Financial System Stability Assessment: Update

Luxembourg hosts a large international financial center that plays a pivotal role in its economy and in European financial markets. The crisis exposed significant vulnerabilities in Luxembourg’s financial system, owing to large cross-border exposures to foreign parent banks. The authorities proceeded with large public support to systemically important financial institutions under stress and with a fivefold increase in the deposit guarantee. Strengthening home-host supervisory collaboration and cross-border bank resolution frameworks will be of crucial importance for Luxembourg. Financial stability assessment and stress tests are also carried out.


Luxembourg hosts a large international financial center that plays a pivotal role in its economy and in European financial markets. The crisis exposed significant vulnerabilities in Luxembourg’s financial system, owing to large cross-border exposures to foreign parent banks. The authorities proceeded with large public support to systemically important financial institutions under stress and with a fivefold increase in the deposit guarantee. Strengthening home-host supervisory collaboration and cross-border bank resolution frameworks will be of crucial importance for Luxembourg. Financial stability assessment and stress tests are also carried out.

I. Macro Financial Setting

A. Structure of the Financial System

1. Luxembourg’s financial sector is exceptionally large and globally interconnected (Table 1). It represents about one-fourth of Luxembourg’s GDP, one-third of its tax revenues, and 12.5 percent of its labor force. It comprises the banking industry, with total assets surpassing 20 times GDP; the investment fund industry, with assets under management equivalent to around 50 times GDP; and the insurance industry, with an aggregate balance sheet of about four times GDP. Luxembourg’s international financial center has strong linkages with France, Germany, Italy, the Kingdom of the Netherlands, the United Kingdom, and the United States (Box 1), and is driven by private banking and investment fund activities (Figures 1 and 2). Its monetary and financial institutions (MFIs) intermediate about 16 percent of total cross-border exposures among euro area MFIs.1

Table 1.

Luxembourg: Structure of the Financial System

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Sources: CSSF, CAA, STATEC, Luxembourg Stock Exchange, World Federation of Exchange

Data as of July 31, 2010

The first number corresponds to the number of fund entities, whereas the number in brackets corresponds to the total number of units (which is the total number of sub-funds)

Professionals acting for their own account (Art 24-4 LFS)

Figure 1.
Figure 1.

Luxembourg: Banking Sector

Citation: IMF Staff Country Reports 2011, 148; 10.5089/9781455288656.002.A001

Source: BCL, CSSF, ECB
Figure 2.
Figure 2.

Luxembourg: Investment Fund Industry

Citation: IMF Staff Country Reports 2011, 148; 10.5089/9781455288656.002.A001

Source: BCL, CSSF, EFAMA, ECB1/ Data for investment funds in euro area starts from 2008Q4.2/ Data for MMFsin euro are starts from 2006Q1.

2. Luxembourg’s banks are mostly foreign-owned and net providers of liquidity to their parent groups. The banking sector accounts for about 28 percent of total financial sector assets. As of June 2010, there were 149 banks operating in Luxembourg. However, most banks and 90 percent of total bank assets are foreign-owned. The majority of these groups operate through both subsidiaries and branches in Luxembourg, which provides flexibility to accommodate clients’ needs for financial services and to optimize funding operations with parent groups. Indeed, reflecting the liquidity generated by treasury management for institutional customers, as well as private banking and custody activities, the local banking system is a net provider of liquidity to parent banks (“upstreaming”). Overall, interbank positions represent about half of bank assets and liabilities (compared to an average of about 28 percent in the euro area), two thirds of these interbank positions are cross-border exposures, and intra-group exposures account for about 40 percent of total bank assets.

3. Luxembourg is the world’s second largest center for investment funds after the United States. Investment funds domiciled and marketed in Luxembourg account for about 70 percent of its total financial sector assets, and about 30 percent of total assets under management by European funds. Fund sponsors mainly originate from Europe and the United States. Funds domiciled in Luxembourg are generally managed from other international financial centers. Fund shares are distributed in other European countries through an extensive use of the European passport, as well as to investors worldwide (particularly Asia). MMFs represent a fifth of Luxembourg’s investment funds and more than 25 percent of total European MMF assets under management.

4. Luxembourg’s insurance industry is largely outward-oriented. Most insurance and reinsurance companies are subsidiaries of key international players, particularly major European (re)insurance groups. Nondomestic premiums represent more than 90 percent of total premiums. Despite a large number of insurance companies, the industry is highly concentrated, with about 75 percent of total assets held by the top ten companies. Life insurance and reinsurance companies account for about 60 and 35 percent of total assets respectively (Figure 3).

Figure 3.
Figure 3.

Luxembourg: Insurance Companies

Citation: IMF Staff Country Reports 2011, 148; 10.5089/9781455288656.002.A001

Source: CAA

5. Luxembourg is also an international financial center for securities listing, and hosts systemically relevant market infrastructures. The main participants on the Luxembourg Stock Exchange (LSE) include large international banks, brokers, and investment funds. Activity on the LSE is driven by primary issuance, as Luxembourg accounts for about 15 percent of total bonds issued globally. Luxembourg also hosts Clearstream Banking Luxembourg (CBL), one of the two largest international ICSD in the world, which has developed a strong position in international fixed income markets. A core part of CBL’s services offering is the settlement of transactions in international securities and domestic securities traded across borders. CBL also manages, safe keeps, and administers securities on behalf of its customers (i.e., more than 1,200 financial institutions in about 110 countries), and has developed services for collateral management and investment funds. As large amounts of collateral are involved in these activities, the operational and financial soundness of CBL is of relevance to international financial stability.

Luxembourg: Interconnectedness of Luxembourg’s Financial System

Countries are financially interconnected through the asset and liability management strategies of their sovereigns, financial institutions, and corporations. Luxembourg has a large, highly interconnected and systemically-important financial sector that specializes in private banking and wealth management services, with a very strong presence of global banks and asset management firms.1/

Banking Sector. Luxembourg is ranked among the top ten financial centers in term of interconnectedness, as measured through various approaches. The cross-border exposures of Luxembourg’s banks account for more than 70 percent of their total balance sheets, reflecting the predominance of interbank, and often intra-group, transactions, as local banks intermediate funds to parent groups—primarily in Germany, France, Italy, the United States, the United Kingdom, Spain, Netherlands and Belgium.

Cross-Border Exposures of Luxembourg Banks

(Percent of Total, As of Feb 2010)

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Source: CSSF

Investment Fund Sector. Luxembourg’s investment fund industry is also very large and interconnected. It has established a well recognized brand name that provides cross-border investment opportunities for global investors, under the Undertakings for Collective Investments in Transferable Securities (UCITS) scheme regulated through an EU directive. Luxembourg-based UCITS are sold globally (75 percent in Europe and 15 percent in Asia) and invested worldwide (45 percent in the euro area)—as also reflected in the diverse origin of the parent companies that sponsor investment funds in Luxembourg. The investment funds domiciled in Luxembourg have strong balance sheet ties with global financial institutions: about half of their assets (€1 trillion) are invested in nonbank financial institutions (NBFIs), particularly other investment funds, while €350 billion are placed in MFIs and €320 billion in government securities. The majority of the investments in NBFIs are equity holdings, limiting the interconnectedness to NBFIs through non-equity funding. The potential balance sheet spillover from Luxembourg investment funds to European banks’ funding conditions seems to be rather limited, as they hold a small share of cross-border deposits and debt securities issued by euro area MFIs. Luxembourg funds hold about €12 billion deposits in euro area banks, compared to €2 trillion total cross-border deposits in euro area MFIs, and hold less than €100 billion debt securities issued by euro area MFIs, compared to the total outstanding amount of about €5 trillion. As for exposures to government securities, a majority are with Germany, Italy, United States, and France. Exposures to GIIPS sovereign are about 20 percent of the total sovereign exposures, and most are with Italy.

