## EXECUTIVE SUMMARY (cr17258)

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### Introduction and scope
- A focused review of certain aspects of the Luxembourg banking supervisory regime was undertaken as part of the 2016 Luxembourg FSAP update.
- Reference framework: 2012 version of the “Basel Core Principles for Effective Banking Supervision” (BCP); the review is not a formal BCP assessment but updates the 2011 BCP assessment and concentrates on issues arising from Luxembourg’s position as an international financial services center.
- Review period and engagement:
  - Scoping meetings: May 17–21, 2016.
  - Mission meetings in Frankfurt: September 6–12, 2016.
  - Mission meetings in Luxembourg: September 13–26, 2016.
  - Close-out meeting: September 27, 2016.
- Documents and inputs: ECB and CSSF documents, ECB Luxembourg-specific questionnaire, CSSF standard BCP questionnaire with Luxembourg-specific questions, and discussions with Luxembourg Finance Ministry, BCL, banks, Luxembourg Banking Association, and a firm of bank external auditors.

### Institutional setting and market structure
- Key institutional changes since 2011:
  - Establishment of the Single Supervisory Mechanism (SSM) in October 2013; SSM started activity on November 4, 2014.
  - ECB assumed responsibility for direct supervision of large banking groups (Significant Institutions/SIs); National Competent Authorities (NCAs) continue direct supervision of Less Significant Institutions/LSIs under ECB oversight.
  - CSSF assigned as the NCA for supervision of banks in Luxembourg (supervises LSIs under ECB oversight; ECB directly supervises SIs).
  - Major EU directives in effect since 2011 include CRD IV/CRR, BRRD, and the Directive on Deposit Guarantee Schemes.
- CSSF governance and structure:
  - Three executive bodies: Executive Board (Director General + four directors), Resolution Board, and Depositor and Investor Protection Board.
  - The Executive Board is the highest executive authority for matters other than resolution and depositor/investor protection; the Board above it has limited powers.
  - CSSF can issue autonomously legally binding prudential regulations within its competence.
- Role of BCL and JSTs:
  - Under the SSM Framework Regulation, BCL may appoint members to Joint Supervisory Teams (JSTs) for liquidity surveillance.
- Market structure and scale:
  - Investment funds industry: €3.5 trillion in assets under management or 72.1 times GDP.
  - Banking industry: €747 billion in assets or 14.3 times GDP.
  - Insurance industry: €205 billion in assets or 4.2 times GDP.
  - Since 2011, only banking assets have contracted, declining by about 25 percent from their pre-crisis peak.
  - Number of banks (as at June 30, 2016): 143.
    - 61 are SIs (either in their own right—six in number—or as subsidiaries or branches of SIs in other euro area member states).
    - The 61 banks represent about 75 percent of the Luxembourg banking system in aggregate balance sheet size and are supervised directly by the ECB.
    - Only five banks are domestically owned (accounting for 7.2 percent of industry assets).
    - Government ownership is significant in three banks.
    - Top five banks account for almost one third of sector assets.
  - Origin of banks (end-December 2015): 77 percent from EEA jurisdictions, 5 percent from the United States and Canada, 7 percent collectively from Brazil, Russia, and China, 5 percent from Switzerland, and 6 percent from elsewhere.
  - Functional roles: subsidiaries and branches of foreign banks play a central role in intra-group liquidity management and custodial operations for Luxembourg-domiciled investment funds; a small number of banks serve the domestic economy and private banking.

### Main findings and progress since the 2011 FSAP
- Significant progress since 2011:
  - Finance Ministry is no longer responsible for granting or revocation of banking licenses.
  - CSSF no longer has an industry promotional role.
  - Resources have increased substantially.
  - Significant increase in the implementation of sanctioning powers.
- Remaining shortcomings:
  - Governance structures at the CSSF remain an issue (potential for interference despite no evidence of actual interference encountered).
  - On-site inspection capacity and timeliness remain areas needing further improvement.
  - High intra-group assets and liabilities, interconnectedness with investment funds, high sovereign debt exposure, and rising residential property market risks warrant continued focus.

### Remaining weaknesses, vulnerabilities, and risks identified
- Operational independence:
  - Potential for interference in CSSF operational independence remains, although no evidence of actual interference was encountered.
- Supervisory resources and timeliness:
  - Resources increased significantly, but number of on-site inspectors is still relatively low; a major recruitment drive is under way.
  - Some delays persist in completing on-site inspection reports.
  - Frequency of on-site inspections of Luxembourg subsidiaries of Significant Institutions is on the low side.
- Intra-group exposures:
  - Level of intra-group exposures by Luxembourg banks to their foreign parents continues to be high, posing maturity and currency transformation risks.
  - Safeguards introduced by the legislator and CSSF have partially addressed the situation, but underlying risk remains.
- Investment funds—bank linkages:
  - Investment funds industry continues to grow strongly.
  - Volume of deposits placed by such funds with custodian banks continues to increase as a share of outstanding liabilities, potentially posing a funding risk to those banks in the event of a shock to the investment funds industry.
- Residential real estate and mortgage lending:
  - Residential real estate valuations are at rather elevated levels.
  - Increasingly, banks are advancing loans with loan-to-value ratios greater than 80 percent.
  - CSSF measures include:
    - Setting higher risk weightings where the LTV is above 80 percent for banks using the standardized approach for credit risk.
    - Imposing a minimum risk weighting of 15 percent on residential real estate exposures for banks using an internal rating-based approach.
- Credit information infrastructure:
  - Luxembourg does not yet have a domestic credit bureau.
  - Luxembourg participates in an ECB-sponsored initiative that will result in a euro area credit bureau which will receive its first set of credit documentation in September 2018; BCL is charged with implementing the Luxembourg component.

