Trend Watch 2023

Trend Watch 2023 Publication: 3 November 2022

2 Trend Watch 2023 Contents Introduction Page 03 01 Trends Page 07 02 Risk Maps Page 35 03 The Gas Term Market Page 53 04 Impact of Sustainable Investing Page 65

3 Trend Watch 2023 Introduction

4 Trend Watch 2023 Trend Watch addresses important trends and risks in the financial sector. Trend Watch provides background, depth, and coherence regarding relevant supervisory topics. Early detection and understanding of changes in the sector contribute to a risk-oriented, forward-looking, and preventive supervisory approach. In this way, we give substance to our mission to strengthen ourselves for fair and transparent financial markets and to contribute to sustainable financial well-being. Chapter 1 covers developments in areas such as macroeconomics, sustainability, and digitalization. Based on the identified trends, we describe key issues within our supervision and, where possible, provide directions for solutions. The risk maps for the four AFM supervisory areas (Chapter 2) indicate the main risks per supervisory area from their interaction with the trends in Chapter 1. Developments in the gas term market and the market for sustainable investing receive special attention in this edition (Chapters 3 and 4).

Trends Since the previous edition of Trend Watch, the geopolitical and macroeconomic landscape has changed significantly. The cautious optimism that prevailed at the beginning of 2022 regarding the approaching end of the coronavirus pandemic and corresponding lockdowns has now been replaced by a sense of ongoing crisis. A defining turning point was Russia's invasion of Ukraine, which has contributed to energy prices reaching unimaginable levels and inflation reaching record highs (already on an upward trend before the invasion). The increased energy prices and price increases for many other goods and services have a major impact on households (loss of purchasing power) and companies (production costs, transport costs).

1 'Macroeconomic Exploration 2023', CPB, September 2022.

The economic picture emerging from the strongly changed environment has two faces and is characterized by a high degree of uncertainty. Even after Russia's invasion of Ukraine, the Dutch economy continued to grow. Even harder than expected. There are still many vacancies, meaning labor market tightness persists and unemployment remains low. Due to high inflation, consumer confidence is low. However, consumer spending remains at a high level, partly due to catch-up spending after the coronavirus lockdowns. Due to those same lockdowns, groups of households have saved a lot over the past years and therefore have good buffers. The general expectation is that the Dutch economy will continue to grow in 2023, albeit at a significantly lower level than in recent years. In the estimates, such as those by the CPB, attention is drawn to great uncertainties in the economic climate, particularly regarding the development of energy prices.1

Different effects are also visible among households and companies. The extent to which high inflation and high energy prices lead to acute problems depends on many individual factors, for example, how long the fixed energy contract lasts, whether there are solar panels on the roof, and whether the house is well insulated. As a result, there are households that experience relatively few consequences, as well as households whose financial security is directly threatened ('eat or heat'). The picture also varies for companies. Companies that manage to pass on the increased costs to their customers can maintain or even increase their profitability. While other companies that can pass on costs to a lesser extent are getting into trouble. Meanwhile, the government is relying on large support packages to mitigate the consequences of high energy prices and high inflation. An important measure to support household purchasing power is the introduction of a price cap for energy. A challenge is to ensure that support reaches where it is most needed. When a significant portion of (generic) support measures ends up with households and companies that do not directly need this support, this can lead to extra spending that actually fuels inflation further.

After more than 10 years of steady decline, interest rates are rising. In response to high inflation, central banks are raising policy rates with bold steps. The direct effects of rising interest rates are still limited. Mortgage and consumer credit rates are rising, but given the long terms and mostly fixed interest percentages, the interest rate increase only affects new issuances and a small portion of mortgages whose fixed-rate period is expiring. The consequences are visible more quickly for pension funds; the interest rate increase is the most important factor in restoring their funding ratios. The indirect consequences of rising interest rates and the underlying cause—inflation—are considerably larger. This has led to falling stock prices and, in its wake, more risky assets (cryptocurrencies, tech sector, SPACs) have been hit even harder. Decreasing search for yield, as a result of rising interest rates, increases the robustness of capital markets.

