This Selected Issues Paper analyzes the fiscal position and significant challenges for Luxembourg. Luxembourg’s fiscal position is currently sound, however, fiscal safety buffers are being eroded. The country’s healthy fiscal position will be challenged by forthcoming revenue losses as well as rapid trend growth in expenditures. An overall strategy to address this coming deterioration is needed. Beyond the planned value-added tax increase, recurrent property taxes are a possible additional source of revenue. On expenditures, social benefits should be an area of focus, and reforms of these benefits should also aim to reduce disincentives to work.


This Selected Issues Paper analyzes the fiscal position and significant challenges for Luxembourg. Luxembourg’s fiscal position is currently sound, however, fiscal safety buffers are being eroded. The country’s healthy fiscal position will be challenged by forthcoming revenue losses as well as rapid trend growth in expenditures. An overall strategy to address this coming deterioration is needed. Beyond the planned value-added tax increase, recurrent property taxes are a possible additional source of revenue. On expenditures, social benefits should be an area of focus, and reforms of these benefits should also aim to reduce disincentives to work.


Luxembourg’s financial sector has weathered the global crisis relatively well, and appears to be in a sound position. However, challenges are looming, ranging from deep regulatory changes at the European level to the move to automatic exchange of information for individual savings, pressures to increase the transparency of a broader range of cross-border activities, and the rise in real estate exposures at the domestic level. On the other hand, if dealt with properly, these changes could also provide opportunities for growth and diversification. To navigate those challenges, the authorities will have to proactively maintain buffers, monitor risks and plan for the likely adjustments in business model. This paper assesses the challenges in more detail and provides recommendations to continue to strengthen the resilience of the financial sector.

A. A Unique Business Model with a Strong International Orientation

1. Luxembourg hosts a large financial sector mostly focused on cross-border businesses (Figure 1). It hosts the second largest fund industry in the world and is one of a few hubs of European UCITS funds.2 The banking industry’s assets are 15 times GDP, centered around a wide range of mostly cross-border business lines. In synergy with those activities, the country is home to a number of custodian banks and an important central security depository, and is one of the largest primary markets for international bond issuance globally. A wide spectrum of specialized financial service providers gravitate around the industry, with support ranging from legal to accounting and IT activities. The financial sector contributes 22 percent of GDP and 14 percent of employment, and is a substantial contributor to the large current account surplus.


Employment in the Financial Sector

(In number of persons)

Citation: IMF Staff Country Reports 2014, 119; 10.5089/9781484378649.002.A002

Sources: BCL.

2. The country continues to be one of the global hubs for investment funds. The fund industry is second only to the U.S., with 2.6 trillion EUR of assets under management, and has been growing steadily. The industry invests in a diversified class of assets, mostly outside Luxembourg, and caters to a diversified pool of non-resident investors—only 2 percent of promoters of UCIs (Undertaking of Collective Investments) are from Luxembourg. A large part of the investors are from outside of the euro area, but similarly, a substantial part of the funds are invested outside the country, including in assets from non-euro area countries. UCITS funds under EU regulation dominate, with around 80 percent of assets; the rest is accounted for by funds that do not meet UCITS requirements and includes alternative funds such as hedge funds. Money market funds’ share is less than 10 percent of UCIs in asset volume, around half of which are Constant NAV funds.


Investment fund assets by country, 2013

(In percent of the total)

Citation: IMF Staff Country Reports 2014, 119; 10.5089/9781484378649.002.A002

Source: EFAMA

3. The banking sector is dominated by subsidiaries and branches of foreign groups. Those mostly conduct cross-border businesses, including wealth management, intragroup treasury and liquidity management, custody services to investment funds, and international wholesale lending. Only a handful of banks—less than 20 percent of total banking assets, but still about 250 percent of GDP—are catering to domestic non-financial corporate and retail customers through branch networks in Luxembourg. Half of these domestically-oriented banks are stand-alone banking groups with head offices in Luxembourg; the rest are banks owned by foreign European banking groups.