### Key policy recommendations (excerpt)
- Introduce a governance structure for the CSSF that would remove any potential for interference from the government or industry as is required under CP 2.
  - Priority/Time frame: Medium/Medium term
- Broaden the specific supervisory regime for intra-group exposures designed to limit the risks arising from such exposures that is fully consistent with the ECB Regulation and Guideline resulting from the work on Options and Discretions.
  - Priority/Time frame: High/Near term
- Continue to strengthen the on-site inspection regime through the recruitment of additional staff.
  - Priority/Time frame: Very High/Near term
- Review the adequacy of banking risk experts in the Banking Supervision Department.
  - Priority/Time frame: Very High/Near term
- Reduce timeframe for completion of on-site inspection reports.
  - Priority/Time frame: High/Near term
- Increase frequency of on-site inspections of subsidiaries of Significant Institutions.
  - Priority/Time frame: High/Near term
- Continue to monitor very closely any potential impact on banks from rising residential real estate prices.
  - Priority/Time frame: Very High/Near term
- Harmonize information submitted by banks on loan-to-value and debt-to-income ratios.
  - Priority/Time frame: High/Near term
- Work closely with ECB to include households in its credit bureau initiative.
  - Priority/Time frame: Medium/Medium term
- Complete MOU with BCL on liquidity supervision regarding LSIs.
  - Priority/Time frame: High/Medium term
- Where warranted and in keeping with the provisions of Core Principle 11––Corrective actions––impose monetary fines commensurate with the breach in question.
  - Priority/Time frame: Medium/Medium term
- Ensure close interaction with supervisors of parents of Luxembourg banks located outside the euro area.
  - Priority/Time frame: High/Near term
- Continue to monitor closely banks’ holding of sovereign debt.
  - Priority/Time frame: High/Near term
- Advocate for stronger oversight at the European level of nonbank holding companies that include banks.
  - Priority/Time frame: Medium/Medium term

*Source: IMF staff, “EXECUTIVE SUMMARY” (cr17258).*

### Distribution of bank assets by principal line of activity
- Corporate finance/trade finance: 24.3 percent
- Private banking: 20.7 percent
- Retail and commercial banking: 17.2 percent (Almost all domestic)
- Custodian banking: 14.4 percent
- Intragroup treasury and liquidity management: 8.8 percent
- Covered bonds banking: 8.0 percent
- Activities linked to investment funds and firms: 2.6 percent
- Other activities: 4.0 percent

### Private banking activity and impact of automatic exchange of information
- Since January 1, 2015 Luxembourg switched to automatic exchange of information under the Savings Directive.
- Number of banks engaged in private banking increased from 38 in 2011 to 42 in 2015.
- Total assets in private banking increased from €165 billion to €201 billion between 2011 and 2015.
- Assets under management in private banking increased from €121 billion to €144 billion between 2011 and 2015.

### Profitability, capitalization, and liquidity
- Return on equity: in the region of 10 percent over the last five years but on a declining trend.
- Average solvency ratio: 21.5 percent.
- Four banks have solvency ratios between 10.5 percent, the minimum requirement (including buffers), and 12 percent. The rest have ratios in excess of 12 percent.
- Liquidity: most banks comfortably exceed the minimum liquidity ratio required under Basel/CRD IV/CRR.

### ECB Asset Quality Review and stress testing
- Luxembourg emerged well from the ECB Asset Quality Review carried out by the ECB in 2014.
- No additional provisions were recommended in relation to asset quality.
- Under the advanced stress test exercise, the banks remained comfortably in excess of minimum core equity tier 1 requirements.
- Luxembourg transposed CRD IV/CRR conservatively, partly due to its decision not to allow unrealized gains to be included in capital until the final deadline in 2018.

### Regulatory, accounting, and legal environment
- Luxembourg has implemented IFRS for prudential reporting as required under EU rules.
- For annual statutory accounts, banks generally use local GAAP mainly arising from tax considerations; main difference noted: local GAAP is based on prudence whereas IFRS applies market value to certain assets.
- The audit profession is supervised by the CSSF which approves statutory auditors and audit firms and operates a quality assurance system based on best international practice.
- Luxembourg introduced a system of automatic information exchange and withholding tax on financial income in accordance with the EU Savings Directive and the Administrative Cooperation Directive.

### CSSF independence, governance, and coordination with BCL
- Legal reference places the CSSF “under the direct authority of the minister responsible for the financial center.”
- Board composition includes members proposed by the Minister and members proposed by companies and persons subject to supervision; members appointed for renewable five year terms.
- Potential conflict of interest exists because industry representatives participate in decisions on supervisory resources and fees.
- CSSF funding is via fees paid by supervised entities, determined in the context of a five-year budget project; fees are collected directly by the CSSF and incorporated into its annual budget submitted to the government for approval.
- Transposition of CRD IV clarified responsibilities: CSSF is national competent authority for credit institutions; ECB is competent authority for direct supervision of SIs and indirect supervision of LSIs.
- BCL required to supervise the general liquidity situation of the market and market operators; BCL carries out liquidity surveillance of 25 of the largest LSIs; CSSF responsible for the remainder.
- An MOU between CSSF and BCL on respective supervisory tasks is not in place; an MOU exists on technical aspects of information sharing. Recommendation: initiate an MOU to clarify tasks and avoid gaps or overlap.

### Resources and skills in banking supervision
- CSSF staff numbers (all activities covered by the CSSF):
  - 2010: 358
  - 2011: 402
  - 2012: 444
  - 2013: 489
  - 2014: 551
  - 2015: 624
  - 2016: 675
- Since establishment of the SSM in 2013, significant increases in resources in all areas relating to banking supervision.
- Number of full time equivalent staff (FTEs) involved in off-and on-site supervision increased by 48.3 percent from 2013 to 2015.
- Number of on-site supervisors rose by 106.5 percent from 2013 to 2015.
- Number of off-site supervisors increased by 32.8 percent from 2013 to 2015.
- As of December 2016, around 150 staff members are working for departments directly involved in banking supervision, including experts in specialist banking risk areas.

### On-site supervision: resources, activity, and timeliness
- Prior to June 2009 CSSF had no on-site inspection department separate from the banking supervision department.
- In 2011, there were 10 on-site inspectors only; this rose to 35 in September 2016.
- CSSF was recruiting 20 additional on-site inspectors in 2016 and a similar number in 2017.
- Current complement (reported later) of on-site inspectors: 42 inspectors (deals only with on-site inspections).
- Number of inspections (excluding AML/CFT and MiFID) by year:
  - 2013: 68
  - 2014: 52
  - 2015: 44
  - 2016 planned: 57
- All inspections are targeted; no full scope inspections are carried out.
- The maximum interval between inspections in any one bank is about four years.
- The average time between the closing meeting with the bank and the communications of findings is six months.
- CSSF acknowledges delays in completing inspection reports due in part to inadequate staffing and staff diverted to other tasks; situation improving with increased staffing.
- Recommendation: carry out full scope inspections on a risk basis, particularly for small banks.
- In 2016, ten significant institutions were subject to on-site inspections:
  - Five in banks directly supervised by the ECB.
  - Five in banks supervised by the ECB as subsidiaries of parents deemed to be SIs.
- Frequency of on-site inspections for indirectly supervised banks: five per annum out of a cohort of more than 50.

