The new prudential regime for investment firms

Introduction

Significant alterations to the prudential framework

The way in which investment firms are to be treated for the purposes of prudential regulation is changing. The introduction of the Investment Firms Regulation¹ (IFR) and Investment Firms Directive (IFD)² will make significant alterations to the prudential framework governing investment firms.

The new regime deviates from the strict MiFID II³ services-based categorisation and uses instead quantitative indicators (so called K-factors) that reflect the risk that the new prudential regime intends to address. The new regime will mean higher regulatory capital requirements for most investment firms, subject to transitional phasing-in. It will also mean new remuneration rules based on those that are currently applicable to banks, and internal governance and disclosure and reporting requirements.

Legislative process

On December 5, 2019, the IFR and the IFD were published in the Official Journal of the European Union (OJ).

Both the IFR and the IFD enter into force on the twentieth day following its publication in the OJ (December 25, 2019). The IFR becomes directly applicable in Member States 18 months following its entry into force (June 26, 2021). Member States have 18 months following the entry into force of the IFD to adopt and publish measures that transpose the Directive. Most of these measures come into force after this date (June 26, 2021).⁴ The IFR also contains a number of transitional provisions⁵ which are discussed later in this briefing. These provisions are designed to reduce the impact the new requirements will have on investment firms by allowing them to build up the new required amounts of capital over a longer period.

The current prudential regime

Presently, both investment firms and credit institutions are subject to the same EU prudential rules, being a combination of the provisions set out in Capital Requirements Regulation⁶  (CRR) and the Capital Requirements Directive IV⁷ (CRD IV) (and soon under CRD V⁸ and CRR II⁹) which are derived from the Basel standards. This is notwithstanding the fact that investment firms have very different primary business models and risk profiles to credit institutions. The prudential framework for investment firms in the CRR/CRD IV works in conjunction with MiFID II. The prudential requirements that apply to investment firms under the current prudential regime depend on what MiFID II services and activities the investment firm performs. The more risky the activities that an investment firm performs, the more onerous the prudential obligations.

The risks faced and posed by most investment firms is substantially different to the risks faced and posed by credit institutions. Investment firms generally do not have large portfolios of retail and corporate loans and do not take deposits. The likelihood that their failure can have a detrimental impact on overall financial stability is lower than in the case of credit institutions. Therefore the Commission has introduced the IFR and the IFD to ensure that such differences are reflected in the EU’s prudential framework.

Source: EBA December 2015 Report on investment firms, EBA/Op/2015/20

IFR and IFD categorisation of investment firms

Introduction to K-factors

The new regime deviates from the strict MiFID II services-based categorisation and uses instead quantitative indicators known as K-factors that reflect the risk that the new prudential regime intends to address. The new regime differentiates the prudential regime that will apply to investment firms according to the size and complexity of the firm. IFR will divide investment firms into three different classes (discussed further below).

In terms of what is an investment firm for the purposes of the IFR and IFD, this is defined by reference to Article 4(1) of MiFID II¹⁰. Therefore the IFD and the IFR directly impact MiFID II investment firms but not credit institutions, insurers and other financial services firms. The IFD has, however, certain implications for alternative investment fund managers and UCITS management companies in the sense that it provides that own funds of these entities can never be less than the IFR’s fixed overheads requirement¹¹.

The three classes of investment firm are as follows:

• Class 1 firms: Large investment firms. There are two types of investment firm in this class. First, investment firms meeting the conditions of systemically important firms will be reclassified as a credit institution under the CRD IV and CRR. The reasoning behind this is that such investment firms have business models and risk profiles similar to those of significant credit institutions. Their activities expose them to credit risk, mainly in the form of counterparty credit risk, as well as to market risk for positions they take on own account, client related or not. As such they present a risk to financial stability. Second, large investment firms that are not of systemic importance but whose size and activities present some risks to financial stability. These will remain subject to the CRR and CRD IV but will not be required to be reauthorised as a credit institution.
• Class 2 firms: Other investment firms exceeding the categorisation thresholds for small and non-interconnected investment firms. Class 2 investment firms will be subject to the full prudential IFR/IFD regime.
• Class 3 firms: Small and non-interconnected investment firms. These firms will also be subject to the new IFR regime but can benefit from various exemptions and modifications given that the risks incurred by them are limited for the most part.