Bank Assets

(End 2012)

Citation: IMF Staff Country Reports 2014, 119; 10.5089/9781484378649.002.A002

Sources: National Authorities, IFS, IMF Staff

4. Other businesses include bond issuance, and custodian and settlement activities. Luxembourg is one of the biggest international bond issuance markets in the world. It hosts an important global clearing and settlement player focusing on euro denominated bonds, Clearstream Banking—which also holds a banking license. The amount of assets under custody by banks in Luxembourg, including Clearstream Banking, reaches over 11 trillion EUR. It is also home to various kinds of other financial schemes, such as SICARs, PFSs and Securities Undertakings, although their combined asset size remains small. The insurance sector is relatively large and growing, with total assets over 200 billion euro (over 5 times GDP), of which life insurance accounts for close to half. The captive insurance business is another important pillar of the insurance industry. SOPARFI, a form of company, is also often used as an investment vehicle, but is not supervised.

5. The country’s business model benefits from several key factors, which over time have created a unique “eco-system” supporting Luxembourg’s role as a financial hub within the euro area:

  • There has been a first-mover advantage. The country’s financial center status was first built on its flexible regulation that attracted foreign exchange and euro loan businesses of European banks. Since then, taking advantage of established operations, these banks have grown global treasury and cash management businesses.

  • The industry has taken full advantage of EU and euro area market integration, in particular the European passport for financial intermediaries and single rulebooks for financial regulation, such as UCITS directives.1

  • The extensive financial infrastructure has grown to support banks’ treasury and cash management businesses and the investment fund business. These include the clearing and settlement system as well as a number of banks providing custodian services. The auxiliary services have also grown, including legal, accounting, and IT activities. The concentration of these players makes it possible for the financial center to provide services and create products based on the EU regulation and the civil law tradition.

  • Stable political and economic conditions, as exemplified by the AAA sovereign rating, have attracted the industry. The authorities have generally been proactive in implementing new European regulations. A multilingual workforce and the absence of a wealth tax for individuals are also regarded as supporting the financial center.2

  • In the past, bank and tax secrecy had also been seen as an advantage in attracting money from individual and corporate customers mostly from neighboring countries.

B. Recent Developments: Adjusting to Ongoing Challenges

6. As the deleveraging trend in the euro area continues, Luxembourg’s banking sector balance sheet has continued contracting, although the soundness of the system has been maintained (Figure 1). Total assets declined from 931 billion EUR at end-2008 to 714 billion EUR in February 2014. This reduction has largely been driven by the contraction in intragroup exposures with core euro area parent banks. Other activities, such as domestic credit and private banking, have been less affected. This development, together with the low interest rate environment, has hampered profitability, although fee incomes from rapidly growing investment fund activities have been compensating. The capitalization and liquidity ratios remain healthy, with Tier 1 capital ratio of over 16 percent and liquid assets to total assets at around 60 percent. NPLs are low, at just 0.3 percent of total loans.1 An additional strength of the banking sector is that it is a net liquidity provider; customer deposits are one and half times larger than non-interbank loans, with net deposits of residents for the entire system of more than 600 billion EUR. These excess deposits, partly arising from deposits from the investment fund industry, are financing cross-border interbank lending, mostly intra-group.

Figure 1.
Figure 1.

Developments in the Banking Sector

Citation: IMF Staff Country Reports 2014, 119; 10.5089/9781484378649.002.A002

Sources: BCL, IMF Staff calculations.

7. Another challenge is the move toward more tax transparency, although the April 2013 announcement to switch to the automatic exchange of information had a negligible impact on deposits so far.2 Some outflows occurred for retail deposits from neighboring countries, but these had been offset by an increase in other deposits, mostly from institutional depositors. The extent of the impact may not have fully materialized yet and some banks whose business is mostly with affected customers may face difficulties. But the benign impact observed so far could be an indication that the role played by bank secrecy has already diminished in Luxembourg. Indeed, the government has been signaling the need to increase transparency for the past few years and had urged the financial industry to prepare for it. Thus the move was not a surprise for the industry.3


Household and Non-Financial Corporate Deposits

(in billions of euro (LHS), and in monthly changes in level (bars, RHS))

Citation: IMF Staff Country Reports 2014, 119; 10.5089/9781484378649.002.A002

Sources: Global insight.