### Expertise allocation (FTEs by risk area)
- Credit risk: 4.25 full time equivalent — Includes assessment of internal models
- Operational risk: 2.00 full time equivalent — Includes governance and internal models
- Liquidity: 2.00 full time equivalent
- Market risk/interest rate risk in the banking book: 0.50 full time equivalent
- Risk analysis: 3.00 full time equivalent — Including stress tests
- Reporting: 3.00 full time equivalent — Includes FINREP/COREP
- Methods: 2.75 full time equivalent — SREP methodology
- Comment: allocating only half an FTE to market risk and interest rate risk in the banking book appears inadequate.

### Interconnectedness with foreign parent groups and intra-group exposures
- Risk mainly from parents funding local affiliates or upstreaming liquidity from Luxembourg subsidiaries and branches.
- EU CRR provisions allow member states to exempt intra-group exposures from the CRR Large Exposures limits provided prudential conditions are met (member state option exercised in Luxembourg by CSSF Regulation and Luxembourg financial sector law effective July 2015).
- CRR gives the ECB (for SIs) and the CSSF (for LSIs) the power to limit or withdraw the intra-group large exposure exemption if conditions are no longer valid.
- Basel Committee Supervisory Framework for Measuring and Controlling Large Exposures (April 2014) chose not to include intra-group transactions; effective from 2019.
- 77 percent of Luxembourg banking operations have their parent in SSM jurisdictions.
- Introduction of Basel III liquidity requirements has led to a move away from intra-group exposures:
  - Level of intra-group assets for the Luxembourg system fell from €320 billion to €266 billion between 2014 and 2015.
  - This represents a decline from 43.3 percent to 35.9 percent of total assets over the two-year period.
- New safeguards introduced and applicable from January 1, 2014 (selected):
  - Counterparty must itself be a bank or investment firm, save for the bank’s own subsidiaries when included in consolidated supervision.
  - Counterparty’s financial situation must not create disproportionate risk for the bank itself.
  - Financing of the exposure must not create significant liquidity risk from asymmetric maturities or currency mismatches.
  - No disproportionately negative impact on the bank if a hypothetical resolution process became applicable to the group.
- CSSF guidance elaborations:
  - A SREP measurement of 1 or 2 in the counterparty is acceptable; 3 triggers discussion; 4 is unacceptable.
  - CSSF will require a table of mismatches and exchange rates between assets and liabilities and a description of policy regarding these risks.
  - CSSF will require group-level analysis of potential hurdles to repayment of intra-group exposures outside of resolution and legal analysis of intra-group claim regime in resolution.
- Surveillance gaps:
  - No formal application process to avail of the waiver nor a dedicated ongoing surveillance regime for intra-group exposures; a notifying letter suffices to exercise the waiver.
  - Information on maturity profiles remains fragmented; quarterly large exposures reports provide extent but not full maturity detail; annual SREP provides ad-hoc maturity information.
- Possible supervisory measures recommended:
  - Formalize approval process and require applicants to await authorization before availing the waiver.
  - Introduce specific limits in respect of maturity and currency transformations.
  - Require banks to submit quarterly details on intra-group exposures indicating maturity profiles and past quarter breaches.
  - Continue periodic reviews of waivers, including during on-site inspections.
  - Intensify application of capital add-ons and use power to limit exposures and seek collateral where intra-group exposures could be excessive.

### Box 2. Investment Funds—Bank Linkages (selected highlights)
- Growth and scale:
  - Assets of investment funds have quadrupled since 2000.
  - Of this growth, 80 percent is accounted for by net inflows and 20 percent by valuation gains.
  - Luxembourg’s fund industry: €3.5 trillion of net assets; about 72 times GDP; about one tenth of total world-wide investment funds’ assets.
  - Since end-2008, about one-fifth (or €1.16 trillion) of all new net inflows into investment funds worldwide were in Luxembourg’s funds.
- Key statistics on fund–bank exposures and custody:
  - Luxembourg investment funds hold bank deposits domestically of about €110 billion.
    - This is 3.1 percent of investment funds net asset value.
    - This is 14.5 percent of Luxembourg’s banks aggregate balance sheet.
  - Broader bank deposit estimate: investment funds hold about €220 billion in bank deposits, about half placed in Luxembourg’s largest depository banks.
  - Custody concentration: five banks hold 60 percent of investment fund assets under their custody.
  - Fund deposits account for about 50 percent of depository banks’ liabilities.
- Regulatory and operational features:
  - Depositary banks must be established in the same country as the investment fund and are all located in Luxembourg for Luxembourg authorized investment funds.
  - Depositary banks are described as ‘liability-driven’ rather than ‘asset-driven’.
  - Liquidity coverage ratio requirements have forced depository banks to channel fund deposits into eligible high quality liquid assets (HQLA), resulting in a decline in the level of assets placed with the parent.
- Channels for shock transmission:
  - Withdrawal of large operational deposits during sustained redemptions.
  - Direct exposures of funds to bank bonds, equity and derivative exposures domestically and abroad.
  - Cross-border transmission via bond and stock holdings, derivative exposures, loans and deposits.
- Historical evidence:
  - Data from the BCL shows deposits of non-money market investment funds in Luxembourg banks declined by €6.7 billion in Q4 2008 and by another €5 billion in Q1 2009.
- Authorities’ assessment:
  - Authorities note mitigating features: the operational nature of deposits, liability-driven custodial banks, and liquidity preference of asset managers.
  - Nevertheless, unexpected and sustained redemptions could have an adverse impact on the banking system if deposits are withdrawn to avoid asset sales.

