## 18. The Supervisory department focusing on asset management has limited resources

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**Canonical URL:** [18. The Supervisory department focusing on asset management has limited resources](https://www.imf.org/-/media/files/publications/cr/2023/english/1albea2023001.pdf)

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### Resource constraints and supervisory capacity
- AFSA has four staff in charge of fund supervision in the private pension and investment funds market directorate.
- This compares to six staff in the securities market directorate, and four staff in the DLT-based financial market supervision directorate.
- Given the limited number of staff dedicated to the fund sector, AFSA needs to increase resources to perform more risk analysis.
- Analysts with a quantitative background would be best placed to carry out this work.

### Main risks in the fund sector
- Primary risks: liquidity transformation, potential outflows, and concentrated exposures to the domestic sovereign bond market.
- Contextual drivers:
  - Tightening of financial conditions through rises in interest rates could cause Albanian bond funds to experience negative returns and trigger outflows.
  - Redemptions could force asset managers to sell assets, including domestic sovereign bonds, and it is uncertain whether the market would absorb those sales without price discounts.
- Investor base considerations:
  - Investor base has been stable over time but sensitivity to past performance and distribution channels (including through bank networks) require further analysis.

### Data reporting and risk analysis recommendations
- Increase frequency of reporting for key items:
  - Data on flows and returns should be reported at least on a weekly basis, in line with the redemption profile of the funds.
- Perform further analysis of investor behavior:
  - Understand main factors driving redemptions and subscriptions.
  - Assess distribution of fund products and sensitivity of flows to past performance.
- Enhance portfolio-level and sectoral monitoring:
  - Use portfolio information to calculate risk metrics related to interest rate risk (duration) and credit risk (credit spread).
  - Perform analysis of portfolio overlap at instrument-level across funds with sovereign exposures to assess potential liquidation costs and spillovers.
  - Analyze correlation of funds’ returns to identify market-based interconnectedness.
- Monitor risks at sectoral level because similar concentrated exposures can create direct impacts across funds (liquidation by one fund reduces available liquidity and puts downward pressure on similar bonds).

### Stress testing and intersectoral linkages
- AFSA could use stress tests and scenario analysis to identify vulnerable funds and potential vulnerabilities in the financial system.
- Joint analysis with BoA could:
  - Map interlinkages between financial institutions and markets.
  - Quantify materiality of those linkages and assess main risk transmission channels.
  - Support scenario analysis.

- Box 1 — An illustrative stress test for Albanian funds (scenario and impacts)
  - Scenario design:
    - Yields on Albanian bonds increase by 100 basis points (parallel shift of the yield curve).
    - Duration of sovereign bond holdings assumed to be 2, resulting in a loss of 2 percent.
  - Impact on returns and flows:
    - Mark-to-market losses would amount to Lek 1.1 billion.
    - Flow/return relationship estimated to be around 0.75 for funds mainly exposed to sovereign bonds, and 0.38 for corporate bond funds (using monthly data on returns and flows over January–August 2022).
    - Aggregate investor outflows would amount to around Lek 750 million (1.3 percent of funds’ total net assets after the interest rate shock).
    - Outflows across funds range from around 0.6 percent of assets up to 1.8 percent.
  - Asset sales:
    - Under a pro rata liquidation approach, funds would sell around Lek 753 million of assets, including Lek 502 million of sovereign bonds.
  - Absorption capacity of the market:
    - Bank of Albania reports bond trading volumes amounted to Lek 3 billion in 2021h1, implying daily volumes of around Lek 25 million.
    - At average trading conditions it would take at least 20 days to sell Lek 502 million of sovereign bonds, more than twice the settlement period for fund shares.
    - Banks’ sovereign bond holdings estimated at around Lek 450 billion; additional purchase by banks of Lek 502 million would represent 0.1 percent of banks’ bond holdings.
    - Commercial banks might have limited appetite to increase their sovereign bond exposures.
  - Conclusion from stress test:
    - Funds might face challenges in selling sovereign bonds quickly, unless banks were willing to increase their portfolio of domestic sovereign debt.

### Liquidity management tools (LMTs) and operational options
- AFSA should consider making additional LMTs available to funds and perform a cost-benefit analysis in coordination with the industry; operational issues related to activation and use should be considered.
- Price-based LMTs:
  - Redemption fees aim to pass some disposal costs to redeeming investors, reducing incentives to redeem and protecting remaining investors.
  - Effectiveness depends on appropriate and prudent valuation policies, which may be challenging when markets are illiquid.
- Quantity-based LMTs:
  - Mechanisms such as side pockets and gates can limit value of shares/units redeemable in a single valuation/dealing day and help mitigate liquidity risk and downward pressure on domestic sovereign markets.
- Use of repo operations:
  - Funds could obtain liquidity by pledging sovereign bonds as collateral for repo transactions with banks to meet redemptions without causing downward price pressure.
  - AFSA could engage with the industry to discuss set-up of repo operations, given very limited use by funds so far.