8. The investment fund sector has continued growing, despite bouts of volatility on global financial markets since May 2013. The net inflow to the sector remains strong. Assets under management declined in June and August, mostly due to a fall in asset values triggered by the tapering discussions by the U.S. Federal Reserve, but net outflows were only recorded in June, and growth resumed thereafter. The diversified nature of the industry, both in terms of the investment policies (categories of assets invested) and the customer base, contributed to the stability—a shock to specific asset classes is not believed to cause a substantial impact on the industry as a whole as investors are expected to shift funds only from one type of funds to another. In December 2013, the volume of assets under management amounted to more than 2.6 trillion EUR— a historical peak.


Investment Fund: Asset Under Management

(In billions of euros)

Citation: IMF Staff Country Reports 2014, 119; 10.5089/9781484378649.002.A002

Sources: BCL.

9. To cope with the ongoing challenges, the financial sector has started to diversify into new areas, with the support of the government:

  • Emerging market economies. The financial center is trying to strengthen its ties with emerging market economies, such as China and the Gulf countries. During 2013, 8 banks—of which 2 Chinese banks—opened a branch or subsidiary, making up for exiting euro-area banks. It is also working to position itself as a European hub for the Renminbi business, such as Renminbi-denominated bonds issuance.

  • High net-worth customers. In response to the move toward more transparency and, in particular, to the switch to automatic exchange of information under the EU Savings Directive, banks have started to shift their private banking activities from “mass-affluent” and “affluent” customers, generally from neighboring countries, to “high net-worth” individuals from broader regions.4 Because the fee structure is different for that type of clientele, this move could however put pressure on profit margins and smaller banks might have difficulties adapting to the new business model.

  • Alternative Investment Fund Management. Luxembourg was one of the first countries to transpose the Alternative Investment Fund Directive (AIFMD). The effort is part of a broader strategy to make Luxembourg a hub for AIFMs.

10. Regulatory and supervisory efforts have been stepped up since the 2011 FSAP. Staffing at the Commission de Surveillance du Secteur Financier (CSSF), the supervisor for banks and investment funds, has continued to grow. Techniques for stress testing banks have been improved and now cover various scenarios. Investor protection was also strengthened, including through enhanced monitoring of adequacy of disclosures by investment funds and bond issuers. The collaboration between the CSSF and the central bank, Banque Centrale du Luxembourg (BCL), is being enhanced through the evolution of institutional arrangements such as the start of the Single Supervisory Mechanism (SSM) and will be further enhanced in the context of the proposed establishment of a national Systemic Risk Committee. The latter will be chaired by the Finance Minister, with participation of the CSSF, BCL and Insurance Commission; the BCL will serve as its secretariat. It will meet at least twice a year. Also, importantly, the organic law for the CSSF was revised in December 2012 and a provision that could have been interpreted as giving the supervisor an objective of promoting the financial center was removed.5

C. Challenges Ahead: European Regulatory Initiatives and Responses

European regulatory and supervisory initiatives

11. Financial regulation and supervision will go through unprecedented changes due to European developments. These include the move to the Banking Union, particularly the start of SSM, and the enhancement of the single rulebook—including the CRD IV/CRR, which transposes Basel III for the EU, as well as the BRRD and DGSD, now finally agreed at the EU level. There are also developments in capital market-related regulations. These add to the challenges Luxembourg’s financial industry is facing, particularly banks, and have the potential to further change the landscape of the financial sector in the Grand Duchy. (Box 1)

Regulatory and Supervisory Initiatives at the EU and Euro Area Levels

Banking Union
SSM (Single Supervisory Mechanism):

The ECB will assume the role of single supervisor for banks in euro area countries (and other EU countries who opt in) in November 2014. It will directly supervise around 130 significant banks in the region. For other banks, national supervisors will continue to operate direct supervision.

Comprehensive assessment:

ECB and national supervisors (with the support of third parties) will conduct a comprehensive assessment of the banking system in preparation for SSM. The comprehensive assessment is composed of three pillars: a supervisory assessment; an asset quality review; and a stress test. An eight percent Common Equity Tier 1 (CET1) will be used as a threshold. Results of the comprehensive assessment will be disclosed in fall 2014.

SRM (Single Resolution Mechanism):

In December 2013, the ECOFIN agreed on the establishment of a single resolution board—which will have broad powers over bank resolution—and a single fund to support resolution processes, and in March 2014, an agreement was found between the Council and the European parliament on a common position. The SRM will cover all banks in countries that participate in the SSM.