K-factor formula

The IFR uses quantitative indicators (K-factors) that reflect the risk that the new regime intends to address. K-factors are divided in the IFR into three groups and they aim to capture the risk the investment firm can pose to customers, to market access or the firm itself. This is the most significant innovation of the new regime.

Class 2 firms will be required to calculate their capital requirement based on the K-factor formula.

Class 3 firms are not required to calculate their capital based on the K-factor formula. However, Class 3 firms still need to calculate the K-factors for categorisation purposes.

Categorisation – Class 1 firms

The largest investment firms that provide key wholesale market and investment banking services have business models and risk profiles that are similar to those of significant credit institutions. Their activities expose them to credit risk, mainly in the form of counterparty credit risk, as well as to market risk for positions they take on own account, client related or not. As such, they present a risk to financial stability, given their size and systemic importance. Such investment firms will be reclassified as credit institutions, making them subject to the same prudential requirements as large credit institutions under the CRR and the CRD IV regimes¹².

IFR amends the definition of a credit institution in the CRR¹³ by including firms:

• Whose business includes dealing on own account or underwriting or placing financial instruments on a firm commitment basis (or both)
•  Is not a commodity and emission allowance dealer, a collective investment undertaking or an insurance undertaking
• The total value of the consolidated assets is equal to or exceeds EUR30 billion (special rules apply undertaking is part of a group)

Investment firms meeting these conditions will have to be authorised as a credit institution and will be subject to the same prudential requirements as large credit institutions.

The IFD inserts a new Article 8a into the CRR¹⁴ requiring already authorised MiFID II investment firms to submit an application for authorisation pursuant to Article 8 of the CRR where they meet the above requirements. Investment firms that meet the requirements of systemically important investment firms before the entry into force of the IFR must submit the application for re-authorisation within a year of the IFR/IFD regime coming into force.

The IFR¹⁵ provides that large investment firms will also be subject to the prudential regime set out in the CRR. However, such investment firms will not be required to seek authorisation as a credit institution under the IFD. A large investment firm which is not systemic is classified by the IFR as follows:

• Its business consists of carrying out the activities of dealing on own account or underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis (or both)
• Is not a commodity and emission allowance dealer, a collective investment undertaking or an insurance undertaking
• One of the following has been satisfied: (i) the total value of its assets exceeds EUR15 billion; (ii) it is part of a group where the combined total value of the assets of all undertakings in the group that carry out the MiFID II activities of dealing on own account and underwriting financial instruments and/or placing financial instruments on a firm commitment basis exceeds EUR15 billion.

In addition to the above, an investment firm could come within the scope of Article 1(2) of the IFR where a decision has been taken by a Member State competent authority under Article 5 of the IFD. Article 5 of the IFD gives Member State competent authorities some discretion to subject investment firms to the requirements of the CRR.

The discretionary approach given to Member State competent authorities may be of particular relevance for any investment firm acting as a clearing member.

The IFR also provides that Member State competent authorities may allow investment firms that are subsidiaries and included in the consolidated supervision of a credit institution to continue to be subject to the requirements of the CRR¹⁶.

Significant investment firms relocating from London to the EU27 as a result of Brexit should also consider whether they are affected by the new Class 1 classification.

Categorisation – Class 2 firms

A Class 2 firm is an investment firm that exceeds one of the pre-defined thresholds set out in the table below for Class 3 firms. Class 2 investment firms will be subject to the full prudential requirements set out in the IFR and IFD.

Categorisation – Class 3 firms

Class 3 firms are those investment firms that do not conduct investment services which carry a high risk for clients, markets or themselves and whose size means they are less likely to cause widespread negative impacts for clients and markets if the risks inherent in their business materialise or if they fail.

Class 3 firms still need to calculate the K-factors for categorisation purposes. The methodology is based on a threshold approach whereby the investment firm is precluded from being a Class 3 firm if an indictor exceeds one of the pre-defined thresholds set out in the table below. The selected indicators are the K-factors. This approach assumes that the threshold is an indication of the riskiness of an investment firm and the potential impact it can have on others.