### Conclusions on financial stability implications
- Growth benefits:
  - The growth of the fund sector can support economic development and expansion of capital markets, offering diversification benefits and risk-sharing opportunities.
- Current stability assessment:
  - Financial stability issues in the fund sector are limited at the current juncture due to:
    - Relatively small size of the sector.
    - Low degree of interconnectedness with the rest of the financial sector.
    - Stable investor base.
    - Existence of liquidity requirements.
- Main remaining risk:
  - Concentrated exposures to the domestic sovereign bond market and lack of substantial secondary market activity can make selling large amounts of sovereign bonds challenging.
  - The stress observed during the summer of 2022 illustrates how liquidity risks can crystallize.
  - Ongoing efforts on the establishment of Primary Dealers are welcome and should continue.
- Systemic considerations:
  - The financial system is highly exposed to retail clients and investors; maintaining confidence is crucial.
  - Most bank funding depends on deposits from retail clients, and retail investors are by far the main investors in funds.
  - Retail investors directly hold a sizeable share of domestic sovereign debt (higher than 10 percent of outstanding debt).

*Source: 1albea2023001 - 18. The Supervisory department focusing on asset management has limited resources.*

### Preface.................................................................................................................

### Preface

### Mission background
- At the request of the Albanian Financial Services Authority (AFSA), a Monetary and Capital Markets (MCM) Department remote mission assisted AFSA from May 9 to June 16, 2022 to assess risks related to investment funds and their interconnectedness with the financial sector.
- The mission met with senior officials and representatives of AFSA and the Bank of Albania (BoA).
- The mission phases:
  - initial questionnaire completed by AFSA with supporting material provided in May 2022;
  - virtual meetings between May and June 2022 with senior officials and representatives of AFSA and BoA;
  - information assessment phase; and
  - drafting of this report.

### Executive summary — key findings
- Data sources and scope:
  - The report relies on information submitted by AFSA and discussions with AFSA and BoA.
  - Detailed data on the fund sector were shared by AFSA.
- Size and growth:
  - Net asset value of Albanian funds reached Lek 77 billion in Q1:2022.
  - This equates to approximately 4 percent of GDP, and 4 percent of financial sector assets.
  - Since end-2019 the net asset value of Albanian funds has increased by 15 percent.
- Concentration:
  - The largest fund accounts for 62 percent of total fund assets.
  - The top 3 funds (all from the same manager) account for around 95 percent of the sector.
  - Five asset management companies manage the funds, with one accounting for 96 percent of the fund net assets.
- Asset composition and correlations:
  - Around 65 percent of funds’ assets are composed of domestic sovereign bonds.
  - Funds’ returns are highly correlated; correlation coefficients across funds higher than 0.93 for tested funds.
  - Funds hold significant exposures to cash as well.
- Investor base and flows:
  - Funds are held by around 41,000 investors, almost exclusively retail; institutional investors share is less than 0.1 percent of total investors.
  - Between June and end-August 2022 cumulative redemptions reached almost Lek 11 billion, 15 percent of total net assets of the sector.
  - Some funds experienced redemptions of 10 percent in August 2022 although returns declined by only 100 basis points over the same period.
- Liquidity and market structure:
  - Funds are open-ended with daily redemptions and settlement done over a maximum of 7 days.
  - Liquidity requirement: high-quality liquid assets (HQLA) equal to the maximum between (i) 10 percent of total net assets, or (ii) the cumulative gross outflows over the last three months.
  - At least 50 percent of the HQLA has to be in cash or assets maturing within 7 days (except for funds investing at least 50 percent in ‘active markets’).
  - Funds hold only 5 percent of domestic public debt, but secondary market activity is lacking, implying difficulty selling sovereign assets quickly to meet redemptions.
- Interconnectedness and counterparty exposures:
  - Interconnectedness between funds and the rest of the financial system is limited.
  - Fund shares mainly held by retail investors; institutional investors play a very minor role.
  - Funds do not have significant direct exposures to securities issued by financial entities.
  - Fund bank deposits account for around 13 percent of fund assets (Lek 9.9 billion), and funds’ deposits account for 2 percent of banks’ total assets.
  - Counterparty exposures towards banks are small; funds barely use repo operations or derivatives.
  - As of Q1:2022, no funds had derivative exposure and SFT use was minimal (one reverse repo and one repo, both using Albanian sovereign bonds as collateral).
- Episodes of stress:
  - In the summer of 2022, tightening monetary policy (BoA increased interest rates by 25 basis points in July and 50 basis points in August) led to declines in fund returns and increased redemptions concentrated in bond funds.
  - All funds managed to meet redemptions through cash drawdown, sales of bonds, and proceeds from maturing bonds; nevertheless, the episode illustrates liquidity risk crystallization.