Single Rulebook
CRD IV/CRR (Capital Requirements Directive/Capital Requirements Regulation):

It transposes the Basel III framework in EU law. A phased-in implementation starts in 2014 for the minimum risk-weighted capital ratio, including the introduction of Common Equity Tier 1 (CET1). Liquidity Coverage Ratio (LCR) starts in 2015. The full implementation will be completed by 2019.

DGSD (Deposit Guarantee Schemes Directive)

It harmonizes deposit guarantee schemes in the EU. National deposit funds will have to cover at least 0.8 percent of eligible deposits. A shorter payout period, of less than seven days, was also introduced.

BRRD (Bank Recovery and Resolution Directive)

It harmonizes tools and powers of national regulators to deal with the resolution of banks. It requires recovery plans to be prepared by banks and resolution plans by regulators and introduces the ability to bail-in bank liabilities with a specific pecking order. Some liabilities are exempt, such as short-term liabilities and insured deposits. Countries need to set up national resolution funds of 1.0 percent of covered deposits to support the process. The directive becomes effective from 2015 and bail-in of bank liabilities can happen starting from 2016.

UCITS IV/V (Undertakings for Collective Investment in Transferable Securities)

UCITS is a harmonized regulatory framework for investment funds that can be marketed to retail investors in EU. UCITS IV, which became effective July 2011, harmonized disclosures and introduced an EU passport for management companies. UCITS V, for which the Commission published a proposal in 2012, will introduce harmonized rules on depository functions, remuneration policies and sanction regimes.

AIFMD (Alternative Investment Fund Managers Directive)

It introduced a harmonized regulatory framework of alternative investment funds, covering all non-UCITS funds and some other joint investment schemes. Existing AIF managers are required to be authorized and to become subject to supervision by July 2014.

MMFR (Money Market Funds Regulation)

In September 2013, the Commission published a proposal which requires MMFs to be authorized and regulates such matters as eligible assets for investment, diversification requirements and liquidity levels. For CNAV (Constant Net Asset Value) funds, which seek to maintain a fixed price per share for redemption and purchase of shares through the use of amortization valuation, a three percent capital buffer would be required.

12. The progress towards Banking Union was seen as having a positive impact on the banking sector in the long run. The majority of the sector, at this point 69 banks representing about 80 percent of total assets, including many subsidiaries and branches of major European banks, will come under the direct supervision of the ECB when the SSM starts operating in November 2014. To the extent that these changes will strongly contribute to the stability of the euro area banking sector, this could have positive impact on Luxembourg. However, the comprehensive assessment as well as the prospect of bail-in might exacerbate deleveraging pressures on euro area banks, with implications for intra-group exposures, possibly leading to a further reduction in the size of the Luxembourg banking sector. There could also be long-term implications for the business case of having Luxembourg as a treasury hub for euro area activities. As banks are supervised at the group level, euro area parent banks may review their current group structures to maximize the use of their current capital and liquidity, which could negatively affect their Luxembourg operations. Finally, some in the industry are concerned about the lack of familiarity of SSM supervisors with the unique business model of banks in Luxembourg.

13. The role of national supervisors will remain important in the SSM. In the transition phase, efforts are needed to make the hand-over of the responsibilities smooth and seamless. In particular, care needs to be taken that the establishment of SSM does not result in any supervisory gaps or disruptions. Also, while supervisory responsibilities will be shifted to the central level, responsibilities for resolution will remain at the national level until the SRM is fully in place. This will give a strong interest for national supervisors to remain closely involved in supervisory activities.

14. Basel III implementation has begun in Europe as CRD IV/CRR became effective. The new capital requirements are to be implemented from 2014, although phase-in will be applied in most jurisdictions. Given the current high CAR, most Luxembourg banks will not have problems meeting the new capital requirement. However, a number of banks, particularly those depending on their parent banks for funding, may have difficulty meeting the Liquidity Coverage Ratio (LCR); these banks are expected to apply for an exemption, allowed in the framework, whereby the LCR will be applied only at the consolidated level, and not at the level of individual subsidiaries in EU countries. Meeting the leverage ratio recently agreed by the Basel Committee on Banking Supervision (BCBS) may also be challenging for banks focused on activities that carry low risk weights, such as interbank loans or investment in sovereign bonds. But banks have time to adjust, and the BCBS has not decided whether the leverage ratio will be a binding measure.6