*Source: IMF staff report excerpt (cr17258).*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 5

### EXECUTIVE SUMMARY

### Introduction and scope
- A focused review of certain aspects of the Luxembourg banking supervisory regime was undertaken as part of the 2016 Luxembourg FSAP update.
- Reference framework: 2012 version of the “Basel Core Principles for Effective Banking Supervision” (BCP); the review is not a formal BCP assessment but updates the 2011 BCP assessment and concentrates on issues arising from Luxembourg’s position as an international financial services center.
- Review period and engagement:
  - Scoping meetings: May 17–21, 2016.
  - Mission meetings in Frankfurt: September 6–12, 2016.
  - Mission meetings in Luxembourg: September 13–26, 2016.
  - Close-out meeting: September 27, 2016.
- Documents and inputs: ECB and CSSF documents, ECB Luxembourg-specific questionnaire, CSSF standard BCP questionnaire with Luxembourg-specific questions, and discussions with Luxembourg Finance Ministry, BCL, banks, Luxembourg Banking Association, and a firm of bank external auditors.

### Institutional setting and market structure
- Key institutional changes since 2011:
  - Establishment of the Single Supervisory Mechanism (SSM) in October 2013; SSM started activity on November 4, 2014.
  - ECB assumed responsibility for direct supervision of large banking groups (Significant Institutions/SIs); National Competent Authorities (NCAs) continue direct supervision of Less Significant Institutions/LSIs under ECB oversight.
  - CSSF assigned as the NCA for supervision of banks in Luxembourg (supervises LSIs under ECB oversight; ECB directly supervises SIs).
  - Major EU directives in effect since 2011 include CRD IV/CRR, BRRD, and the Directive on Deposit Guarantee Schemes.
- CSSF governance and structure:
  - Three executive bodies: Executive Board (Director General + four directors), Resolution Board, and Depositor and Investor Protection Board.
  - The Executive Board is the highest executive authority for matters other than resolution and depositor/investor protection; the Board above it has limited powers.
  - CSSF can issue autonomously legally binding prudential regulations within its competence.
- Role of BCL and JSTs:
  - Under the SSM Framework Regulation, BCL may appoint members to Joint Supervisory Teams (JSTs) for liquidity surveillance, reflecting its national responsibility to supervise “the general liquidity situation of the markets as well as evaluating market operators.”
- Market structure and scale (as presented):
  - Investment funds industry: €3.5 trillion in assets under management or 72.1 times GDP.
  - Banking industry: €747 billion in assets or 14.3 times GDP.
  - Insurance industry: €205 billion in assets or 4.2 times GDP.
  - Since 2011, only banking assets have contracted, declining by about 25 percent from their pre-crisis peak.
  - Number of banks (as at June 30, 2016): 143.
    - Of these, 61 are SIs (either in their own right—six in number—or as subsidiaries or branches of SIs in other euro area member states).
    - The 61 banks represent about 75 percent of the Luxembourg banking system in aggregate balance sheet size and are supervised directly by the ECB.
    - Only five banks are domestically owned (accounting for 7.2 percent of industry assets).
    - Government ownership is significant in three banks.
    - Top five banks account for almost one third of sector assets.
  - Origin of banks (end-December 2015): 77 percent from EEA jurisdictions, 5 percent from the United States and Canada, 7 percent collectively from Brazil, Russia, and China, 5 percent from Switzerland, and 6 percent from elsewhere.
  - Functional roles: subsidiaries and branches of foreign banks in Luxembourg play a central role in intra-group liquidity management and custodial operations for Luxembourg-domiciled investment funds; a small number of banks serve the domestic economy and private banking.

### Main findings and progress since the 2011 FSAP
- Significant progress since 2011:
  - Finance Ministry is no longer responsible for granting or revocation of banking licenses.
  - CSSF no longer has an industry promotional role.
  - Resources have increased substantially.
  - Significant increase in the implementation of sanctioning powers.
  - Some issues from 2011 remain inadequately addressed, e.g., governance structures at the CSSF.
- Focus of this review: issues arising from Luxembourg’s unique features—high intra-group assets and liabilities, interconnectedness of banking and investment funds, high sovereign debt exposure, and rising residential property market risks. Where relevant, issues are analyzed further in separate Technical Notes.

### Remaining weaknesses, vulnerabilities, and risks identified
- Potential for interference in CSSF operational independence remains, although the mission encountered no evidence of actual interference.
- Supervisory resources:
  - Resources increased significantly, but the number of on-site inspectors is still relatively low; a major recruitment drive for additional on-site staff is under way.
  - Some delays persist in completing on-site inspection reports.
  - Frequency of on-site inspections of Luxembourg subsidiaries of Significant Institutions is on the low side.
- Intra-group exposures:
  - Level of intra-group exposures by Luxembourg banks to their foreign parents continues to be high, posing potential maturity and currency transformation risks to Luxembourg banks.
  - External factors (e.g., advent of SSM) and certain safeguards introduced by the legislator and CSSF have partially addressed the situation, but underlying risk remains.
  - Improvements to the supervision of these exposures are recommended.
- Investment funds—bank linkages:
  - Investment funds industry continues to grow strongly.
  - Volume of deposits placed by such funds with custodian banks continues to increase as a share of outstanding liabilities, potentially posing a funding risk to those banks in the event of a shock to the investment funds industry.
- Residential real estate and mortgage lending:
  - Residential real estate valuations are at rather elevated levels.
  - Increasingly, banks are advancing loans with loan-to-value ratios greater than 80 percent, potentially posing a threat to mortgage lending banks.
  - CSSF measures introduced include:
    - Setting higher risk weightings where the LTV is above 80 percent for banks using the standardized approach for credit risk.
    - Imposing a minimum risk weighting of 15 percent on residential real estate exposures for banks using an internal rating-based approach.
- Credit information infrastructure:
  - Luxembourg does not yet have a domestic credit bureau.
  - Luxembourg participates in an ECB-sponsored initiative that will result in a euro area credit bureau which will receive its first set of credit documentation in September 2018; BCL is charged with implementing the Luxembourg component.