Finally, balance sheet linkages between Luxembourg’s investment fund industry and the rest of the domestic financial system are limited. Most are through cross-shareholdings between investment funds (over € 110 billion) and through bank deposit (€72 billion), representing about 9 percent of total bank balance sheets. From the banking system side, banks hold about €13 billion assets in investment funds, and provide depository and custodian services to investment funds.

1 International Monetary Fund, August 2010, Integrating Stability Assessments Under the Financial Sector Assessment Program into Article IV Surveillance, Washington D.C., and October 2010, Understanding Financial Interconnectedness, Washington D.C.

B. The Financial Crisis

6. Luxembourg’s financial sector was severely affected by the crisis (Box 2). The subsidiaries of three Icelandic banks failed on contagion from their parent groups and were promptly subject to resolution procedures. Liquidity and solvency problems facing Fortis and Dexia also affected their Luxembourg-based affiliates and government support was provided by Belgium, France, the Netherlands and Luxembourg. In aggregate, bank balance sheets shrank by almost 15 percent in 2009 (essentially through interbank deleveraging). A few insurance companies exhibited serious problems, primarily reflecting high levels of intra-group concentrated risk exposures. The investment fund industry endured large outflows at the peak of the crisis, causing in particular a group of funds with significant exposures to structured products to suspend redemptions. At the same time, the impact of the crisis on domestic credit markets was muted, reflecting the dual nature of the financial system, as well as moderate household indebtedness and a resilient housing market.2

7. The immediate policy response helped preserve financial stability during the crisis. Aggressive monetary easing and emergency liquidity provision in the euro area proved critical to reduce financial market distress. In Luxembourg, decisive action was taken to quickly identify and address problems in the investment fund industry, and to support systemically important financial institutions under stress, including through the provision of large public support and a fivefold increase in the deposit guarantee. Overall, these interventions prevented contagion to the rest of the financial system, and risks to financial stability have receded since then, as illustrated by the absence of further bank failures.

8. The crisis also uncovered a number of weaknesses in the prudential and resolution frameworks. The crisis entailed the materialization of major liquidity and counterparty risks due to concentrated cross-border exposures vis-à-vis parent banking groups, reflecting the predominance of foreign bank subsidiaries in Luxembourg. Significant weaknesses in crisis response mechanisms were apparent, including with regard to cross-border risk detection and communication, and to international and interagency cooperation. The provision of public support to failing banks, while justified from a stability standpoint, entailed significant fiscal resources and moral hazard.

9. In response, several financial sector reforms have been implemented or initiated, reflecting both global and EU-level priorities and Luxembourg-specific risks. The authorities created a macro-financial stability unit in the BCL, and revised the framework for liquidity risk supervision, entrusting the BCL with enhanced monitoring of systemic liquidity and liquidity management by market operators,3 while the CSSF issued new regulations on qualitative aspects of liquidity risk management, and sharpened the supervisory focus on banks’ risk management practices and risk profiles. A revision of prudential regulations governing quantitative aspects of liquidity risk is pending until the issuance of a European Commission (EC) directive reflecting the new Basel III framework. Finally, the authorities prepared a completely new draft law to revamp the deposit guarantee scheme (DGS), but the new regime also awaits the finalization of EC proposals.

Luxembourg: Resolution of Troubled Banks

Several financial institutions operating in Luxembourg failed during the recent financial crisis owing to contagion from their parent banks abroad, necessitating swift policy intervention. In all these cases, the transmission of financial distress to Luxembourg-based banks was exacerbated by liquidity and counterparty risks stemming from large intra-group exposures:

  • The systemically-important banks Fortis and Dexia lost access to money and interbank markets due to solvency concerns, triggering concerted support by the governments of Belgium, France, the Netherlands, and Luxembourg through capital injections and debt guarantees. Unlike most other foreign bank subsidiaries in Luxembourg, these two banks’ subsidiaries had large local retail operations. For the Luxembourg government, the cost of such support amounted to about 7 percent of GDP (which may be recovered with the sale of the associated government claims on the banks going forward).1

  • In addition, the local subsidiaries of three Icelandic banks faced severe liquidity strains on contagion from their parent companies and were quickly placed under suspension of payments and subject to resolution procedures.

The resolution of the troubled institutions has proceeded as planned:

  • The financial situation of the institutions that received public support has stabilized, allowing them to slowly improve their access to market funding. BNP Paribas acquired majority stakes in Fortis’ Luxembourg subsidiary, BGL. This operation helped improve the funding and risk profiles of BGL, and the refocusing of BGL’s businesses and the integration of its treasury and risk departments with central group management are underway. Dexia exited the government guarantee program earlier than anticipated and continues to implement its EU-approved restructuring plan. This plan provides, inter alia, for the winding down of noncore businesses and financial deleveraging. The authorities are closely monitoring these restructuring processes in cooperation with the home and other host-country supervisors.

  • The liquidation or restructuring procedures applied to the subsidiaries of the Icelandic banks were ratified in court, and all deposits were reimbursed or transferred. One of the institutions was split in two entities: a bank that started activities in July 2009 and a special purpose vehicle (SPV) that is planned to be unwound over time. Interbank deposits were transferred to the SPV and will be redeemed as assets mature or are sold.

  • Restructuring (including divesting from noncore activities and cleaning nonperforming assets) is also taking place in a few other institutions that underwent severe stress during the crisis, including the Luxembourg subsidiaries of German Landesbanken that suffered large investment portfolios losses related to their focus on investment banking activities.

1/ The governments of Belgium, France, the Netherlands and Luxembourg granted state support to Fortis and Dexia totaling €22.9 billion, of which €2.9 billion were provided by Luxembourg. The support packages also included emergency liquidity assistance and state guarantees on certain bank liabilities and impaired asset portfolios. These measures were accompanied with a number of conditions, including on liquidity ratios and restructuring plans. In one case, an initial government loan was converted into shares, so that shareholders’ equity was diluted.

II. Stability Assessment

A. Financial Sector Soundness and Performance

10. Indicators of financial sector soundness and performance appear generally favorable (Table 4 and Figure 4). Average bank solvency ratios (Basel II regulatory capital-to-risk-weighted assets) are high at 19.5 percent,4 and have recovered due to the contraction of bank balance sheets, capital injections, and the impact of Basel II implementation in 2008-2009.5 Asset quality has also improved: non-performing large exposures declined from a peak of 0.8 percent of total large exposures in June 2009 to 0.2 percent at end-2010. Even though Luxembourg compares favorably to other European countries, ROA and ROE levels are still low compared to the strong performance recorded before the crisis.6 A strong recovery has been registered in the investment fund industry: by end September 2010, total assets under management had increased to about €2.1 trillion assets, close to historical highs.

Table 2.

Luxembourg: Financial Soundness Indicators for the Banking Sector1/


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Source: BCL

AS/IFRS introduction in 2008. New capital requirements under Basel II w ere gradually implemented during 2008-09 periods and contributed to the improvement of solvency ratio.