15. The recent European agreement on deposit guarantee scheme and bank resolution and recovery will require changes in the country’s current arrangements. Luxembourg’s current deposit guarantee scheme is based on ex-post funding only, although banks provision explicitly to cover insured deposits. This scheme worked smoothly during the financial crisis when a few small banks had to be resolved, and various improvements have been made recently, including shortening the time necessary to gather depositor information. However, the directives will require fundamental changes to the current scheme.

16. There are also ongoing EU regulatory initiatives for the investment fund industry. These include the AIFMD, the UCITS V proposal, and the MMF reform proposal. The AIFMD has been transposed and the number of institutions authorized and registered is steadily increasing.7 The CSSF has established a new department responsible for AIFMs. The impact of UCITS V and the MMF reform is expected to be limited: for the former, the intention is to align the regulatory framework to that of AIFMD and the industry has already started to prepare for it. For the latter, while the proposal could impact CNAV MMFs, it is still unclear how the final rules would be, and CNAV MMFs in Luxembourg account for a relatively small share, of about five percent of total UCIs.8

Authorities’ actions

17. The authorities are taking steps to ensure a smooth adjustment to these changes while maintaining higher regulatory thresholds. They viewed these European reforms as supportive to the Luxembourg financial sector in the long run, as they would provide an improved and more integrated European regulatory framework. However, they also stressed the imperative for the country to adapt quickly and effectively. The authorities are well aware of the need to preserve existing buffers even under the new framework. Measures being taken include:

  • SSM: The authorities are actively participating in the ongoing discussion in the SSM. The CSSF will be part of the Joint Supervisory Teams for many of the Luxembourg banks that will be supervised directly by the SSM, and is expected to be substantially involved in the supervision of those banks. Preparation is proceeding according to schedule, although it is taxing the resources of the supervisor. The authorities did not expect the comprehensive assessment to have a substantial impact on their banks given the high level of capitalization.

  • Capital requirements: After the 2011 EBA stress test, the authorities decided to apply a 9 percent core Tier 1 ratio as a minimum for all banks—above the 8 percent European minimum—as a way to ensure a level-playing field and signal the resilience of the sector.9 For domestic systemic banks, a 10 percent solvency ratio has been required. Under the new Basel III framework, the authorities decided to frontload the implementation of the new capital requirements; banks have to meet a 7 percent CET 1 requirement from 2014, without any phase-in period.10 Again, given the high level of capitalization, the authorities expected that most banks would be able to meet this requirement without much difficulty.

  • Deposit guarantee: Last year, the authorities introduced a new requirement for banks to provision at least 1 percent of their covered deposits, in part to prepare for the introduction of ex-ante contributions11. With the DGSD and BRRD now close to adoption, they have started the work to transpose them expeditiously—a move they see as important for the confidence of the financial center. A final decision has not yet been made, but the authorities saw merit in making the new deposit insurance scheme partially ex-ante funded while preserving the overall amount of protection for the deposit guarantee scheme at the level currently provisioned, which amounts to 2.2 percent of insured deposits.

D. Remaining Risks

Residential real estate exposures in domestically-oriented banks

18. Rising residential real estate exposures are emerging as a risk for domestically-oriented banks. At 250 percent of GDP, these banks’ size is in line with euro area peers’ domestic banking sector. Soundness indicators suggest they are generally in a good position: capital ratios are high, NPLs low, and deposits comfortably cover total (non-interbank) loans. Yet, the share of real estate exposure in their total balance sheet has increased substantially, from 12 percent in 2008 to 24 percent in 2012. Loan to value ratios (LTV) of new loans have also been rising.12 Given the high level of concentration in the domestically-oriented banking sector, any distress would have a significant impact on the domestic economy and could pose a risk to public finances (Figure 2). Furthermore, a few of those domestically-oriented banks are subsidiaries of large European banks, exposing them to the risk of contagion from troubles in their parents, as happened with Dexia. In case of severe stress, the large size of the parent groups compared to their home countries could further complicate things, as sole bail-out by the home country may be difficult.