### AFSA’s current approach to identify, monitor, and mitigate risks
- Reporting and data collection:
  - AFSA receives full portfolio information, balance sheet data, and income statements on a quarterly basis and publishes detailed information every quarter.
  - Reporting frequency increased in early 2022:
    - Returns reported monthly (previously quarterly).
    - Net redemptions reported weekly (previously monthly).
    - Liquidity indicators (HQLAs and cash buffers) reported monthly (previously quarterly) since May 2022.
    - Managers required to report stress test results for end-March 2022.
  - AFSA has the power to request additional information from fund managers.
- Coordination and oversight:
  - AFSA is a member of the Financial Stability Advisory Group (FSAG) alongside the Minister of Finance, the Chairman of the Financial Supervisory Authority Board, the Governor of BoA, and the General Director of the Albanian Deposit Insurance Agency.
  - FSAG provides advisory input on policies, inter-agency coordination and systemic risk monitoring.
- Risk monitoring practices:
  - AFSA monitors risks primarily at individual fund level rather than systematically at sector-wide level.
  - AFSA has taken steps to increase reporting frequency and collect stress test results.

### Key recommendations (high-level)
- Recommendation 1: Data and portfolio analysis (AFSA)
  - Increase the frequency of reporting of key data items such as flows and returns (¶20-23). Priority: 1; Timeframe: Medium-term.
  - Provide detailed analysis of funds’ portfolio including risks related to interest rate (duration) and common exposures (portfolio overlap) at sectoral level (¶6-7; 19-22). Priority: 1; Timeframe: Near-term.
- Recommendation 2: Investor behavior and stress tests (AFSA)
  - Analyze the drivers of investors flows (¶11;21). Priority: 2; Timeframe: Medium-term.
  - Perform scenario analysis and stress tests (¶25-26). Priority: 2; Timeframe: Medium-term.
- Recommendation 3: Liquidity Management Tools (LMTs) (AFSA; MoF as needed)
  - Conduct a cost-benefit analysis of price-based and quantity-based LMTs for Albanian funds (¶27-30). Priority: 2; Timeframe: Medium-term.
  - Expand the list of available LMTs, including through legislative change if necessary (¶27-30). Priority: 3; Timeframe: Medium-term.
  - Consider use of repo operations by fund managers to mitigate downward pressure on the sovereign bond market in case of stress.
- Recommendation 4: Cross-sectoral linkages (AFSA, BoA)
  - Conduct joint work to (i) map interlinkages between funds and financial institutions and (ii) quantify the identified interlinkages (¶13-14;27). Priority: 3; Timeframe: Medium-term.
- Recommendation 5: Resources (AFSA)
  - Increase number of staff working on risk analysis in the fund sector to support (i) financial stability assessment and (ii) risk-based supervision (¶123-24). Priority: 2; Timeframe: Medium-term.

*Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1albea2023001.pdf*

### 18. The Supervisory department focusing on asset management has limited resources.

### 18. The Supervisory department focusing on asset management has limited resources

### Resource constraints and supervisory capacity
- AFSA has four staff in charge of fund supervision in the private pension and investment funds market directorate.
- This compares to six staff in the securities market directorate, and four staff in the DLT-based financial market supervision directorate.
- Given the limited number of staff dedicated to the fund sector, AFSA needs to increase resources to perform more risk analysis.
- Analysts with a quantitative background would be best placed to carry out this work.

### Main risks in the fund sector
- Primary risks: liquidity transformation, potential outflows, and concentrated exposures to the domestic sovereign bond market.
- Contextual drivers:
  - Tightening of financial conditions through rises in interest rates could cause Albanian bond funds to experience negative returns and trigger outflows.
  - Redemptions could force asset managers to sell assets, including domestic sovereign bonds, and it is uncertain whether the market would absorb those sales without price discounts.
- Investor base has been stable over time but sensitivity to past performance and distribution channels (including through bank networks) require further analysis.