GDP of 2009Q3 is used for 2009 and 2010 data.

Change in the underlying reporting instructions as of 31/12/2010.

Table 3.

Luxembourg: Selected Economies: Macro Stress Testing, Macroeconomic Assumptions

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Source: IMF staff calculation

Adverse scenario is generated by applying the difference between baseline and adverse scenario in 2010 CEBS stress testing exercise to October 2010 WEO projection. In terms of 2-year cumulative real GDP growth rate, the shock in adverse scenario roughly corresponds to 1 standard deviation shock (using 1980-2009 history). Using empirical distribution of real GDP growth rate for 1980-2009 period, the baseline scenario puts euro area countries above 20 percentiles, and the adverse scenario puts euro area countries below 10 percentiles on average.

Baseline projection is adjusted reflecting the actual market data for government bond yields. WEO baseline reflect overall financing cost for the governments, which reflect lower rates carried by EU and IMF funds.

Table 4.

Luxembourg: Summary of Macro Stress Testing for the Banking Sector

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Source: CSSF Footnotes

Sample inlucdes 108 banks (subsidiaries and some branches of non-EU banks that are required to report regulatory capital to CSSF). 67 banks (90 percent by asset) are owned by euro-area domiciled parent, 16 banks (4 percent by asset) are owned by parent domiciled in non-euro area EU countries, and the rest are affiliated with parents domiciled in the rest of the world.

Actual solvency ratio as of June 2010 includes half-year retained earnings.

The solvency position as of June 2012 includes utilization of the lump-sum provision for those banks where CAR turns negative. The lump sum provision is a regime of countercyclical provisioning that allows banks to set aside capital buffers for unrealized losses By year end 2009, the total stock outstanding was 1,3bn€ (72 banks). Under the adverse scenario, the use of the lump sum provision allows two banks to avoid falling below the 8 percent minimum CAR.

Figure 4.
Figure 4.
Figure 4.

Luxembourg: Financial Soundness Indicators for Banks 1/

Citation: IMF Staff Country Reports 2011, 148; 10.5089/9781455288656.002.A001

Source: IMF, CSSF, BCL1/ Data for Luxembourg are as of December 2010. Data for other countries range from Dec 2009 to September 2010, depending on the availability of data.

11. Liquidity risk in the banking system continues to be a core concern owing to concentrated exposures with parent groups. The liquidity position of Luxembourg banks appears strong by international standards: the aggregate liquidity ratio stands well above the minimum of 30 percent, and has been stable even during the crisis. As of mid-2010, it was about 64 percent on aggregate. Moreover, banks retain a significant proportion (about half) of their portfolios in liquid assets. Nonetheless, Luxembourg’s banking system does incur serious liquidity risks, as illustrated during the crisis: in 2008, several banks faced sudden and large-scale liquidity pressures originating in their parent groups, highlighting the risks associated with large and concentrated balance sheet exposures to parent banks, combined with funding risks reflecting the quality of repoed collateral (e.g., sovereign assets).

12. In the insurance sector, strong improvements in solvency and profitability have been posted since the crisis (Figure 5). During the crisis, insurance companies suffered from portfolio losses and stagnant activity. However, the impact was less severe than that of the dotcom crisis and no major liquidity pressures (insurance contract cancellations) were observed. Solvency ratios indicate that, overall, the industry is adequately capitalized. Premium income has expanded rapidly since the crisis, including due to the relocation in Luxembourg of a major international insurance group, and profitability more than doubled in 2009. In line with forthcoming Solvency II standards, the industry has tightened both qualitative and quantitative requirements for technical provisioning and solvency.

Figure 5.
Figure 5.

Luxembourg: Financial Soundness Indicators for Insurance Companies

Citation: IMF Staff Country Reports 2011, 148; 10.5089/9781455288656.002.A001

Source: CAA1/ Break in series for reinsurance as accounting changes.

B. Stress Tests

13. Top-down sensitivity and macro-stress tests were implemented based on supervisory data by the authorities, and network analysis was used to assess bank vulnerabilities linked to both large and concentrated exposures, and funding sources. Sensitivity tests focus on credit, interest rate, and equity price risks. Macro scenario-based stress tests cover a two-year horizon, with an adverse scenario assuming a global double-dip recession and further distress on sovereign exposures (Table 3). In addition, a network analysis framework was used to model the transmission of systemic credit and liquidity shocks through large and concentrated exposures and funding sources, in order to assess in particular the risks arising from Luxembourg’s central role in intra-group cross-border financial transactions. These tests are applied to a sample of banks holding over 80 percent of the total assets in the system, and using data as of June 2010.

14. Overall, stress test results lead to the following conclusions (Table 4 and Figure 6):

  • Luxembourg-based subsidiaries of foreign banks are vulnerable to distress in their parent banks, through both credit and funding exposures. The tests identify 19 counterparties, any one of whose failure could cause the failure of at least one bank in Luxembourg.

  • However, interbank contagion risks within Luxembourg appear to be limited. Indeed, the failure of a local subsidiary would likely not directly cause that of other banks due to limited interbank balance sheet linkages in Luxembourg.7

  • The overall banking sector has enough capital to withstand substantial losses from GIIPS sovereign securities; however, the exposures are concentrated in a small group of banks (about 10 percent of the system), which could become undercapitalized.

  • Other risks, including market risks, appear fairly contained, including due to the limited size of trading book activities.8

Figure 6.
Figure 6.

Luxembourg: Macro Stress Testing, Cumulative Changes in Solvency Ratio for Adverse Scenario between June 2010 and June 2012

Citation: IMF Staff Country Reports 2011, 148; 10.5089/9781455288656.002.A001

Source: CSSF1/ Excluding provisions and dividend payment.2/ Gross profit before provisions. Projected gross profits implies 10 percent year on year declines overall. Commissions and fees income is projected by applying 0.75 correlation to equity market prices, which are assumed to decline 15% year-on-year for two years. As for interest margin, spread is assumed to remain constant, in contrast with beneficial increases Luxembourg banks actually experienced in 2008 during liquidity crisis as net liquidity provider.

15. Stress test results indicate that the insurance sector can withstand a wide range of shocks (Table 5). Several both top-down and bottom-up stress tests, including sensitivity tests for market, credit, and catastrophe risks, were applied to the balance sheets of all life and nonlife insurance companies.9 The system appears resilient, reflecting improved risk management practices as well as high levels of technical provisions and capitalization. While marginal in aggregate, linkages between banks and insurance companies may have a significant impact for several smaller nonlife insurance companies: under the credit risk stress scenario (failure of the largest depository bank), ten small companies would record a solvency shortfall.

Table 5.

Luxembourg: Insurance Stress Test Results1/

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Source: CAA

Stress tests for equity prices and sovereign distress use data as of the fourth quarter of 2010. Other tests use 2009 data. The tests cover all balance sheets of insurance companies.

QIS5 correlation factors, the correlation coefficients for the aggregation of the risk modules, are used.

Number of companies corresponding to the distribution of solvency ratio are in the parenthesis

C. Summary Risk Assessment

16. Luxembourg will remain subject to substantial macro-financial stability risks in the period ahead, with relevance to broader European financial markets (Risk Assessment Matrix). The potential impact of adverse shocks is magnified by the size of Luxembourg’s financial sector relative to its economy and its high degree of international interconnectedness. Key sources of risk in the banking and investment fund industries are detailed below.