19. Aware of these risks, the authorities have taken several positive steps, but continued vigilance is warranted. Since July 2013, banks using the standardized approach to compute capital requirements need to apply a 75 percent risk weight for the part of residential mortgage loans exceeding 80 percent LTV—rather than the 35 percent risk weight prevailing until then. Banks are also required to conduct stress tests on their retail real estate portfolios periodically to make sure they have adequate capital buffers. Early indications suggest that these measures are gaining traction as LTVs for new loans have been declining most recently. Still, close monitoring will be important and additional macro-prudential measures should be taken if exposures continue to rise and loan standards deteriorate further.

20. Additional capital buffers for domestically-oriented banks should also be considered. The systemic importance of these banks for the domestic economy would warrant that these banks maintain higher capital levels, particularly given that real estate activities are concentrated among a few banks. The authorities should explore ways to do so, for example by applying a Domestic Systemically Important Bank (D-SIB) buffer under the Basel III framework.

Deposit outflow and large intragroup exposures in internationally-oriented banks

21. Internationally-oriented banks are exposed to a number of risks, depending on their business lines, although there are some mitigating factors. The private banking business could experience a drain on deposits as the automatic exchange of information is introduced and as non-covered deposits could be subject to bail-in. However, there has been no evidence so far of deposit outflows at the aggregate level (see also paragraph 7). Banks as a whole remain net providers of liquidity, and the soundness of the banking system has not been affected. Intragroup credit is still the largest exposure for these banks, amounting to more than 40 percent of total loans (Figure 2). A failure of a parent group would therefore have substantial reputational repercussions for Luxembourg, potentially exacerbated by the fact that new bail-in requirements will apply to such exposures. The new power given to the supervisor by the CRD IV framework to limit the amount of intragroup exposures will provide a valuable tool in containing these risks.

Figure 2.
Figure 2.

Domestically-Oriented Banks and Internationally-Oriented Banks

Citation: IMF Staff Country Reports 2014, 119; 10.5089/9781484378649.002.A002

Growing links among domestic financial sector players and ongoing diversification

22. A severe shock to the investment fund industry could have potential systemic implications through the liquidity channel, even though various measures to contain the risk are in place. In principle, investment fund losses are borne by investors and do not have systemic implications. If redemptions are requested by investors, the first choice for a fund to generate cash is to sell some of its assets. However, if sudden and substantial redemptions were to take place— possibly triggered by extreme market events or if substantial reputational risks materialize—demand could exceed the amount of assets that can be liquidated easily, leading investment funds to request liquidity support from sponsoring banks (Box 2). In this way, shocks in the investment fund would spill over to banks, and banks would be exposed to liquidity and credit risks of the investment fund. This was the case for Luxembourg CNAV MMFs during the crisis, some of which faced severe redemptions—leading sponsoring banks to step in. Some sponsoring banks accessed BCL liquidity at the time. If funds are short of liquidity, the risk is that they would proceed to fire-sale their illiquid assets, which would push down further those assets’ price and increase contagion.1 However, a number of measures already exist to minimize such risk. Unlike bank deposits, investment funds usually do not need to meet redemption requests immediately, and the supervisors also have the power to suspend redemptions. UCITS funds, which form the bulk of funds in Luxembourg, are subject to a set of regulations to ensure that they invest in liquid assets, and UCITS directives limit these funds’ borrowing from banks to no more than 10 percent of their net assets. Finally, funds are required to conduct stress tests, including on redemption risks.

23. More generally, strong and growing links between various domestic financial players could be channels for spillovers. The fund industry, specialized financial service providers, and financial holdings are all connected to the banking sector via financial infrastructures and substantial deposits. The latter amount to, respectively, 13 percent, 5 percent and 4 percent of total deposits. Acute liquidity stress in one of those sub-sectors could have the potential to spillover to the banking sector through deposit withdrawals. In addition to close monitoring, new techniques to assess such risk are needed. For example, system-wide stress testing, applying the same scenario both to banks and investment funds, would be able to show the system-wide impact of a liquidity shock as well as the system’s weakest links.