### Data reporting and risk analysis recommendations
- Increase frequency of reporting for key items:
  - Data on flows and returns should be reported at least on a weekly basis, in line with the redemption profile of the funds.
- Perform further analysis of investor behavior:
  - Understand main factors driving redemptions and subscriptions.
  - Assess distribution of fund products and sensitivity of flows to past performance.
- Enhance portfolio-level and sectoral monitoring:
  - Use portfolio information to calculate risk metrics related to interest rate risk (duration) and credit risk (credit spread).
  - Perform analysis of portfolio overlap at instrument-level across funds with sovereign exposures to assess potential liquidation costs and spillovers.
  - Analyze correlation of funds’ returns to identify market-based interconnectedness.
- Monitor risks at sectoral level because similar concentrated exposures can create direct impacts across funds (liquidation by one fund reduces available liquidity and puts downward pressure on similar bonds).

### Stress testing and intersectoral linkages
- AFSA could use stress tests and scenario analysis to identify vulnerable funds and potential vulnerabilities in the financial system.
- Joint analysis with BoA could:
  - Map interlinkages between financial institutions and markets.
  - Quantify materiality of those linkages and assess main risk transmission channels.
  - Support scenario analysis.

Box 1 — An illustrative stress test for Albanian funds (scenario and impacts)
- Scenario design:
  - Yields on Albanian bonds increase by 100 basis points (parallel shift of the yield curve).
  - Duration of sovereign bond holdings assumed to be 2, resulting in a loss of 2 percent.
- Impact on returns and flows:
  - Mark-to-market losses would amount to Lek 1.1 billion.
  - Flow/return relationship estimated to be around 0.75 for funds mainly exposed to sovereign bonds, and 0.38 for corporate bond funds (using monthly data on returns and flows over January–August 2022).
  - Aggregate investor outflows would amount to around Lek 750 million (1.3 percent of funds’ total net assets after the interest rate shock).
  - Outflows across funds range from around 0.6 percent of assets up to 1.8 percent.
- Asset sales:
  - Under a pro rata liquidation approach, funds would sell around Lek 753 million of assets, including Lek 502 million of sovereign bonds.
- Absorption capacity of the market:
  - Bank of Albania reports bond trading volumes amounted to Lek 3 billion in 2021h1, implying daily volumes of around Lek 25 million.
  - At average trading conditions it would take at least 20 days to sell Lek 502 million of sovereign bonds, more than twice the settlement period for fund shares.
  - Banks’ sovereign bond holdings estimated at around Lek 450 billion; additional purchase by banks of Lek 502 million would represent 0.1 percent of banks’ bond holdings.
  - Commercial banks might have limited appetite to increase their sovereign bond exposures.
- Conclusion from stress test:
  - Funds might face challenges in selling sovereign bonds quickly, unless banks were willing to increase their portfolio of domestic sovereign debt.

### Liquidity management tools (LMTs) and operational options
- AFSA should consider making additional LMTs available to funds and perform a cost-benefit analysis in coordination with the industry; operational issues related to activation and use should be considered.
- Price-based LMTs:
  - Redemption fees aim to pass some disposal costs to redeeming investors, reducing incentives to redeem and protecting remaining investors.
  - Effectiveness depends on appropriate and prudent valuation policies, which may be challenging when markets are illiquid.
- Quantity-based LMTs:
  - Mechanisms such as side pockets and gates can limit value of shares/units redeemable in a single valuation/dealing day and help mitigate liquidity risk and downward pressure on domestic sovereign markets.
- Use of repo operations:
  - Funds could obtain liquidity by pledging sovereign bonds as collateral for repo transactions with banks to meet redemptions without causing downward price pressure.
  - AFSA could engage with the industry to discuss set-up of repo operations, given very limited use by funds so far.

### Conclusions on financial stability implications
- The growth of the fund sector can support economic development and expansion of capital markets, offering diversification benefits and risk-sharing opportunities.
- Financial stability issues in the fund sector are limited at the current juncture due to:
  - Relatively small size of the sector.
  - Low degree of interconnectedness with the rest of the financial sector.
  - Stable investor base.
  - Existence of liquidity requirements.
- Main remaining risk:
  - Concentrated exposures to the domestic sovereign bond market and lack of substantial secondary market activity can make selling large amounts of sovereign bonds challenging.
  - The stress observed during the summer of 2022 illustrates how liquidity risks can crystallize.
  - Ongoing efforts on the establishment of Primary Dealers are welcome and should continue.
- Systemic considerations:
  - The financial system is highly exposed to retail clients and investors; maintaining confidence is crucial.
  - Most bank funding depends on deposits from retail clients, and retail investors are by far the main investors in funds.
  - Retail investors directly hold a sizeable share of domestic sovereign debt (higher than 10 percent of outstanding debt).

*Source: 1albea2023001 - 18. The Supervisory department focusing on asset management has limited resources.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1albea2023001.pdf_