Financial markets have so far weathered the geopolitical and economic turbulence well. After the financial crisis, strengthening measures were introduced in the system for professional market participants, such as measures regarding risk management and larger capital buffers, to prevent a recurrence of a crisis of such magnitude. These strengthening measures seem to be bearing fruit. This does not mean there are no points of attention. Think, for example, of the current challenges on the gas term market, a market that is extensively illuminated in Chapter 3 of Trend Watch. With regard to households, the suddenly worsened (purchasing power) circumstances have underscored the utility of various consumer protection measures, such as the lending norms that limit the taking of consumer and mortgage credit. Nevertheless, the vulnerability of (specific groups of) households will remain a challenge in the coming period. In particular, financial service providers will need to pay extra attention to their duty of care.

In addition to acute changes, structural transitions and trends continue. The importance of the transition to a sustainable society is becoming increasingly prominent. Climate change and the associated extreme weather conditions, and on a national level also the nitrogen problem, already have major consequences. Much supervisory attention is focused on promoting transparency regarding the impact companies have on their environment and on how the financial sector can play its role in facilitating financing flows to enterprises and projects that contribute to sustainability. Improvement of reporting by companies regarding sustainability risks and performance plays a key role in this. With increasing attention for sustainability, sustainable investing is gaining popularity. A growing supply of investment products responds to this. However, the way in which investments contribute to the sustainability transition is not always clear to consumers. Chapter 4 of Trend Watch offers an in-depth analysis on this subject. Digitalization and platformization also cause major changes in the way financial products and services are offered and consumed. The increasing dependence on digital systems combined with the trend of outsourcing digital business processes creates vulnerabilities in the financial sector. New European legislation attempts to influence the direction of various digital developments and address potential risks. For example, the Digital Operational Resilience Act (DORA) aims to strengthen the digital resilience of enterprises, and the Markets in Crypto-Assets Regulation (MiCAR) takes a first step in the regulation of cryptocurrencies. The trend of internationalization means that financial markets are increasingly taking on an international character. In addition to the positive effects of an increase in supply and greater diversity of providers, the cross-border nature of financial markets leads to cross-border risks that are increasingly inadequately addressed at the national level. In response to this, we see a movement towards further internationalization of supervision and supervisory convergence.

6 Trend Watch 2023 Risks The risk maps provide an overview of important risks per supervisory area. The risk maps make it clear how the changing environment works through on specific risks. There are risk maps for each of the four supervisory areas of the AFM: financial services, capital markets, asset management, and reporting and audit firms. Below, some risks are highlighted per supervisory area; for the full overview, reference is made to Chapter 2.

Financial services. Within financial services, the pension transition stands out. The system change is complex and has profound consequences for millions of households. The transition also brings impactful and irreversible choices regarding the pension date as well as during the working period. Therefore, the importance of careful choice guidance increases. Additionally, attention is paid to how high inflation and, in its wake, rising interest rates could exacerbate the risk of over-indebtedness. Furthermore, the risk map highlights points of attention regarding: the low-threshold access to risky products such as cryptocurrencies, the pressure that the consolidation trend in the financial services sector can place on the quality of service provision, and consumers in vulnerable situations being tempted into less suitable, or even illegal, financial services.

Capital markets. For capital markets, it applies that macro-economic and market-disrupting factors create unrest and uncertainty on financial markets. This can affect the orderly functioning of markets. Additionally, advanced digitalization places high demands on the controlled management of institutions active in capital markets. The operational digital resilience of institutions therefore receives our attention. Think of preventing disruptions and outages, the use of AI, and maintaining cybersecurity. Market dynamics and complex regulation ultimately contribute to concentration in the trading chain through the so-called winner-takes-all effect. Dependence on a few institutions makes markets less robust.

Asset management. Within the asset management supervisory area, attention is paid, among other things, to the strategic repositioning of parties and the outsourcing of activities. This influences the strategy of asset managers and may place pressure on sound and controlled management. Additionally, we see that technological developments and digitalization are changing the management of asset managers and the wealth management chain, and we emphasize the risk that the asset management sector still appears insufficiently resilient to cyber incidents. The important role that asset management parties play in the sustainability transition is also addressed. It is important that asset managers integrate sustainability into their management, control risks of the sustainability transition, and are transparent to investors regarding how sustainability is implemented. Due to high volatility in capital markets, we pay extra attention to liquidity risks in the asset management sector, as these may undermine the financial stability of the system.

Reporting and audit firms. Digitalization and sustainability change the nature of audited enterprises and lead to new material risks. This places different demands on reporting and audit control, with the risk that these changes are not implemented sufficiently. Furthermore, sustainability and the economic conjuncture create an increased risk of fraud and discontinuity. Additionally, audit firms themselves are also changing, partly due to digitalization, which comes with new control risks. There is also an important change in supervision: the shift of supervisory focus from the segment of regular license holders to the AFM. We are therefore working, among other things, on increasing insight into integrity risks in this segment.