24. Risks may also emerge from ongoing diversification of financial activities. For example, as banks increase foreign currency businesses, the currency mismatch risk grows, which was less of an issue when activities were mostly denominated in euro. Similarly, as private banking activities target more high-net worth individuals from different parts of the world, unless KYC (know your customer) policies also change accordingly, banks could possibly be exposed to higher risks. Supervisors should be proactive in capturing and assessing these risks. Publishing assessments periodically would be beneficial in communicating supervisors’ concerns (or lack thereof) to the industry and customers. As these assessments should be made in a cross-sectoral fashion, the proposed Systemic Risk Committee would be a natural candidate to perform these tasks.

25. The potential impact of reputational risks is growing as the financial sector’s business model changes. If reputational risks materialize, the impact on the investment fund industry, for example, could be substantial, as it draws part of its attractiveness from the established trademark. Once this image is tarnished, investors may easily shift funds to other financial centers in the euro area. It is therefore critical that Luxembourg’s regulatory and supervisory frameworks and procedures as well as industry practices are seen as adhering to the highest international standards. In that context, enhanced and proactive communication by the government and the industry would be beneficial, emphasizing ongoing efforts focused on investor and depositor protection.

Estimating Possible Redemptions from Investment Funds—Applying a Historical Scenario

While it is not easy to estimate possible redemptions in case of shocks, past experiences provide some guidance. In this box, we use redemption behaviors derived from past experiences to illustrate how they would applied to the current level of asset under management by investment funds.

The table shows past episodes where the highest redemption was recorded on a monthly basis (in September 2008), including the percent changes and how much impact they would have if the same level of redemption (relative to the total asset) happened now. For reference, the average monthly changes in the preceding 12 months are also shown. Gross redemptions correspond to repurchases in the month, while net redemptions deduct purchases from repurchases during the month. Both are shown for the whole investment fund sector.

article image
(source: BCL, IMF staff estimates)

Although using past episodes to estimate the size of redemptions has inherent limitations, such as not reflecting changes in investment strategies among funds or in investor behaviors to date, a few observations can be made:

  • - The amount of redemption under a very severe stress could be substantial as the investment fund industry has grown further since the crisis.

  • - When a significant shock hits, the level of redemption, both gross and net, can rise substantially from levels observed immediately before the shock.

  • - The net redemption is much smaller than the gross redemption, as many investors likely shifted money between funds with different investment strategies, rather than retrieving their investment.1

Investment funds have a number of options to address an increase in redemption requests. The first choice is to sell assets, in particularly for UCITS funds, which are subject to regulations aiming at ensuring funds have a liquid portfolio of assets. Redemptions can be suspended to avoid disruptions. However, in some cases, funds may still need to withdraw their deposits in banks (175 billion EUR total at end-2012, 65 billion EUR in banks in Luxembourg and 110 billion EUR in banks outside of the country) in order to avoid fire sales of assets. If more liquidity is needed, funds may borrow from banks, possibly resulting in increased liquidity needs for banks.

While it is difficult to estimate the level of liquidity needs for each investment fund based on published industry-wide data, supervisors could use more granular data from individual investment funds to compute more accurate estimates, also taking into account alternative strategies pursued by funds to respond to redemption requests. The estimates could also be used by supervisors to assess the severity of assumptions used by investment funds and banks for liquidity risk management and associated stress testing scenarios.

In this context, the CSSF plans to undertake, in the near future, further reflections on possible approaches to estimate liquidity needs arising for investments funds and banks in the case of stressed market conditions.


However, this does not necessarily eliminate all the shock to the industry if investors may decide to shift to a fund managed by another management company or to use another depository.

Macroeconomic stability and fiscal sustainability

26. Finally, macroeconomic policy could also be an important source of risk for the financial sector. The country’s business model as a financial center hinges upon the economic and political stability of the country. A potential deterioration in the country’s fiscal situation and, in an extreme case, doubts about the stability of the AAA sovereign credit rating, could lead investors and the industry to question the viability of the current regulatory and tax environment, ultimately undermining the Luxembourg’s attractiveness as a financial center.2

E. Conclusions and Recommendations

27. The financial sector in Luxembourg is at a critical juncture, faced with economic, market and regulatory changes, as exemplified by the continued decline in banking assets and the growth of investment funds. The authorities need to continuously address those challenges and continue to strengthen the resilience of the financial center.