The categorisation thresholds for Class 3 firms are as follows:

Transition between Class 2 and Class 3

A Class 3 firm will become a Class 2 firm (either immediately or after three months) if it no longer satisfies the above categorisation thresholds. A Class 2 firm will become a Class 3 firm, if it has satisfied the above categorisation thresholds for six months and no breach has occurred. Class 2 and Class 3 firms will therefore be required to monitor the categorisation thresholds.

New prudential requirements

This section will focus on the new requirements under the IFR/IFD regime which affect those investment firms that fall into Classes 2 and 3.

Level of application

Investment firms subject to the IFR must comply with the requirements relating to own funds composition, capital requirements, the K-factor requirements, concentration risk, liquidity requirements, the disclosure and reporting requirements on a solo basis. However, in the event a Class 3 firm is part of a banking consolidation group the Member State competent authority responsible for consolidated supervision can waive this requirement in certain circumstances.

On the other hand, the IFR provisions apply to a parent investment firms, parent investment holding companies or parent mixed financial holding companies on a consolidated basis. Alternatively, instead of prudential consolidation, where the investment firm is part of a group structure which is deemed sufficiently simple and if there is no significant risk to clients or to the market stemming from the investment firm group as a whole that would otherwise require supervision on a consolidated basis as set out in Article 8 of the IFR, Member State competent authorities may allow the parent undertaking in the group to have sufficient capital to support the book value of its holdings in the subsidiaries.

Entities within a group structure will therefore need to determine at an early stage which group regime will apply to the group.

Own funds

The own funds requirements are set out in Articles 9 and 10 of the IFR. Class 2 firms shall at all times have own funds (consisting of the sum of Common Equity Tier 1, additional Tier 1 and additional Tier 2, subject to certain conditions) which amount at least to the highest of the following:

• The fixed overheads requirement
• The permanent minimum requirement
• The K-factor requirement

For Class 3 firms there is a simple application of a minimum own funds requirement. Such investment firms should have own funds equal to the higher of their permanent minimum capital requirement or a quarter of their fixed overheads measured on the basis of their activity of the preceding year. Class 3 firms will not be subject to the K-factor requirement. Class 3 firms that wish to exercise caution and avoid the cliff edge effects of being reclassified as a Class 2 firm may hold own funds in exccess of that required by the IFR¹⁷.

The fixed overheads requirement

This is the amount equal to at least one quarter of the investment firm’s fixed overheads for the preceding year¹⁸. Draft regulatory technical standards (RTS) on the exact method of calculating this will be issued by the European Banking Authority (EBA). The EBA is expected to submit draft RTS to the Commission within 12 months after the date of entry into force of the IFR.

The permanent minimum requirement

Under the new K-factor regime, the permanent minimum capital requirement acts as a floor for all levels of capital required under the new regime. The permanent minimum capital requirement (which is required on an ongoing basis) shall amount at least to the levels of the initial capital requirement (which is required in the authorisation phase).

The initial capital requirement is set out in Article 9 of the IFD and is based on the MiFID II services that an investment firm is authorised or plans to offer. As mentioned later in this note, transitional arrangements will be available. The varying amounts and the activities they are tied to are summarised in the table below:

K-factor requirements

The K-factor requirements are calculations that are entirely new and unique to the regime. The requirements are tailored to the respective activities of an investment firm, with a view to creating a capital requirement that is more directly proportional to the risk profile of the investment firm than was achievable under the previous CRR/CRD IV framework.

The K-factors specifically target those services and business practices that are most likely to generate risks for a particular investment firm. As mentioned above, K-factors are divided in the IFR into three groups and they aim to capture the risk the investment firm can pose to customers, to market access or liquidity or the investment firm itself. The overall K-factor position is a sum of the K-factors in respect of the three heads of risk. The general principles concerning the calculation of the three groups of K-factors – Risk-to-Client (RtC), Risk-to-Market (RtM) and Risk-to-Firm (RtF) – can be found in Article 15 of the IFR.

Class 2 firms will be required to calculate their capital requirement based on the K-factor formula.

RtC

For the vast majority of investment firms, the most important element of risk will be the potential harm they may pose to their customers. The K-factor RtC covers a range of different factors, taking into account the need for full coverage of a wide range of investment firms and different ways in which they can service customers.