Agenda 2023 Trend Watch contributes to determining the supervisory priorities of the AFM. The concrete implications of the trends and risks for our supervisory activities are elaborated in the Agenda 2023, which will be presented in early 2023.

7 Trend Watch 2023 01 Trends Annually, the AFM conducts an environmental analysis of trends that influence the way we supervise. This chapter describes these important trends in the areas of (1) macroeconomics, (2) sustainability, (3) digitalization, (4) internationalization, and (5) financial crime and integrity. The final paragraph addresses developments in the supervisory landscape.

01 8 Trend Watch 2023 1.1 Macroeconomic Climate In the Netherlands, economic prospects have deteriorated due to rising inflation and increasing pressure on economic growth. The strong economic contraction due to the coronavirus pandemic was followed by robust economic recovery in 2021. At the end of 2021, the tide began to turn cautiously due to rising inflation, partly caused by supply-side frictions (e.g., chip shortage) and catch-up spending in consumer spending after the coronavirus lockdowns. This supply friction has been reinforced since the beginning of this year by Russia's invasion of Ukraine. The sanctions imposed by Europe on Russia and closed factories in Ukraine have halted many production processes and disrupted trade flows, particularly in the energy and raw materials market. This leads to very strong price increases, including those of energy and raw materials, which further disrupt production processes. In the Netherlands, this is reflected in high inflation, which has shown a nearly continuous upward trend since August last year (see Figure 1). In September this year, inflation rose to 14.5%, the highest figure ever measured by the CBS. The supply disruptions and rising inflation lead to downwardly adjusted GDP growth estimates. For now, the effect of rising inflation is still limited in the growth figures of the Dutch economy, but it is expected that this effect will become stronger at the end of 2022 and beginning of 2023.

High inflation leads to a decrease in purchasing power for Dutch households, and this affects different income groups unequally. Because inflation is mainly caused by higher energy and raw material prices that flow through into the prices of various products, the purchasing power of Dutch households deteriorates if wage growth lags behind. The CPB estimates that the collective labor agreement (cao) wage increase for companies in 2023 will amount to 3.7%.1 Although this is more than in previous years, it will not be enough to compensate for the purchasing power loss of 2022—the CPB expects that purchasing power in the average household will decrease by 6.8%. In the Budget Memorandum 2023, the government has therefore announced several (temporary) policy measures so that purchasing power in the average household increases by more than 3% in 2023. The extent to which a household experiences a loss of purchasing power depends, among other things, on the level of energy consumption, which is again partly determined by the energy efficiency of the home. Additionally, households with low incomes remain vulnerable because they spend a relatively larger portion of their income on basic necessities (e.g., food and energy) and often have less savings buffers built up. This increases the chance of financial stress for this group, which may lead to suboptimal financial decisions, such as the accumulation of (consumer) credit and payment alternatives like private lease and buy-now-pay-later.

Geopolitical tensions and deteriorated macroeconomic conditions have a major impact on consumer confidence in the economy. Consumer confidence is falling sharply this year, breaking low records from the past. Currently, consumer confidence hovers around -50. Consumers state they have very little confidence in both the economy and their own situation (see Figure 2). Despite this, consumer spending remains at a high level.2 A explanation for this is that households have built up more savings during the coronavirus pandemic. Additionally, the current tight labor market, and the resulting high job security, play a role. Also, high energy prices are not yet felt in the wallet by every household. It is expected that over the course of the year, more and more households will feel the high inflation and that spending will decrease as expected. Here, it is also important to what extent wages rise along with high inflation.

01 9 Trend Watch 2023 Figure 1. Left: Strong increase in Dutch inflation (CPI), mainly driven by high energy prices. Right: Inflation is also rising in the eurozone, but not as hard as in the Netherlands.3 3 HICP: Harmonized Index of Consumer Prices. This is the European standard for inflation. Source: CBS, Eurostat, Macrobond.