### Key policy recommendations (Table 1: Luxembourg: Main Recommendations)
- Introduce a governance structure for the CSSF that would remove any potential for interference from the government or industry as is required under CP 2.
  - Priority/Time frame: Medium/Medium term
- Broaden the specific supervisory regime for intra-group exposures designed to limit the risks arising from such exposures that is fully consistent with the ECB Regulation and Guideline resulting from the work on Options and Discretions.
  - Priority/Time frame: High/Near term
- Continue to strengthen the on-site inspection regime through the recruitment of additional staff.
  - Priority/Time frame: Very High/Near term
- Review the adequacy of banking risk experts in the Banking Supervision Department.
  - Priority/Time frame: Very High/Near term
- Reduce timeframe for completion of on-site inspection reports.
  - Priority/Time frame: High/Near term
- Increase frequency of on-site inspections of subsidiaries of Significant Institutions.
  - Priority/Time frame: High/Near term
- Continue to monitor very closely any potential impact on banks from rising residential real estate prices.
  - Priority/Time frame: Very High/Near term
- Harmonize information submitted by banks on loan-to-value and debt-to-income ratios.
  - Priority/Time frame: High/Near term
- Work closely with ECB to include households in its credit bureau initiative.
  - Priority/Time frame: Medium/Medium term
- Complete MOU with BCL on liquidity supervision regarding LSIs.
  - Priority/Time frame: High/Medium term
- Where warranted and in keeping with the provisions of Core Principle 11––Corrective actions––impose monetary fines commensurate with the breach in question.
  - Priority/Time frame: Medium/Medium term
- Ensure close interaction with supervisors of parents of Luxembourg banks located outside the euro area.
  - Priority/Time frame: High/Near term
- Continue to monitor closely banks’ holding of sovereign debt.
  - Priority/Time frame: High/Near term
- In line with the recommendations of the 2016 Article IV Staff Report, the authorities should advocate for stronger oversight at the European level of nonbank holding companies that include banks.
  - Priority/Time frame: Medium/Medium term

*Source: IMF staff, “EXECUTIVE SUMMARY” (cr17258).*

### 15.      There is a wide range of business activity undertaken by banks in Luxembourg. Table 2

### 15.      There is a wide range of business activity undertaken by banks in Luxembourg. Table 2

### Distribution of bank assets by principal line of activity
- Corporate finance/trade finance: 24.3 percent
- Private banking: 20.7 percent
- Retail and commercial banking: 17.2 percent (Almost all domestic)
- Custodian banking: 14.4 percent
- Intragroup treasury and liquidity management: 8.8 percent
- Covered bonds banking: 8.0 percent
- Activities linked to investment funds and firms: 2.6 percent
- Other activities: 4.0 percent
- Source: CSSF

### Private banking activity and impact of automatic exchange of information
- Since January 1, 2015 Luxembourg switched to automatic exchange of information under the Savings Directive instead of the imposition of a withholding tax.
- Private banking activity has not diminished as a result of the EU Directives providing for the exchange of information about bank depositors among member states revenue authorities.
- Number of banks engaged in private banking increased from 38 in 2011 to 42 in 2015.
- Total assets in private banking increased from €165 billion to €201 billion between 2011 and 2015.
- Assets under management in private banking increased from €121 billion to €144 billion between 2011 and 2015.
- The new regime led to a shift in customer base: small scale depositors withdrew funds while banks attracted a number of very high net worth individuals following an international marketing initiative.

### Profitability, capitalization, and liquidity of the banking sector
- Return on equity: in the region of 10 percent over the last five years but on a declining trend.
- A number of smaller banks incurred losses in recent years, mainly due to the low interest rate environment and higher administrative charges including increasing cost of regulation.
- High capitalization mitigates immediate stability risk from these losses.
- Average solvency ratio: 21.5 percent (twice the required minimum).
- Liquidity: most banks comfortably exceed the minimum liquidity ratio required under Basel/CRD IV/CRR.
- Four banks have solvency ratios between 10.5 percent, the minimum requirement (including buffers), and 12 percent. The rest have ratios in excess of 12 percent.

### ECB Asset Quality Review, stress testing, and regulatory transposition
- Luxembourg emerged well from the ECB Asset Quality Review carried out by the ECB in 2014.
- In relation to asset quality no additional provisions were recommended.
- Under the advanced stress test exercise, the banks remained comfortably in excess of minimum core equity tier 1 requirements.
- Luxembourg was deemed to have transposed CRD IV/CRR in a conservative manner, partly due to its decision not to allow unrealized gains to be included in capital until the final deadline in 2018.

### Impact of the global financial crisis and domestic resilience
- The Luxembourg banking sector was deeply affected by the global financial crisis; local subsidiaries suffered from solvency and liquidity problems at their foreign parents.
- Aggregate bank balance sheets contracted by almost 15 percent in 2009, essentially through interbank deleveraging.
- Luxembourg contributed to the bail outs of systemically-important banks, Fortis and Dexia, and local subsidiaries of three failed Icelandic banks.
- Domestic credit markets were resilient throughout the crisis in terms of credit volumes and lending spreads.

### Regulatory framework, accounting, and legal environment
- Luxembourg is a founding Member State of the EU, the wider European Economic Area, and the euro area; it has adopted European directives on regulation of financial services.
- Luxembourg has implemented IFRS for prudential reporting as required under EU rules.
- For annual statutory accounts, banks generally use local GAAP mainly arising from tax considerations.
  - Footnote: The main difference between IFRS and local GAAP is that the latter is based on prudence (unrealised losses taken to profit and loss whereas unrealised gains are not accounted for). Under IFRS, market value applies to assets held for trading and assets available for sale.
- The audit profession is supervised by the CSSF which approves statutory auditors and audit firms and operates a quality assurance system based on best international practice.
- Luxembourg’s legal system is based on civil law with many laws derived from French or Belgian legislation and EU regulations; the judicial system is regarded as independent and efficient.
- Luxembourg introduced a system of automatic information exchange and withholding tax on financial income in accordance with the EU Savings Directive and the Administrative Cooperation Directive.

### Main findings from the 2011 BCP Assessment and subsequent actions
- The 2011 assessment concluded Luxembourg had a high level of compliance with the Basel Core Principles.
- Many gaps and deficiencies identified in 2011 have since been addressed.
- Considerable actions have been taken in response to the 2011 FSAP recommendations (see summarized actions below).

