants with the largest exposures, and compares results with available liquid resources in euros and U.S. dollars.
  - Recommendations:
    - Diversify cash correspondent bank (CCB) base for GBP and other larger currencies.
    - Continue discussions with relevant central banks to obtain direct access.
    - Prepare contingency plans for a crisis event in which access to FX markets for GBP and other currencies is not available.
- Principle 8 — Settlement finality:
  - Internal settlements are final under CBL securities settlement system rules; Payment Services Law provides statutory basis for finality.
  - Settlements over the bridge with Euroclear Bank: final after completion of receiving ICSD checking process during day time, and after delivering ICSD verification during night time.
  - External settlements final according to local market rules and practices.

*Source: Annex IV. Report on the Observance of Standards and Codes (ROSC) — Summary Assessments of CPSS-IOSCO Principles for Financial Market Infrastructures: Clearstream Banking Luxembourg (cutoff date for information: December 10, 2016).*

### 9. Money settlements

### 9. Money settlements

### Overview of settlement arrangements
- Money settlements are conducted in commercial bank money via the cash accounts in CBL’s systems.
- For internal settlement, settlement in central bank money is not considered practical because (i) CBL settles more than 40 currencies and (ii) many of its clients do not have access to central bank money in these currencies.
- Money settlements take place at the cash accounts at CBL (i.e. in commercial bank money).
- CBL’s cash accounts are funded through CCBs, which in most cases are commercial banks. CCBs are supervised banks that comply with a range of criteria as defined by CBL.
- CBL monitors its risks towards CCBs on an ongoing basis, including the concentration of exposures.

### External settlement arrangements and channels
- For external settlement CBL uses a combination of commercial and central bank money.
- For outbound links CBL uses depository banks/CCBs to fund settlements in local markets.
- CCBs execute payments and may provide CBL with free and mostly unsecured intra-day liquidity facilities, as well as overnight credit if need be.
- For some markets the accounts are funded through central banks; the use of central banks in this regard is expected to increase with the full migration to T2S.
- CBL is linked to Euroclear Bank via the Bridge and to 56 local CSDs worldwide, often through depository banks and CCBs.

### Key risks identified
- Concentration risk: exposures are very concentrated in only a few CCBs in many markets, exposing CBL to credit, liquidity and operational risks in case a CCB defaults.
- Risks are particularly significant in the U.S. and U.K. markets.
- Uncollateralized credit risks may occur as part of current settlement practices (noted in relation to the Bridge).
- Reconciliation frequency: reconciliation of securities accounts for Bridge settlements happens on a weekly and monthly basis, which should be done on a daily basis.
- Finality disclosure: the moment of finality for outbound links can be more clearly disclosed in the Creation Link Guides.
- Contingency and operational resilience: business continuity management should be strengthened; two data centers are in close proximity, there is no third data center, and no full failover test has been conducted, leaving uncertainty about swift takeover of all critical operations from other locations.

### Relevant operational and control practices
- CCBs are included in CBL’s aggregated credit risk monitoring.
- CBL requires participants to indicate whether assets are proprietary or client assets and maintains a list with this information.
- CBL does not permit overdrafts of securities accounts and performs daily reconciliation for all its securities accounts (securities-specific control).
- CBL has a publicly disclosed investment policy and keeps assets at supervised and regulated entities with prompt access arrangements.

### Recommended actions related to money settlements and connected risks
- Continue seeking opening a direct account in central banks.
- Reduce CBL’s dependencies on commercial banks, through the use of additional depositories, CCBs and direct links with CSDs and central banks where possible.
- Diversify the CCB base for GBP, USD and other larger currencies and continue discussions with relevant central banks and CSDs to obtain direct access.
- Prepare contingency plans to manage a crisis event in which it cannot access FX markets to obtain liquidity in GBP and other currencies.
- Conduct daily reconciliations (Bridge settlements).
- Increase transparency in relation to the moment of settlement finality through Creation Link Guides for local markets.
- Include relevant external stakeholders, in particular authorities, Euroclear Bank and the most relevant depository banks and CCBs, in the default management tests (to address risks that can materialize from settlement counterparties).
- Apply broader operational resilience actions that affect settlement safety: conduct a full failover test and invest in a third data site at a location with a significantly different risk-profile than other datacenters.

*Source: cr17122 - 9. Money settlements (IMF assessment text).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17122.pdf_