Figure 2. Left: Strong decline in consumer confidence. Right: The sub-indicators of consumer confidence—willingness to buy and economic climate—are also falling sharply. Source: CBS, Eurostat, Macrobond. Percentages jan-18 jul-18 jan-19 jul-19 jan-20 jul-20 jan-21 jul-21 jan-22 jul-22 Inflation of energy and food prices Inflation (CPI) Core Inflation -2 0 2 4 6 8 10 12 14 16 18 -2 0 2 4 6 8 10 12 14 16 18 Percentages jan-18 jul-18 jan-19 jul-19 jan-20 jul-20 jan-21 jul-21 jan-22 HICP (NL) CPI (NL) HICP (Eurozone) jul-22 -2 0 2 4 6 8 10 12 14 16 18 -80 -60 -40 -20 0 20 40 60 jan-10 nov-10 sep-11 jul-12 mei-13 mrt-14 jan-15 nov-15 sep-16 jul-17 mei-18 mrt-19 jan-20 jul-22 nov-20 sep-21 Consumer Confidence * Balance % positive and negative answers Index*

• Balance % positive and negative answers -80 -60 -40 -20 0 20 40 60 jan-10 okt-10 jul-11 apr-12 jan-13 jul-14 okt-13 apr-15 jan-16 okt-16 jul-17 apr-18 jan-19 okt-19 jul-20 apr-21 jan-22 Economic Climate Willingness to Buy Index*

01 10 Trend Watch 2023 Rising Interest Rates After a long period of steadily declining interest rates to a very low level, (nominal) capital market and policy interest rates have been rising for some time. The direct effects of rising interest rates seem limited for now. On the other hand, the indirect consequences of rising interest rates and the underlying cause—inflation—appear considerably larger. Points of attention for the AFM regarding these developments seem to lie primarily in the increase in payment risks on credit by consumers, the redistribution of pension wealth, and margin calls on derivative portfolios. Figure 7 gives an overview of points of attention regarding rising interest rates from the AFM's supervisory perspective.

For central banks, the persistently high inflation is a reason to raise the policy rate. A number of central banks, including the ECB, the Fed, and the Bank of England, aim to maintain price stability. They strive for an inflation rate of 2% in the medium term. In this way, monetary policy would make the best contribution to economic growth and employment. Now that inflation is rising significantly beyond the 2% target, this puts pressure on the very loose monetary policy regimes that central banks have followed for several years. The Fed and the Bank of England already started tightening their monetary policy at the beginning of 2022 by raising policy rates. The European Central Bank (ECB), now that inflation is also persistent in the eurozone, decided in the summer to start tightening monetary policy by stopping the expansion of the purchase program and raising the policy rate (see Figure 3, left). The policy rate thereby went above 0%, meaning that for the first time in eight years, there is an end to negative policy rates. It is expected that central banks will continue to raise policy rates in the coming period to cool the economy and bring inflation back to the 2% target.

4 The downside of this is that the wealth of companies and households is affected, see also: 'Households suffer large losses on stocks again', DNB, September 2022.

The rise in interest rates helps to bend the imbalances in the financial sector, which have built up due to long-term low interest rates, towards more robust market conditions. Long-term low interest rates have caused increasing pressure on the solidity of financial institutions, such as banks, (life) insurers, and pension funds, in recent years. Additionally, low interest rates led to very loose financial conditions and a search for yield prevailed among investors and financial institutions. Especially this search for yield causes various imbalances in the financial sector, because underlying risks are systematically undervalued. This manifested in strongly increased stock prices and other asset valuations, the rise of risky assets like SPACs and cryptocurrencies, and the overextended housing market and the associated pressure on mortgage lending norms. The normalization of interest rates leads to a revaluation of risks, which is visible in, among other things, the recently started decline in house prices and the already longer declining stock and cryptocurrency valuations (see Figure 3, right).4 Additionally, the pressure on the business models of banks and life insurers decreases on a relatively short term, and the funding ratio of pension funds increases. This increases the financial resilience of these financial institutions (see also Figure 7). Note, however, that the real interest rate—the nominal interest rate corrected for inflation—is falling due to recent high inflation levels. This weakens the impact of the rising nominal interest rate.

01 11 Trend Watch 2023 Figure 3. Left: Central banks let policy rates rise. Right: Decline visible in stock valuations since peak end of 2021. Source: ECB, Fed, BoE, Euronext, MSCI, Macrobond.

The higher interest rates have led to higher funding ratios and possible indexation of pension claims in recent months, but this will mostly not be sufficient to fully compensate pension participants for high inflation. An increase in interest rates has, on the one hand, a positive effect on the funding...