Actions taken (selected highlights)
- Some governance changes introduced: ECB now responsible for granting and withdrawal of banking licenses, replacing the Ministry of Finance, though basic governance structure remained in place.
- The reference in legislation to a promotional role for the CSSF has been deleted.
- Clarity between microprudential role of the CSSF and macroprudential role of the BCL introduced through adoption of CRD IV/CRR.
- Use of enforceable regulations introduced to replace existing normative circulars.
- Significant increases in staff numbers for supervision, though on-site resources still need further increase.
- Bank licensing is now the responsibility of the ECB.
- A rule to ensure intra-group lending conducted under arm’s length conditions was introduced in 2015.
- Improvements made to reporting timeliness of on-site findings, though some delays persist.
- Significant increase in the implementation of sanctioning powers.

### Independence, objectives, and governance of the CSSF
Findings
- The Basel Core Principles recommend operational independence for the supervisor; the CSSF’s corporate governance structure does not fully meet some recommendations regarding operational independence.
- Law provides that the CSSF falls “under the direct authority of the minister responsible for the financial center.”
- No evidence encountered of active ministerial interference on a day-to-day basis.
- CSSF governance comprises two boards: a non-executive Board (seven members) and an Executive Board (director-general plus two to four directors).
  - Board composition includes members proposed by the Minister and members proposed by companies and persons subject to supervision; members appointed for renewable five year terms.
  - The law is silent on dismissal procedures and publication of dismissal reasons.
  - Current Board composition (roles listed in source): Director of the Luxembourg Treasury (Chair); Vice Chair – to be appointed upon proposal by the Minister (currently vacant); Further representative of the Minister responsible for the CSSF; The President of the Luxembourg insurance supervisory authority (CAA); Representative of a Luxembourg accounting firm; The Director General of the Luxembourg Bankers Association (ABBL); and The Director General of the Luxembourg association of the funds industry (ALFI).
- The Board meets two to three times a year, has limited powers, does not concern itself with prudential matters, and approves the Executive Board’s rules and regulations and the annual budget.
- Potential for conflict of interest exists because industry representatives participate in decisions on supervisory resources and fees.
- Government may propose dismissal of the Executive Board to the Grand Duke in case of fundamental disagreement; Executive Board members are nominated by the Grand Duke on government proposal for five-year renewable terms.
- CSSF funding is via fees paid by supervised entities, determined in the context of a five-year budget project; fees are collected directly by the CSSF and incorporated into its annual budget submitted to the government for approval. No evidence that the Board rejected Executive Board proposals; government has always approved the budget.
- CSSF law amended in 2015 to introduce new rules on conflicts of interest and to clarify liability regime for staff and decision-making members; these measures meet relevant BCP requirements.
- The CSSF no longer has an industry promotional role; the clause was deleted and the role assumed by a separate agency.

Coordination with BCL and systemic risk governance
- Transposition of CRD IV clarified responsibilities of CSSF and BCL, particularly regarding liquidity surveillance.
- CSSF is the national competent authority responsible for supervision of credit institutions; ECB is competent authority for direct supervision of Significant Institutions (SIs) and indirect supervision of Less Significant Institutions (LSIs).
- BCL required under its legal mandate to supervise the general liquidity situation of the market and market operators; BCL carries out liquidity surveillance of 25 of the largest LSIs, CSSF responsible for the remainder; CSSF has access to liquidity information for all banks.
- CSSF retains ultimate responsibility for all LSIs and would take enforcement action for LSIs under BCL surveillance.
- The arrangement between CSSF and BCL is not formally documented by an MOU on respective supervisory tasks; an MOU exists on technical aspects of information sharing.
- Recommendation: an MOU between CSSF and BCL should be initiated to bring certainty to tasks and avoid regulatory gaps or overlap.
- CSSF, BCL, the government, and insurance supervisors now form part of the Systemic Risk Committee for macroprudential oversight.

Regulatory instruments
- CSSF has moved away from using non-binding Circulars for transposing laws; it is using enforceable Regulations and has issued 12 since 2013.
- Circulars retained only to advise on CSSF’s interpretation of law and regulations.

Recommendations on CSSF governance (verbatim)
- The mission did not encounter any evidence that the current governance structure of the CSSF does not have operational independence. Nonetheless, it does have the potential for interference in the future. Accordingly, it is recommended that the authorities consider a structure whereby:
  - the financial supervisor would no longer fall under the direct authority of the minister but would be answerable to Parliament which is the practice in many jurisdictions;
  - have a board comprising independent directors and expand the powers of that independent board to be reasonable for all the functions of the CSSF;
  - be in a position to determine its own budget and be responsible for its hire and dismissal of executive staff.
- CSSF and the BCL should consider entering into an MOU.

### Resources and skills in banking supervision
- CSSF staff numbers (all activities covered by the CSSF):
  - 2010: 358
  - 2011: 402
  - 2012: 444
  - 2013: 489
  - 2014: 551
  - 2015: 624
  - 2016: 675
- Since establishment of the SSM in 2013, significant increases in resources in all areas relating to banking supervision in the CSSF.
- Number of full time equivalent staff (FTEs) involved in off-and on-site supervision increased by 48.3 percent from 2013 to 2015.
- Number of on-site supervisors rose by 106.5 percent from 2013 to 2015.
- Number of off-site supervisors increased by 32.8 percent from 2013 to 2015.
- As of December 2016, around 150 staff members are working for departments directly involved in banking supervision, including experts in specialist banking risk areas (credit risk, capital, liquidity).

*International Monetary Fund, Luxembourg Financial Sector Assessment excerpt (selected paragraphs).*

### 38.      In particular, the CSSF is augmenting its on-site supervision resources. This is from an

### 38.      In particular, the CSSF is augmenting its on-site supervision resources. This is from an

### Resources and staffing for on-site supervision
- Prior to June 2009 CSSF had no on-site inspection department separate from the banking supervision department.
- In 2011, there were 10 on-site inspectors only; this has risen to 35 in September 2016.
- CSSF was in the process of recruiting 20 additional on-site inspectors in 2016 and a similar number in 2017.
- Current complement (reported later) of on-site inspectors: 42 inspectors (deals only with on-site inspections).
- Staff turnover at the CSSF over the period 2010 to 2015: maximum annual turnover rate was 2.82 percent—almost all were either through retirement or staff moving to another public administration agency.