17. In the banking sector, key risks reflect large exposures to parent banks and to sovereign risk, as well as the lack of well-defined cross-border resolution framework. As shown by the stress tests, solvency or liquidity pressures affecting large parent banks could have adverse impacts on their Luxembourg affiliates. Similarly, direct and indirect GIIPS sovereign exposures (i.e., including through parent banks, some of which are incorporated in vulnerable euro area countries) represent another key source of vulnerability. As the crisis illustrated, in case of failure of a large European bank with local presence, potentially large contingent fiscal liabilities may result from the lack of international burden-sharing mechanisms (see below) and the need for Luxembourg to contribute public support as part of a European-level rescue package. In contrast, the potential fiscal cost of domestically-active bank failures seems manageable: there are only a few such banks, and stress tests indicate that there is limited scope for interbank contagion within Luxembourg.

18. In the investment fund sector, risks reflect primarily the systemic importance of Luxembourg as a European and global hub. The likelihood of spillovers from investment funds to the domestic banking system may be small due to limited balance sheet exposures (Box 1), but as observed in other jurisdictions, sudden redemption pressures (e.g., on reputational concerns) may create liabilities for sponsoring banks.10 More broadly, Luxembourg is a systemically-important hub for investment fund business in and out of Europe (about 60 percent of European investment funds distributed internationally are domiciled in Luxembourg). Such concentration of global activity in a single financial center, as well as on European UCITS, raises a number of risks. For instance, fraud events or a tarnishing of Europe’s UCITS brand quality could affect global investor confidence in segments of the industry and in Luxembourg’s funds in particular. In turn, a loss of confidence in Luxembourg’s funds may trigger knock-on effects on other European financial systems (due to the close association between these funds and the whole European UCITS industry), and beyond given the global asset allocation of these funds.

19. In the longer term, Basel III-related and other regulatory changes will represent challenges for Luxembourg’s financial center. While the impact of the Basel III capital requirements seems manageable given the current level and composition of banks’ own funds,11 forthcoming Basel III liquidity regulations could have a material impact. Changes in capital and liquidity requirements in the banking and insurance industries should also have repercussions for global investment fund activities and thus for Luxembourg.12 Going forward, the international role of Luxembourg in this sector will be impacted by ongoing reforms to taxation, bank secrecy and investment fund regulation, in other countries and at the EU level.13 However, it is difficult at this stage to determine in which direction Luxembourg’s financial center will evolve as a result of these combined changes, as in the past it has shown a strong capacity to adapt and maintain comparative advantages as a global hub for global investment fund domiciliation.

Risk Assessment Matrix

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III. Financial Sector Oversight

A. Banking Sector

20. Overall, Luxembourg’s observance of international standards for banking sector oversight (Basel Core Principles) is high (Appendix). The CSSF is the competent authority for prudential supervision of banks and a range of other financial institutions, including investment funds, securities markets and their operators, and payment institutions. Basel II and IFRS standards have been fully implemented. As noted, following the crisis, the CSSF has increased its supervisory and analytical capacities and focus on on-site work, upgraded liquidity requirements, and required prudential adjustments from banks.14

21. Nonetheless, there is a need to better guarantee the operational independence of the CSSF, and to clarify its supervisory cooperation with the BCL. The current legal framework does not sufficiently guarantee the full operational independence of the CSSF: the CSSF is placed under the direct authority of the Minister; its missions include the “orderly expansion” of Luxembourg’s financial center; its general policy and budget are decided by a Board whose members are all appointed by the government upon proposals from supervised entities and the Minister; its executives are appointed by the government and can be dismissed in cases of disagreement about policy or execution of the CSSF’s remit; and its statute confines the executives’ role to elaborating measures and taking decisions required to accomplish its missions. Also, supervisory cooperation may be impeded by unclear segregation of duties between the CSSF and BCL. Such cooperation is mandated on matters relating to payment systems, financial stability and liquidity supervision. While cooperation seems to work in practice, there is scope to clarify the legal framework in order to avoid overlaps and jurisdictional uncertainties that may become critical in crisis circumstances.15

22. In practice, the CSSF’s oversight procedures and remedial actions should be made more expeditious and effective. First, there appears to be a heavy reliance on moral suasion, and a certain reluctance to use formal remedial powers, including sanctions. This is a concern in particular given the potential conflict between the need for managers of local subsidiaries of foreign-owned groups to exercise their fiduciary responsibilities and demands from the parent group, especially given the large-scale related party exposures. Moreover, reports of on-site inspections are sometimes delayed in their presentation to institution management and follow-up is not always timely. This seems to reflect two main factors: the modest number of on-site inspectors relative to the large number of institutions (including non banks), and the CSSF’s internal review and decision-making processes. There is also evidence that required corrective actions may not always be forceful enough. Going forward the authorities might consider the option of establishing a “ladder” of remedial actions and related triggers, which would provide flexibility and help reduce reliance on moral suasion.

23. Given contagion risks from home jurisdictions, the authorities should continue to closely monitor exposures to parent banks and be ready to take further action to limit them when necessary. As noted, local subsidiaries are closely interconnected with their parent banks and highly vulnerable to cross-border contagion—often operating de facto as if they were branches. The CSSF acknowledges this risk and has tried to mitigate it, while still permitting central liquidity management by parent institutions. It would be unrealistic to expect the CSSF to fully insulate local subsidiaries against such a risk, and it is important that the authorities continue to take swift action when necessary to address unsound exposures to parent banks, including through formal sanctions. In this context, further progress in strengthening home-host supervisory collaboration is also crucial to allow the CSSF to better anticipate cross-border sources of financial instability. The CSSF’s active participation in colleges of supervisors existing for many of the banking groups active in Luxembourg is welcome and should continue.

B. Investment Funds Sector

24. The regulatory framework for investment fund supervision in Luxembourg is largely compliant with IOSCO principles (Appendix). As noted, the CSSF is the competent authority responsible for the prudential supervision of the investment fund industry, and it approves and registers Luxembourg-based UCI (TS) on the CSSF’s official list.16 The current regulatory framework closely transposes the relevant European directives, but with a degree of flexibility that constitutes a comparative advantage for Luxembourg in attracting European and global investment fund operators.

25. Until recently, the CSSF’s structure and procedures tended to make it too reactive to supervisory issues and challenges. Typically, investment funds domiciled in Luxembourg are administered by a Luxembourg-based operator, and the investment management functions are largely (if not fully) delegated abroad. This led the CSSF to adopt a structure that focuses on the supervision of fund administration and relies predominantly on ex-post review of reports. Recently, increasing staff resources have been dedicated to investment fund supervision, and the CSSF has initiated a more pro-active supervisory approach by performing routine or specific on-site inspections and/or addressing questions to funds or their operators. These efforts should be further intensified, including through additional increases in expert staffing.

26. Going forward, priority reforms should be pursued in order to strengthen the CSSF’s capacity to safeguard investor protection and financial stability. These include: addressing the lack of operational independence of the CSSF (see above); intensifying the recent efforts towards a more effective and expeditious enforcement of rules; and strengthening investor protection rules. In particular, an operationally independent CSSF could aim at a more effective use of its enforcement powers and should, as a matter of priority, increase further its ex-ante supervision to deter and sanction significant breaches to the rules. In order to better comply with investor protection and financial stability objectives, the rules regarding segregation and protection of client assets also deserve to be clarified and strengthened, and fund ownership rights should be clearer.