RtC is the sum of client assets under management (K-AUM), client money held (K-CMH), assets safeguarded and administered (K-ASA), and client orders handled (K-COH), multiplied by a corresponding coefficient¹⁹.

RtM

The RtM K-factor requirement for the trading book positions of an investment firm dealing on own account, whether for itself or on behalf of a client shall be either the net position risk (K-NPR) calculated in accordance with Article 22 of the IFR or clearing member risk (K-CMG) calculated in accordance with Article 23 of the IFR.

The RtM applies to all trading book positions, which include in particular positions in debt instruments (including securitisation instruments), equity instruments, collective investment undertakings, foreign exchange and gold, and commodities (including emissions allowances). For the purposes of calculating the RtM, investment firms shall include positions other than trading book positions where these give rise to foreign exchange risk or commodity risk.

In summary, the calculations are as follows:

RtF

The K-factors under the RtF cover an investment firm’s exposure to the default of their trading counterparties (K-TCD) in accordance with simplified provisions for counterparty credit risk based on the CRR, concentration risk in an investment firm’s large exposures to specific counterparties based on the CRR that apply to large exposures in the trading book (K-CON), and operational risks from an investment firm’s daily trading flow (K-DTF).

The RTF-factor requirement is the sum of K-TCD, K-DTF and K-CON calculated in accordance with the IFR requirements²⁰ and in relation to K-DTF multiplied with the respective coefficient.

Liquidity

Investment firms will also be required to hold an amount of liquid assets equal to at least one third of their fixed overheads requirement. This is in addition to the own funds requirements. Modified requirements apply to Class 3 firms²¹. Member State competent authorities may also exempt Class 3 firms from the liquidity requirement completely. Should a Member State competent authority make an exemption it will have to notify the EBA.

Exactly what can be used to comprise the liquid asset component is set out in Article 43 of the IFR, which contains strict requirements as to what would be applicable. The requirements are detailed and stringent, but in summary, the following would all be included within that which could be used as liquid assets:

• Central bank exposures
• National government claims
• High quality covered bonds
• Corporate debt
• Securitisations and unencumbered short term bank deposits (subject to certain eligibility criteria)
• Shares and units in a collective investment scheme (up to a maximum value of EUR50 million)

The above is a non-exhaustive list, and other types of asset may be applicable.

ICAAPS

Investment firms must have in place an internal capital adequacy process (ICAAPs). The process needs to be appropriate and proportionate to the nature, scale and complexity of its activities. There is an exemption available for Class 3 firms. However, a Member State competent authority can request a Class 3 firm to comply with the ICAAP requirement.

Other issues emerging from the new prudential regime

Remuneration requirements

The IFR/IFD includes remuneration requirements²² largely based on the framework set out in CRR/CRD IV. Key features include a requirement for variable remuneration to include at least 50 per cent as non-cash, that variable remuneration must be deferred over a three- to five-year period, and that all variable remuneration components must be subject to malus and clawback.

Broadly speaking, remuneration policies should be proportionate to the size and nature of the investment firm. Investment firms shall disclose certain information regarding their remuneration policy and practices²³ including aspects related to gender neutrality and the gender pay gap, for those categories of staff whose professional activities have a material impact on the investment firm’s risk profile.

With respect to the remuneration provisions, the House of Commons’ European Scrutiny committee noted when clearing the IFR and IFD from scrutiny:

“with respect to pay practices in the investment industry, the rules introduce new restrictions on variable remuneration to discourage excessive risk-taking in pursuit of higher pay, in particular by deferring bonuses and requiring them to be partially paid out in the form of instruments like shares. However, these new restrictions would not apply to investment firms with less than €300 million (£256 million) in assets, or to individual employees who are paid €50,000 (£42,700) or less by way of bonus in a given year. The Minister notes with satisfaction that there will not be a bonus cap for staff in Class 2 and 3 investment firms.”

Governance and reporting obligations

The IFR/IFD prescribes a wide range of reporting and disclosure obligations upon firms that are held to be in scope. Public disclosures are required in respect of capital, capital requirements, risk management objectives and policies; internal governance arrangements; and remuneration policies and practices.