28. The authorities should transpose the necessary European regulatory reforms initiatives expeditiously, while preserving existing buffers in the banking system:

  • The decision to frontload CRD IV minimum capital requirements is welcome, but the authorities should remain vigilant and carefully monitor systemic banks to determine, in collaboration with European authorities, whether specific additional measures, including requiring additional buffers in a way consistent with the CRD IV framework, might be warranted over time. Applying the D-SIB buffer to domestically-oriented banks should also be considered.

  • An ex-ante deposit guarantee scheme should be established. The overall level of protection should not be lowered from the amount currently provisioned. The authorities should also expedite their work on the national resolution fund while taking into account the ongoing discussion on the design of the SRM, particularly with respect to the single resolution fund.

29. Financial sector oversight could be strengthened further, including through continuing cooperation with the SSM. The operational independence of the CSSF as well as its sanctioning power could be further strengthened as part of the SSM-related revision of the institutional framework. The national supervisors need to continue to play an active role in JSTs of major banks in Luxembourg, as envisaged in the framework. This will also require continued close cooperation between the CSSF and BCL. Close monitoring of domestic residential real estate exposures should be continued, and further macro-prudential measures should be considered if the need arises.

30. Finally, the authorities should closely monitor the entire financial sector, carefully scrutinize new risks, and communicate more proactively on actions to mitigate them. Spillover risks arising from different sectors of the financial industry, as well as emerging risks from ongoing diversification efforts need to be carefully watched and regularly assessed. These assessments should be periodically published to show that the authorities are closely following new developments and emerging trends in the industry. The soon-to-be-established national Systemic Risk Committee will be ideally placed to carry out these mandates. Likewise, to maintain the confidence in the financial sector and ward off reputational risks, more communication on the authorities’ commitment to investor and depositor protection should be carried out, with Luxembourg for Finance, the private-public partnership to market the financial center, to spearhead the effort.


Prepared by Mamoru Yanase (MCM).


UCITS (Undertakings of Collective Investment in Transferable Securities) funds are investment funds regulated at European level. The UCITS Directive provides a regulatory and supervisory framework that makes the funds suitable for retail investors. UCITS funds are given European passports, thus enabling them to be sold in every EU jurisdiction.


Being a euro area country is regarded as an important competitive advantage over other major international financial centers, notably Switzerland and the UK.


The capacity to provide services in non-English European languages is also seen as a big advantage in attracting customers from continental European countries and service providers targeting them.


The low NPL partly reflect the unique business model of the sector, where a large part of the exposure is to counterparties with low risk weights, such as parent banks. But domestically-oriented banks with more traditional retail banking activities also have high capital ratios.


In April 2013, the authorities announced that from 2015, they will start automatically exchanging information on EU residents’ savings income with other tax authorities under EU Savings Directive. Currently, the government imposes a withholding tax of 35 percent—a provision allowed as a transitionally measure under the directive.


The authorities and the industry did not expect any substantial impact from the implementation of U.S. FATCA (Foreign Account Tax Compliance Act), as the sector’s cross-border customer base is centered on Europe.


While there is no set definition, “high net-worth” individuals are often regarded by the private banking industry as those having more than 1 million USD or EUR in financial assets.


CSSF Law (Law of 23 December 1998), Article 3.


Even if the leverage ratio were to become binding, it would only become so in 2018.


As of February 2014, 16 entities are authorized as AIFMs, and 10 more authorizations have been finalized. In addition, 263 other entities do not need a formal authorization as they fall below the AIFM threshold.


The asset under management for CNAV MMFS is EUR 161 bn at end-June 2012, according to an ESRB survey.


In addition, risk-based capital add-ons are applied, in particular with respect to intragroup exposures.


This includes the 4.5 percent minimum common equity capital ratio and the 2.5 percent conservation buffer, which should be fulfilled by CET1 capital.


Banks need to satisfy this requirement by end-2016.


See also Selected Issues Paper: “The Residential Real Estate Market”.


See, for example, “Asset management and financial stability”, U.S. Office of Financial Research, 2013, for the discussion on the financial stability implication of asset management business.


See also Selected Issues Paper: “The Fiscal Position: Sound for Now, but Significant Challenges Ahead”.

Luxembourg: Selected Issues
Author: International Monetary Fund. European Dept.