27. Given the cross-border nature of Luxembourg’s investment fund industry, the CSSF should remain proactive in cooperating with foreign counterparts and implementing EU-level rules.17 Some key functions, including risk management-related, are often delegated to external parties, and other foreign regulators have to rely on investment fund oversight by the CSSF in Luxembourg. In recent years, Luxembourg’s law has imposed minimum requirements regarding risk management practices by UCITS. Luxembourg has moved forward in transposing the new UCITS IV Directive, which provides detailed guidelines regarding risk management and is expected to lead to a high level of harmonization of such rules across the EU.18

C. Insurance Sector

28. The Commissariat aux Assurances (CAA) is the competent authority for prudential supervision in the insurance sector, under the direct authority of the Minister in charge of the financial sector. By law, the licensing and de-licensing of insurance intermediaries is the responsibility of that same Minister (Minister of Treasury), based on CAA recommendations. Similar to other sectors, the role of the Minister in operational tasks of the supervisor introduces a potential weakness in the operational independence of the CAA.

29. The supervisory approaches applied by the CAA have been enhanced. In line with the 2001 FSAP recommendations, the CAA almost doubled its staff and has been performing stress testing on an ongoing basis. Its cooperation with domestic and foreign supervisory agencies has also intensified. Going forward, the CAA plans to introduce a quarterly solvency statement for all supervised entities (from the fourth quarter 2010 onwards) and is developing a framework for risk-based supervision consistent with Solvency II (to be implemented from 2011 onwards). With respect to cross-border groups, supervision is carried out within supervisory colleges comprising representatives of all insurance supervisors concerned and chaired by a lead supervisor.

D. Securities Markets

30. There are currently two markets operated in Luxembourg by the same operator, Société de la Bourse de Luxembourg (SBL): the LSE and a multilateral trading facility (Euro MTF). The establishment of a regulated market in Luxembourg is subject to a written authorization from the Minister responsible for the CSSF. The organization and operations of regulated markets are supervised by the CSSF. The operation of the MTF is part of the investment services and activities defined in the law. The LSE reports on a daily basis and on all transactions to the CSSF which, as the Luxembourg securities markets regulator, performs market surveillance and enforcement.

31. In order to ensure the continuity of Luxembourg’s ICSD, it will be important to strengthen cooperation between its oversight authorities and to improve their contingency planning. Luxembourg’s ICSD, CBL, is a core market infrastructure, supervised by both the CSSF (as a licensed credit institution) and the BCL (as an operator of a system defined in the November 2009 payments law). While supervision is undertaken by dedicated teams on the basis of clear and comprehensive procedures, increased resources and skills are needed to perform more risk-focused inspections and shorten the period needed to complete assessments. In addition, a more formal framework detailing the respective roles and tasks of the BCL and CSSF would help reduce uncertainty and potential overlap between them, and facilitate crisis management. A formal supervisory arrangement with the Belgium authorities should also be established. Finally, the authorities should complete contingency plans in case of CBL’s default, including arrangements to move participants’ positions to a solvent intermediary and to continue core functions.


32. The Financial Action Task Force (FATF) recently assessed that Luxembourg has largely addressed the major shortcomings identified in its AML/CFT framework. In its February 2010 mutual evaluation report on Luxembourg, the FATF had identified numerous shortcomings, judging that overall, Luxembourg’s AML/CFT efforts were not proportional to the risks associated with its role as a key international financial center.19 As a result, Luxembourg was placed under enhanced scrutiny by the FATF’s International Cooperation Review Group (ICRG). Since then, the authorities implemented a speedy remedial action plan, including the adoption of AML/CFT legislation addressing deficiencies in financial and nonfinancial sector areas, and increased supervisory actions in the financial sector. At its latest plenary meeting, the FATF noted that authorities have responded rapidly and agreed to remove Luxembourg from the ICRG process although the effectiveness of these newly implemented measures has not yet been ascertained. Luxembourg will continue to provide updates on its progress as part of the regular FATF follow-up process for assessed members.

IV. Crisis Preparedness and Safety Nets

33. The crisis management framework needs to be improved to limit macro-financial risks. Given the small size of the economy compared to its financial sector, Luxembourg has very little capacity to bear large resolution costs without jeopardizing its macroeconomic stability. Overall, crisis prevention could be enhanced by setting up institutional arrangements for macro-prudential oversight, for earlier intervention and resolution, and for more effective depositor protection. Effective macro-prudential oversight, in particular, should allocate a consistent set of policy objectives, functions, instruments, and powers across all agencies involved in such a task. Each supervisor would be charged with initiating corrective actions well before financial institutions undergo distress (e.g., based on rules and on a stringent set of supervisory criteria), building an industry database to allow for the identification of macro-prudential risks, and communicating a macro prudential opinion to the entity in charge of macro-prudential supervision for appropriate follow up.

A. Cross-Border Challenges

34. The dependence of Luxembourg’s financial system on foreign parent banks is central to assessing its crisis preparedness. Experience with the resolution of Fortis and Dexia was relatively successful but costly, and involved ad hoc decision-making among several countries. The authorities had to react promptly by passing a law authorizing the government to raise public funds for extra-budgetary expenditures in order to preserve financial stability. Going forward, more formal or institutionalized crisis preparedness mechanisms should aim to improve international coordination and reduce potential fiscal pressures. Importantly, the effectiveness of the work of supervisory colleges is crucial in allowing the authorities to have a fuller ex ante assessment of potential risks stemming from cross-border financial institutions, and be prepared for early intervention and resolution.

35. Large uncertainties remain as to how a cross-border insolvency scenario would be handled. The absence of a unified insolvency and resolution framework for cross-border banking groups leaves unclear the legal treatment of the (large-scale) liquidity transfers through which Luxembourg-based subsidiaries provide unsecured funding to parent companies. The mission recommends that the authorities continue to play a role in promoting gradual moves towards an enhanced coordination framework for the resolution of cross-border banks.20 At its level, Luxembourg has also put in place a number of mechanisms to facilitate cross-border resolution,21 and these could be enhanced, for example through the introduction of mechanisms for mutual recognition of insolvency or reorganization measures.

B. Domestic Bank Resolution Framework

36. The current framework for bank resolution could be strengthened in several respects.22 The intervention should be triggered at an earlier stage than currently contemplated under the suspension of payment proceeding (e.g., based on graduated and objective quantitative thresholds, such as capital ratios). In addition, suspension of payment could be de-linked from the appointment of an administrator, allowing the authorities to take control of the institution on a going concern basis. Also, as is widely recognized, a fully-fledged specific regime for bank resolution would be more appropriate than the current reliance on bankruptcy provisions for commercial enterprises. Finally, the supervisor should be more closely involved also in the liquidation phase, in order to inform the judicial process and ensure that the disposal of the assets and liabilities of failed institutions is consistent with the objective of preserving financial stability.