In terms of reporting, Article 54 of the IFR provides that on a quarterly basis investment firms shall report to their Member State competent authority on a quarterly basis the:

• Level and composition of own funds
• Own funds requirements
• Own funds requirement calculations
• Where the firm is a Class 3 firm – the level of activity, including the balance sheet and revenue breakdown by investment service and applicable K-factor
• Concentration risk
• Liquidity requirements

A derogation from the above is that Class 3 firms may report on an annual basis.

In addition to amending the prudential regime for investment firms, the IFR and the IFD are part of a package of EU legislative measures that revise third country access to the EU. The other legislative measures include changes to the Regulations establishing the European Supervisory Authorities’, revisions to the European Markets Infrastructure Regulation (known as EMIR 2.2) and the Benchmarks Regulation.

All of these legislative measures were touched on in the Commission’s communication on equivalence which was published in the summer. It’s in this communication that the Commission talked about the equivalence process being a risk management exercise, particularly in relation to ‘high impact third countries,’ and that as part of the equivalence process the Commission will talk to third countries about the prudential treatment they will grant to EU market participants.

The key provision in the IFD is Article 55 which deals with the supervision of investment firms with parent undertakings in third countries. It provides that where two or more EU investment firms are subsidiaries of a third country parent undertaking, Member States shall assess whether the investment firms are subject to supervision by the parent’s supervisory authority which is equivalent to the supervision set out in the IFR and the IFD. Where this is not the case, the Member State competent authority which would be the group supervisor had the parent undertaking been established in the EU, may, after consulting other relevant Member State competent authorities, apply certain supervisory techniques including requiring the establishment of an investment holding company or a mixed financial holding company in the EU.

Article 63 of the IFR amends Article 47 of the Markets in Financial Instruments Regulation, which relates to equivalence decisions taken by the Commission concerning third country jurisdictions.

There are a couple of points to note in Article 63:

• The Article requires a “detailed and granular assessment” of the legally binding prudential, organisational and business conduct requirements the third country firm is subject to where the scale and scope of the services to be provided by the firm is likely to be of systemic importance for the EU.
• Further detail on how systemic importance is assessed will be set out in a Delegated Act.
• The Commission must also assess and take into account the supervisory convergence between the third country concerned and the EU.
• Where the scale and scope of the services provided by the third country investment firm is likely to be of systemic importance for the EU, the Commission may attach specific operational conditions to the equivalence decision.

If equivalence is granted by the Commission, it will be very much the beginning, rather than the end of the story. The IFR contains monitoring and reporting requirements in relation to equivalence decisions, as well as provisions on how a third country firm’s registration with the European Securities and Markets Authority may be restricted or withdrawn.

Transitional measures

Article 57 of the IFR sets out transitional arrangements. In summary, it specifies that for a period of five years from the date of entry into force of the IFR:

• Investment firms for which capital requirement under the new regime would more than double compared to their existing capital requirement under the current framework should be allowed to limit their capital requirement to twice their relevant capital requirement under the CRR and the CRD IV.
• Investment firms that were not subject to capital requirements under the CRR and the CRD IV may apply a limit at twice their fixed overheads requirement.
• Investment firms that were only subject to a requirement for initial capital under the CRR and the CRD IV can limit their capital requirement to twice this requirement.

Also, investment firms should calculate their K-NPR in accordance with the existing CRR for a period of five years from the date of entry into force of the IFR, or until the date of entry into force of the changes relating to capital requirements for market risk as set out in the revised CRR²⁴, whichever is later.

UK implementation and Brexit

The IFR and the IFD were both set out in the Financial Services (Implementation of Legislation) Bill indicating that the UK Government would implement them in a no deal Brexit scenario. The FCA stated in its Business Plan this year that it intended to publish a consultation paper in Q4 2019 on the implementation of the IFR and the IFD.

What does the new prudential regime mean in practice?

The starting point for MiFID II investment firms is to start assessing the IFR and the IFD so that they can understand which class of investment firm they will be categorised as. This will be particularly important for UK investment firms looking to establish an entity in the EU27 in light of Brexit. Following this the investment firm can then start assessing what adjustments need to made to capital, liquidity risk, reporting, and remuneration requirements. Another important assessment is whether the shift in the prudential capital framework creates an opportunity for a change in business strategy and approach.