### Costs and FTE trends
- Since 2013, the cost of off- and on-site supervision at CSSF increased by 52.1 percent to €12.3 million.
- Costs to the BCL for banking supervisory tasks increased from €3.5 million in 2013 to €4.37 million in 2015.
- Within the BCL figures:
  - On-site costs fell from €0.13 million to €0.06 million.
  - Off-site rose from €1.62 million to €1.85 million.
  - Other functions (contribution to policies, advisory and regulatory functions) rose from €1.83 million to €2.46 million.
- Staff numbers in terms of FTEs at the BCL rose from 12.4 to 13.2 personnel.

### Supervisory approach: historical weaknesses and improvements
- 2011 BCP assessment noted weaknesses in relation to on-site inspections: long-delayed formal reporting of findings and consequent action.
- Contributing factors: modest staffing levels for the on-site inspection regime, emphasis on AML/CFT inspections after a weak FATF report in 2010, inspectors moved to fresh assignments delaying report completion, escalation of minor decisions to senior executives causing delays, delays in dealing with potentially confrontational issues.
- The tendency to escalate minor decisions to the most senior executives has been addressed: only reports where enforcement action is anticipated—representing about 10 to 15 percent of all inspections—are now referred to the executive committee.

### On-site inspection program, scope, frequency, and timeliness
- Planning of inspections is proposed by the off-site department based on ongoing supervision inputs (risk assessment score, results of previous on-site inspections, new activities launched, internal organization, staffing turnover, etc.).
- Number of inspections (excluding AML/CFT and MiFID) by year:
  - 2013: 68
  - 2014: 52
  - 2015: 44
  - 2016 planned: 57
- All inspections are targeted (focus on a particular risk, e.g., credit risk). No full scope inspections are carried out.
- The maximum interval between inspections in any one bank is about four years.
- The average time between the closing meeting with the bank and the communications of findings is six months. The report itself is not shared with the bank—only the findings and recommendations are communicated.
- CSSF acknowledges delays in completing inspection reports due in part to inadequate staffing and staff diverted to other tasks; situation improving with increased staffing.
- No full scope inspections take place; recommendation that full scope inspections be carried out on a risk basis, particularly for small banks.
- In 2016, ten significant institutions were subject to on-site inspections:
  - Five in banks directly supervised by the ECB.
  - Five in banks supervised by the ECB as subsidiaries of parents deemed to be SIs.
- Corresponding figures for 2015 were five and four respectively.
- For each year, all but one of the inspections were targeted. Exceptions were follow-up inspections.
- Frequency of on-site inspections for indirectly supervised banks: five per annum out of a cohort of more than 50.

### Expertise allocation (Table 5: Risk Areas)
- Credit risk: 4.25 full time equivalent — Includes assessment of internal models
- Operational risk: 2.00 full time equivalent — Includes governance and internal models
- Liquidity: 2.00 full time equivalent
- Market risk/interest rate risk in the banking book: 0.50 full time equivalent
- Risk analysis: 3.00 full time equivalent — Including stress tests
- Reporting: 3.00 full time equivalent — Includes FINREP/COREP
- Methods: 2.75 full time equivalent — SREP methodology
- Comment: allocating only half an FTE to market risk and interest rate risk in the banking book appears inadequate.

### Interconnectedness with foreign-based banking parent groups and intra-group exposures
- Risk stems mainly from parents funding local affiliates or upstreaming liquidity from Luxembourg subsidiaries and branches; Luxembourg banks’ liquidity risks thus mainly rest with the financial soundness of their groups.
- EU CRR provisions (directly applicable since January 2014) allow member states to exempt intra-group exposures from the CRR Large Exposures limits provided underlying intra-group exposures satisfy prudential soundness conditions set out in the CRR (member state option exercised in Luxembourg by CSSF Regulation and Luxembourg financial sector law effective July 2015).
- CRR gives the ECB (for Significant Institutions) and the CSSF (for Less Significant Institutions) the power to limit or withdraw the intra-group large exposure exemption if conditions are no longer valid.
- Basel Committee Supervisory Framework for Measuring and Controlling Large Exposures (April 2014) chose not to include intra-group transactions; effective from 2019.
- 77 percent of Luxembourg banking operations have their parent in SSM jurisdictions.
- External auditors monitor intra-group exposures as part of the Long Form Report.
- Box 1: Exemption for Intra-Group Exposures — member states may, for a transitional period until the entry into force of any legal act following the review in accordance with Article 507 of the CRR, but not after December 31, 2028, fully or partially exempt exposures... (text preserved verbatim in source).
- New safeguards introduced and applicable from January 1, 2014:
  - The bank’s (intra-group) counterparty must itself be a bank or investment firm, save for the bank’s own subsidiaries when they are included in the consolidated supervision of the bank;
  - The counterparty’s financial situation must not create disproportionate risk for the bank itself;
  - The financing of the exposure does not create significant liquidity risk for the bank deriving from asymmetric maturities or currency mismatches;
  - There would be no disproportionately negative impact on the bank if a hypothetical resolution process became applicable to the group.
- CSSF guidance elaborations:
  - A SREP measurement of 1 or 2 in the counterparty is acceptable and will merit a waiver. A 3 rating would trigger a discussion and a 4 rating is unacceptable.
  - CSSF will require a table of mismatches and exchange rates between assets and liabilities of the bank and a description of the policy regarding these risks.
  - CSSF will require a specific analysis at group level of any potential hurdles to repayment of intra-group exposures in conditions outside of resolution.
  - A legal analysis of the regime that would apply to intra-group claims in the event of resolution and, where relevant, an analysis of conformity with MREL/TLAC requirements.
- No formal application process to avail of the waiver nor a dedicated ongoing surveillance regime for intra-group exposures:
  - A bank proposing to avail of the waiver must notify the ECB (for Significant Institutions) or the CSSF (for Less Significant Institutions) and provide a justification; the bank can exercise the waiver on submitting the letter.
  - CSSF has withdrawn the waiver on a number of occasions where it became concerned about group financial soundness and informed another bank at the licensing stage that it would not be granted a waiver.
  - Surveillance: ECB/CSSF will be aware of extent of intra-group exposures through the quarterly large exposures reports but information on maturity profiles remains fragmented under current reporting regime. Annual SREP provides only ad-hoc information on maturity profiles.
  - EBA is discussing a new liquidity monitoring tool which would include a maturity mismatch dimension.
- Introduction of Basel III liquidity requirements has led to a move away from intra-group exposures:
  - Level of intra-group assets for the Luxembourg system fell from €320 billion to €266 billion between 2014 and 2015.
  - This represents a decline from 43.3 percent to 35.9 percent of total assets over the two-year period.