37. The multipartite high-level group for financial stability and crisis preparedness purposes should be revamped and formalized. This framework, led by the MoF and including the BCL, CSSF, CAA, and the reformed deposit insurance scheme (or the two-part financial stability fund, if and when it is introduced),23 should feature institutional arrangements and procedures for interagency cooperation and information sharing, define the roles and responsibilities of each agency, and develop strategies to deal with potential crises. Such a standing group would facilitate crisis prevention and decisive, quick and early interventions whenever necessary, with closer lines of communication among all the agencies involved than those in place during the recent crisis. It should meet regularly to assess systemic risks and to review plans to address them.24 For crisis management, useful reference can be drawn from the procedures currently in place at the BCL, which assign responsibilities, set rules for proceeding, and provide contact information.

C. Safety Net

38. The recently-prepared draft revision of the DGS law is a significant improvement on the existing system, but still falls short of international best practices. While during the crisis the current DGS allowed for full repayment of failing banks’ insured deposits at no fiscal cost, payouts were delayed due to procedural inefficiencies. In addition, the current framework does not allow for the use of DGS funds to assist in bank restructuring; banks are encouraged but not required to build provisions (called AGDL reserves) to cover payouts to depositors in failed banks; and there are neither ex-ante funding mechanisms nor contingent financing alternatives. The MoF’s draft deposit insurance law increases coverage, speeds payouts to 20 days, allows for risk-based ex-ante funding,25 and provides the deposit guarantee fund with backup sources of liquidity. The mission recommended a number of additional changes that would bring the new framework closer to current EU proposals and international good practices.26 While the authorities are waiting to revise the draft law to conform with forthcoming EU requirements, consideration should be given to introducing promptly those changes which do not require legal amendments or are not precluded by existing laws.

39. Revamping the DGS will be critical to limit fiscal contingencies going forward. Insured deposits represent only about 3.5 percent of aggregated bank balance sheets, but still add up to 70 percent of GDP. While available AGDL reserves may suffice to cover the simultaneous failure of several small banks, there are eight banks in the system with insured deposits exceeding the current level of AGDL reserves, and overall, staff estimates that total fiscal contingencies associated with the current DGS under an extreme adverse scenario could amount to 7.5 percent of GDP. The risk-based target of 1.9 percent of covered deposits in the draft law is preferable to the current system that obtains funds only ex post, and would represent significant progress in limiting potential fiscal liabilities. Moreover, implementation of the new forthcoming European regime will further improve DGS coverage and adequacy. Finally, the DGS would have the right to call on additional bank funds ex post, which would give banks (rather than government) first responsibility for depositor repayments.27

40. Given potentially large liabilities from emergency liquidity assistance (ELA) to Luxembourg-based banks, safeguarding the BCL’s capital remains important. The BCL, like other national central banks in the euro area, bears the potential financial costs arising from its ELA provision. Given the exceptionally large size of the local banking system, such costs may threaten the capital position of the BCL. In response, the BCL has established a special privilege over all assets held in Luxembourg by a debtor for claims arising from operations in the context of monetary or exchange policies, as well as ELA. Going forward, the conditions under which this lien would be exercised need to be clarified, for example as relates to its triggers, scope, and articulation with bank insolvency procedures. Such clarification should also aim to address potential unintended consequences on bank resolution. Finally, other means to protect the central bank against potential ELA-related losses may also be considered (e.g., enhanced collateral requirements).

Appendix I: Observance of Financial Sector Standards and Codes—Summary Assessments

I. Basel Core Principles for Effective Banking Supervision

A. Information and Methodology Used for Assessment28

41. The assessment was made on the basis of a study of the legal and regulatory framework, a self-assessment prepared by the CSSF, and detailed discussions with relevant authorities and stakeholders. The assessment focused particularly on supervisory challenges in interagency and cross-border (home host) cooperation and liquidity risk management. Discussions were held with government representatives, the CSSF, Luxembourg Bankers Association or Association des banques et banquiers Luxembourg (ABBL), members of senior management of banks, and auditing firms. The team would like to thank the CSSF and the representatives of banks and other institutions for their cooperation with the mission.

42. The assessment was conducted in accordance with the revised Core Principles (CP) Methodology issued by the Basel Committee on Banking Supervision (Basel Committee) in October 2006 and involved a qualitative assessment of compliance with each CP. The methodology makes a distinction between “essential” and “additional” criteria. However, for assessments conducted as part of an FSAP, the ratings take into account the essential criteria only.

B. Institutional and Macroeconomic Setting and Market Structure—Overview29

43. Luxembourg is a large international financial center specialized in interbank liquidity and asset management activities. Its financial institutions hold assets equivalent to more than 70 times its GDP, and intermediate about 20 percent of total cross-border exposures among euro area banks and money market funds. The banking sector accounts for about 28 percent of total financial sector assets. Most local banks are foreign-owned, including by international banking groups from Germany, France, and other European countries. A core business model of Luxembourg’s banks is to pool liquidity and channel it back to international banking groups, including through intra-group transactions; interbank positions represent about half of bank assets and liabilities, of which two-thirds are cross-border exposures. Intra-group exposures account for about 40 percent of total bank assets. Excluding the relatively small Luxembourg owned-and-operated retail banks, and placements with parents, there are limited lending to the local economy. Typically, banks do not operate trading books, and in almost all cases, liquidity is managed within the centralized framework for liquidity management of the parent company.

44. Luxembourg was severely affected by the crisis through contagion, local subsidiaries suffering from the effects of solvency and liquidity problems of their foreign parents. Aggregate bank balance sheets contracted by almost 15 percent in 2009, essentially through interbank deleveraging. At the peak of the financial turmoil, Luxembourg contributed to the bail outs of systemically-important banks, Fortis and Dexia, which were rescued by the authorities of France, Belgium, and the Netherlands. The local subsidiaries of three Icelandic banks failed, and the investment fund industry endured large redemptions. Domestic credit markets were resilient throughout the crisis, both in terms of credit volumes and lending spreads.

C. Preconditions for Effective Banking Supervision

45. Luxembourg’s macroeconomic performance is generally satisfactory. Unemployment is low; and the trend growth rate and inflation have been satisfactory.

46. Luxembourg is a Member State of the EU and the wider European economic area. Consequently, it has been obliged to implement European directives on regulation of financial services. In addition, it has voluntarily followed a policy of adopting wider international standards, such as those of the Basel Committee. Furthermore, Luxembourg has introduced a system of information exchange and withholding tax on financial income in accordance with the EU Savings Directive.

47. Luxembourg’s legal system is based on civil law and a number of its laws are based on French or Belgian legislation. Most legislation is the result of EU regulations, directives and decisions. There is a highly sophisticated legal infrastructure and a relatively flexible regulatory framework.

48. Luxembourg has implemented IFRS. There is a full range of high-quality accountancy, audit, legal, and ancillary financial services available in the jurisdiction.

49. The 2008 crisis has highlighted weaknesses in the existing safety nets, crisis preparedness, and crisis management. The existing private deposit insurance scheme was able to deal with the challenges posed by the failure of the three Icelandic banks, but is going to be revamped in the context of European legislation currently under discussion. The crisis revealed a lack of implementation of a European framework for crisis management. The authorities have broadly adequate powers to direct, intervene in, and close a troubled financial institution, which became necessary in the case of the Icelandic banks.

D. Main Findings

50. The current assessment confirms a high degree of compliance with the Basel Core Principles, but weaknesses remain to be addressed. Since 2001, and particularly as a reaction to the financial crisis, the CSSF has increased its supervisory capacities, and its ongoing supervision has become more intrusive. At the same time, cooperation with home and other host supervisors within supervisory colleges has intensified.

Objectives, Independence, Powers, Transparency, and Cooperation (CP1)

51. Safeguards for the CSSF’s independence need to be put in place. Its mission and corporate governance structure require revision in order to grant it fully operational independence and to ensure that promotion of Luxembourg’s financial sector or the interests of the supervised entities do not negatively impact the CSSF’s prudential supervision and enforcement. While there was no evidence of actual interference, a certain reluctance to use corrective measures expeditiously was observed.

Licensing and Structure (CPs 2-5)

52. The CSSF should assume the licensing role, notwithstanding current practice whereby the minister grants licenses only on the CSSF’s advice. (The CSSF already has power to grant subsequent authorizations of new members of a bank’s bodies performing administrative, management and supervisory functions, new shareholders, and the change of external auditors.) Rather than relying for deterrence on punitive legislative provisions, the CSSF’s application assessment procedure should include evaluation of proposed directors and senior management for potential for conflicts of interest.

Prudential Regulation and Requirements (CPs 6-18)

53. Regulatory minimum capital requirements are often well below actual capital ratios, which may reduce the effectiveness of the capital adequacy regime (CP 6). The authorities do limit the sources of contagion from related lending but accept that local subsidiaries remain exposed to risk of a failure of a foreign parent. Most of the subsidiaries of large, internationally active banks are actually managed as if they were branches. They often act as deposit gatherers, channeling funds up to the foreign group parent. Thus, they are heavily exposed to their group both from a counterparty and liquidity risk as well as reputational perspective. The CSSF mitigates these risks to a certain extent by limiting maturity transformation and prohibiting lending to peripheral group affiliates.

Methods of Ongoing Banking Supervision (CPs 19-21)

54. The Supervisory Review and Evaluation Process includes an Internal Capital Adequacy Assessment Process (ICAAP) by each bank and its subsequent evaluation by the CSSF. Current risk profiles are produced for each bank for use in discussions with bank executives and applicable colleges of supervisors. Techniques tailored to the specifics of the banking system are in place but challenges remain on effective application. Formal reporting of on-site findings (and thereby management action thereon) can be long-delayed (a function of staff deployment and the process of escalation in the CSSF hierarchy). The frequency, scope and depth of contacts with bank management are good.

Accounting and Disclosure (CP 22)

55. IAS and IFRS are implemented. Also, European-wide harmonized financial and prudential reporting has been introduced in 2008.

Corrective and Remedial Powers of Supervisors (CP 23)

56. There is a noticeable reluctance to use the CSSF’s formal remedial and corrective powers in the form of sanctions.

Consolidated and Cross-Border Banking Supervision (CPs 24-25)

57. Enhancing coordination and cooperation with foreign supervisors within the college framework remains mount for the CSSF. It is already dedicating significant resources to participation in the colleges of supervisors organized by the relevant home supervisory authorities. These colleges are crucial to the CSSF’s being in a position to understand fully the risks to which cross border banking groups and their Luxembourg subsidiaries are exposed.

Table 6.

Luxembourg: Summary Compliance with the BCPs—Detailed Assessments

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Table 7.

Luxembourg: Recommended Action Plan to Improve Compliance with the BCPs

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E. Authorities’ Response to the Assessment30

58. Despite the CSSF’s broad agreement, there are two cases of disagreement as well as one qualification we wish to make. Following the discussions held during the mission, we believe that these reflect choice of words rather than substance.

Capital Add-Ons

59. The report qualifies the use of capital add-ons by the CSSF as “symbolic as it does not always have an impact (§17).” While it is true that the capital add-ons did in most cases not result in increased levels of capital, the measure is far from being symbolic. However, the CSSF determines capital add-ons according to a risk-based analysis. Also, if, on the basis of risks taken, a potential shortfall of capital requirements is determined with respect to the Pillar 1 minimum capital requirements; this shortage is factored into the bank’s Pillar 1 regime as a capital add-on. In this process, the actual level of capital is not a decision criterion per se.

60. As it happens, Luxembourg banks display high capital adequacy as a result of market expectations regarding the capitalization of banks engaging in wealth management activities (“signaling”). These high levels of capital adequacy are the results of higher solvency standards (higher confidence level) fixed by the banks themselves, rather than higher-risk profiles (given the Pillar 1 confidence level). Therefore, most banks operate at levels of capital higher than the minimum Pillar 1 regime augmented by the CSSF capital add-ons.

61. With our capital add-on decisions subject to judicial review, the CSSF has ever more to base its capital add-on decisions upon objective facts (risk profile), rather than upon subjective effects (higher level of capital). Furthermore, under the above mentioned signaling effect, banks care about their perceived risk profile and are clearly not indifferent to capital add-ons given by the CSSF, even if these add-ons do not imply the necessity to raise additional capital. Describing the capital add-ons prescribed by the CSSF as “symbolic,” not only is unjustified, but it is counterproductive because it undermines their effectiveness as well as the CSSF’s position within the mandatory colleges under the capital requirements directive (CRD II) that are required to jointly determine the capital adequacy. In this context, it is extremely important for the CSSF to be able to fix backstop capital levels even if they will be situated below the actual capital levels at the banks.

Independence and Corrective Actions

62. While we agree that the organic law of the CSSF should be amended to remove all possible doubts as regards the independence of the CSSF, the assessment team, as stated in the report, did not find “evidence of actual [political] interference.” It is thus not justified to link the “[observed] certain reluctance to use corrective measures expeditiously” to a lack of independence as is the case with §29, second bullet. The reference made within the comments to CP 23, which further pushes the argument, is unacceptable in this respect; and “the lack of independence and the inherent conflict between the CSSF’s prudential duties and inclusion in its mission of a duty to promote the financial sector are likely to have an impact.” Indeed, it is factually incorrect that the CSSF’s mission includes a duty to promote the financial sector. “Promotion” does not appear in its organic law.

Circulars and Regulations

63. The policy to replace circulars by regulations will be pursued within the CSSF’s general philosophy to have a coherent regulatory body of laws, regulations and circulars. Circulars will thus not completely be abandoned, but their use will comply with the recommended action to CP7.

II. IOSCO Objectives and Principles of Securities Regulation31

A. Information and Methodology Used for Assessment

64. The assessment was conducted based on IOSCO objectives and principles of securities regulation and the associated methodology adopted in 2003 and updated in 2008.32 The conclusions are based on information and findings as of November-2010. As noted below, important reforms have been introduced in the past year, some of which, have already been adopted as implementation of European Union (EU) directives and/or regulations, and others are to be adopted with the same purpose. For instance, Luxembourg envisages implementing the revision of the undertakings for collective investment in transferable securities (UCITS) directive by end-2010.

65. The assessor relied on number of sources in carrying out this assessment. The assessment was based on a review of the relevant legislation; self-assessment questionnaires prepared by the staff of the Commission de Surveillance du Secteur Financier (CSSF); the CSSF annual report and website and detailed discussions with CSSF staff, staff from the Luxembourg stock exchange, law firms, representatives of industry and the ministry of finance. An assessment of the securities settlement systems under the Committee on Payment and Settlement Systems (CPSS)/IOSCO recommendations was conducted setely in early-2011. Thus, Principle 30 was not assessed here.