### Recommendations (specific to sections covered)
- CSSF should continue to recruit on-site examiners as planned and the BCL should maintain adequate resources for liquidity supervision.
- Continue to recruit additional on-site inspection staff.
- Review adequacy of existing number of banking experts.
- Reduce time frame for the completion of on-site inspection reports and seek to eliminate undue delays in completing reports.
- Increase frequency of on-site inspections of institutions supervised as subsidiaries of significant parent institutions.
- Considering the underlying risk of intra-group exposures, and absent Luxembourg abandoning or curtailing the use of the waiver, CSSF should consider introducing a specific supervisory regime in respect of intra-group exposures with particular reference to monitoring maturities mismatches. Possible measures (non-exhaustive):
  - Formalize the approval process and require applicants to await authorization before availing of the use of the waiver; require robust justification and detail of risk control procedures and mitigants.
  - Introduce specific limits in respect of maturity and currency transformations.
  - Require banks to submit specific details on intra-group exposures, on a quarterly basis, indicating maturity profiles and highlighting past quarter breaches of specific limits.
  - Continue periodic reviews of waivers granted, including during on-site inspections.
  - Intensify policy of (a) applying capital add-ons for solvency purposes where intra-group exposures could be excessive and (b) use of power to limit level of exposures and to seek collateral for lending.

*Source: cr17258 - 38. In particular, the CSSF is augmenting its on-site supervision resources. This is from an (PDF chapter/section).*

### Box 2. Investment Funds—Bank Linkages

### Box 2. Investment Funds—Bank Linkages

### Overview and context
- Linkages between investment funds and banks are an important feature of the international financial system, including in Luxembourg.
- This content deals with such linkages only insofar as they fall under the scope of the technical note on the Luxembourg banking supervisory regime.
- For a comprehensive view on the linkages between Luxembourg investment funds and banks, refer to the accompanying Technical Notes on the macroprudential policy framework in Luxembourg and on investment fund regulation and supervision.

### Growth and scale of Luxembourg’s investment funds
- Assets of investment funds have quadrupled since 2000.
  - Of this growth, 80 percent is accounted for by net inflows and 20 percent by valuation gains.
- Luxembourg’s fund industry size and global share:
  - €3.5 trillion of net assets.
  - About 72 times GDP.
  - About one tenth of total world-wide investment funds’ assets.
- Since end-2008, about one-fifth (or €1.16 trillion) of all new net inflows into investment funds worldwide were in Luxembourg’s funds, outperforming inflows into other euro area countries’ funds.

### Key statistics on fund–bank exposures and custody
- Luxembourg investment funds hold bank deposits domestically of about €110 billion.
  - This is 3.1 percent of investment funds net asset value.
  - This is 14.5 percent of Luxembourg’s banks aggregate balance sheet.
- Investment funds’ broader bank deposit estimate:
  - Investment funds hold large bank deposits, estimated at about €220 billion, about half of which are placed in Luxembourg’s largest depository banks.
- Custody concentration:
  - The market for depository banks is concentrated in Luxembourg, with five banks holding 60 percent of investment fund assets under their custody.
- Depository banks’ liability structure and exposures:
  - Fund deposits are concentrated in their depository banks and account for about 50 percent of depository banks’ liabilities.
  - Depository banks have direct exposures mainly through deposits (principally operational deposits), and, to a lesser extent, lines of credit.
- Cross-border placement:
  - The funding share for custodian/depositary banks is considerably larger for those banks, with about the same amount held in banks abroad.

### Regulatory and operational features of depository banks
- Depositary banks are required by regulation to be established in the same country as the investment fund.
- Depositary banks of Luxembourg authorized investment funds are all located in Luxembourg and may provide, besides depositary services, administrative, pricing, brokerage, and accounting services to funds.
- Depositary banks are described as ‘liability-driven’ rather than ‘asset-driven’—they do not search for liabilities to fund asset purchases in the manner of traditional banks.
- As part of the new liquidity coverage ratio requirement, depository banks in Luxembourg have had to channel fund deposits into eligible high quality liquid assets (HQLA), which has resulted in a decline in the level of assets placed with the parent.

### Mechanisms and channels for shock transmission
- Potential domestic banking-system transmission channels from fund shocks:
  - Withdrawal of large operational deposits if fund managers avoid selling less liquid assets during unexpectedly large and sustained redemptions.
  - Direct exposures of funds to bank bonds, equity and derivative exposures domestically and abroad.
- Cross-border and group transmission channels:
  - Extreme shocks to Luxembourg’s investment funds could be transmitted to foreign banks via bond and stock holdings, derivative exposures, loans and deposits.
  - Intra-group placements and significant sums placed with group banks can affect group-wide liquidity management.
  - Although intra-group placements are almost all short-term (typically overnight), difficulties at the parent level might result in the parent not being able to repay in accordance with repayment terms.

### Historical evidence of stress episodes
- Data from the BCL shows deposits of non-money market investment funds in Luxembourg banks declined by €6.7 billion in Q4 2008 and by another €5 billion in Q1 2009.
- Luxembourg authorities cite system resilience in 2008–2009 and 2011 as supporting evidence that the vulnerability can be overstated given the nature of these deposits and typical short-term placement practices.

### Authorities’ assessment of vulnerabilities
- Authorities note features that may mitigate vulnerability:
  - The nature of these deposits as operational deposits.
  - Liability-driven nature of custodian banks, where liabilities are typically placed short-term (mainly overnight) with group sources.
  - The liquidity preference of asset managers in times of stress.
- Nevertheless, unexpected and sustained redemptions could have a potentially adverse impact on the banking system if deposits are withdrawn to avoid asset sales.

*Source: IMF staff report excerpt, “Box 2. Investment Funds—Bank Linkages.”*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17258.pdf_