B. Preconditions for Effective Securities Regulation

66. There are a number of general preconditions necessary for the effective regulation of securities markets which, with some comments, appear to be in place in Luxembourg. As to the legal system, and given that the massive segment of securities markets is constituted by the investment fund industry in Luxembourg, the UCI(TS) law provides a comprehensive framework for asset management, largely inspired from EU directives. The regulatory framework transposes also all other relevant EU Directives. The regulator has legally enforceable powers of decision and action, although some limits to its independence and one of its mandates (i.e., implementing government initiatives for orderly expansion of the financial sector) may be inconsistent with the IOSCO objectives. Regarding the judiciary, the country has in place mechanisms for alternative means of dispute resolution. The accounting system supports the implementation of requirements and effective regulation of market participants. The accounting framework relies on international financial reporting standards (IFRS) regarding consolidated accounts of listed companies although some accounts may be presented in Luxembourg generally accepted accounting principles (Lux GAAP). Finally there are no indications of barriers of entry to the financial sector. Competition is encouraged and foreign participation is welcomed. The taxation framework is supportive to the operations of the industry in the jurisdiction.

C. Main Findings

67. The massive size of the investment fund industry is a key challenge. The regulatory framework developed in Luxembourg by faithfully implementing the European relevant directive provides for a degree of flexibility which is attractive for investment fund operators.33 Luxembourg is the second largest international financial center for investment funds.

68. The CSSF has adopted a structure and procedures which make it, for the time being, reactive to issues and challenges. Usually investment fund domiciled in Luxembourg are managed by a Luxembourg-based operator whereas the management functions are largely delegated to the parent company or to a third-party, often based abroad, and whereas the fund administration is performed by the fund operator itself or delegated to only a Luxembourg-based PFS, itself under regulation of the CSSF. This led the CSSF to adopt a structure that allows focusing on the supervision of the funds themselves but from the central administration perspective and on the regulation of PFS in charge of the fund administration. In so doing, the CSSF predominantly relies on its review of ex-post regular or specific reports. However, it has recently initiated a more pro-active approach by performing routine or specific on-site inspections and/or addressing questions to funds or their operators. These efforts deserve to be maintained and, above all, accentuated.

69. European integration of investment fund market, the pole position as a European center for investment funds and the cross-border dimension of Luxembourg lead other European (and non-European) regulators to rely on the CSSF as the fore regulator, notably regarding investment funds. Most Luxembourg based financial products and, in particular, Luxembourg UCI(TS) are sold on a cross-border basis to clients who are not resident in Luxembourg. Regarding the IOSCO Principles, no EU Member State can be assessed in isolation but instead as part of a wider community and market. Other European countries where domestic investor protection is crucial may be led to challenge Luxembourg’s approach to regulation of financial products and to impose protective additional rules at the national level, notably with regards to marketing/selling practices on their territory.

70. As a matter of priority, the system should work toward strengthening the operational independence of the regulator, accentuating the recent efforts to make more effective its enforcement powers, and strengthening the investor protection rules attached to the products and their operators. Luxembourg has implemented most of the IOSCO Principles in a reasonable way. However, some elements of the Luxembourg regulatory system and CSSF enforcement practices deserve attention (see detailed comments for each Principle).

71. Principles 1-5 relate to the regulator: The CSSF financial independence is correctly ensured by the funding structure in place. Financial accountability, transparency on CSSF decisions and judicial review of CSSF decisions are in line with international standards. However, the assessment found there might be a potential weakness in the operational independence of the CSSF as it is placed by law under the direct authority of the Minister; its executive board may be dismissed by the Government if any fundamental disagreement arises concerning regulation policy; and one of its mandates is often confused with the expansion of the financial sector. Nevertheless, the assessment could not determine that the current legislative structure has been used so that pressure was exercised on CSSF decision process. Finally, should the Government wish to take a decision contrary to CSSF advice or affecting the level of supervision by the CSSF, such a decision would have to be motivated and could be challenged in a Luxembourg or European court.

72. Principles 6-7 relate to self-regulation: there are no self-regulatory organizations (SRO) in Luxembourg. These Principles have not been assessed as they are not applicable to Luxembourg regulation structure.

73. Principles 8-10 relate to the enforcement of securities regulation: The CSSF has comprehensive inspection, investigation, and surveillance powers. However, although the anti-money laundering and terrorist financing rules have not been assessed in detail since they are being modified by the Luxembourg Parliament pursuant to FATF findings, the CSSF should pay more attention to enforce all provisions and should clarify and detail, where needed, notably those relating to the entering into a business relationship with a new customer. In addition, in practice, the CSSF should concentrate its efforts and its resources on the market segments which potentially represent more risk for the regulator.

74. Principles 11-13 refer to the cooperation in regulation: The CSFF has legal authority to cooperate and exchange information with foreign counterparties. Furthermore, it is signatory of the IOSCO Multilateral Memorandum of Understanding (MMoU). At the domestic level, it is important that a framework for domestic cooperation between the Luxembourg Central Bank and the CSSF be put in place.

75. Principles 14-16 refer to issuers: Issuers whose securities are offered to the public or admitted to trading in a regulated market must submit a prospectus to the CSSF, which content is in line with the IOSCO Principles. They are also subject to periodic reporting, including annual and semiannual reports as well as communication of material events (price sensitive information). The CSSF has implemented supervisory measures (in-house practice) for reviewing securities prospectuses to help assure the sufficiency, accuracy and timeliness of the required disclosures. Equity issuers are subject to substantial holdings, as well as insider holdings reporting. Regarding accounting rules however, Luxembourg authorities should pay attention to the gaps between IFRS and Luxembourg GAAP.

76. Principles for collective investment schemes (Principles 17-20): Operators and marketers of CIS are subject to registration requirements (in line with the IOSCO Principles) and to CSSF supervision with an emphasis on the products offered to retail investors. However, the Luxembourg financial sector is marked by the massive size of its investment fund industry, largely operating on a cross-border basis. In this context, it has to be noticed that other European regulators have in part to rely on enforcement of European rules by the CSSF in Luxembourg. Therefore, the CSSF should pay a particularly high attention to an effective use of its supervisory and enforcement powers and should, as a matter of priority, increase its ex-ante supervision (e.g. to ensure that disclosures allow all potential investors, including retail investors, to properly evaluate the suitability of the CIS for them). The assessment did not evidence that the CSSF had ever sanctioned actors involved in asset management. The rules regarding segregation and protection of client assets, in particular in the context of delegation of custody functions, should be strengthened. Potential consequences of a legal practice regarding investor (in funds with the corporate form) ownership rights deserve to be better and more clearly disclosed.

77. Principles 21-24 refer to market intermediaries: There are minimum entry standards for all market intermediaries that include, inter alia, criteria relating to initial and ongoing capital. The CSSF should however verify whether the capital standards are sufficient to allow investment firms to absorb some losses in the context of the forthcoming Capital Requirements Directive IV. It should formalize a procedure for dealing with the failure of a market intermediary in order to minimize damage and loss to investors and to contain systemic risk in cooperation with the BCL.

78. Principles 25-30 refer to the secondary market: There are licensing requirements on both operators of regulated markets as well as multilateral trading facilities. Although the CSSF does not have the power to license markets and their operators (competence of the minister) no evidence of misuse of the current situation has been found and the potential for misuse seems low. The proper management of large exposures could be improved by formalizing or publishing default procedures for market intermediaries. Principle 30 was not assessed here.

Table 8.

Luxembourg: Summary Implementation of the IOSCO Principles

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