EU prudential regime for investment firms - what's the state of play?

The new EU prudential regime for investment firms is expected to be published in the EU Official Journal towards October 2019 and to take effect around mid-2021. The regime introduces a tailored prudential framework for investment firms in the EU, setting new rules and requirements with respect to capital, liquidity and regulatory reporting, as well as internal governance and remuneration.

Introducing a proportionate and fit-for purpose prudential framework for investment firms, the regime keeps ‘bank-like’ investment firms with consolidated asset size above € 30 billion subject to the Capital Requirements Directive (CRD) and Regulation (CRR), considering they are ‘systemic’ by virtue of their size and interconnectedness with other financial and economic actors. These firms (‘Class 1’) will be given the status of credit institutions and will go under direct supervision of the European Central Bank (ECB) within the Single Supervisory Mechanism (SSM) to ensure a more effective supervision of cross-border wholesale market activities. Given this category consist of UK-headquartered investment firms, direct supervision by the ECB is expected to address any potential supervisory challenges that may emerge from the expected shift of operations by UK-based large investment banks to the Eurozone due to Brexit.

Deviating from the proposed framework, the final regime introduces two additional sub-classes for Class 1 firms. The first sub-class captures the EU Markets in Financial Instruments Directive (MiFID) licenced firms providing underwriting and dealing on own account services with asset size above € 15 billion. Considering that these firms have business models and risk profiles that are similar to those of significant credit institutions, it subjects these firms to CRD and CRR, but not to the direct supervision of the ECB under SSM. 

The second sub-class captures MiFID firms providing underwriting and dealing on own account services with asset size of between €5 billion and €15 billion, for which national competent authorities (NCAs) would be able to impose the CRD and CRR rules depending on whether their business models and risk profiles are similar to those of banks and, hence, pose a systemic threat to financial stability.

The regime introduces tailored rules for ‘non-systemic’ (‘Class 2’) investment firms based on a number of quantitative thresholds. It defines these firms as those firms that deal on own account and incur risk from trading financial instruments, hold client assets or money, have assets under both discretionary portfolio management and non-discretionary (advisory) arrangements of over € 1.2 billion, handle in excess of  € 100 million per day of client orders in cash trades or € 1 billion per day in derivatives, and have a balance sheet size of over € 100 million including off-balance sheet items, and total gross annual revenues from the performance of their investment services of over € 30 million.

While the regime applies certain thresholds on a combined basis it applies others on an individual basis to prevent regulatory arbitrage and reduce the incentive for investment firms to structure their operations strategically in an effort to avoid exceeding the categorisation thresholds.  For instance, while thresholds such as those for assets under management, client orders handled, balance sheet size and total gross revenues will apply on a combined basis for all investment firms that are part of the same group, the other criteria, namely whether an investment firm holds client money, administers or safeguards client assets, or trades financial instruments and incurs market or counterparty risk, will be assessed on an individual basis.

The most striking novelty introduced by the new regime is the so-called ‘K-factors’ approach to calculating capital requirements, which captures the risks that Class 2 investment firms can pose to their customers, the markets in which they operate and to themselves, i.e. those risks that may arise from market price movements, counterparty defaults and credit deterioration.  To capture each of these three components, firms are required to use the respective metrics multiplied by prescribed coefficients for assets under management, client money held, assets safeguarded and administered, customer orders handled, trading counterparty default requirement, daily trading flow and concentration risk requirement, net position risk and clearing member margins required. This approach is intended to establish a tailored prudential regime for investment firms in view of their specific business models and the risks they pose to their customers, themselves and the wider market. 

For the remaining ‘small and non-interconnected’ (‘Class 3’) firms, the regime introduces much lighter prudential rules, reducing their compliance burden. For instance, firms in this category will be required to calculate their capital requirements based on their initial regulatory capital requirement of €75,000 or a quarter of their fixed overheads for the previous year, whichever is higher.

The regime also introduces new rules regarding Pillar 2 capital add-ons, allowing NCAs to impose additional capital requirements for risks not covered by the Pillar 1 capital requirements. NCAs will also be able to set additional requirements in relation to capital and liquidity as part of their supervisory assessment of firms’ internal governance and controls, risk management processes and procedures. Firms will be required to meet at least 3/4 of the additional capital requirements with Tier 1 capital and at least 3/4 of the Tier 1 capital should be composed of Common Equity Tier 1 (CET1) capital. Firms will not be allowed to use these own funds to meet other capital requirements.

The final regime also requires Class 2 and Class 3 investment firms to have internal procedures to monitor and manage their liquidity requirements and to hold a minimum 1/3 of their fixed overheads requirement in liquid assets at all times. But, compared to the initial proposal, the framework now allows NCAs to use their discretion to exempt Class 3 investment firms from this requirement. 

In addition to capital and liquidity requirements, the new regime also introduces a complex mix of rules with respect to concentration risk rules, consolidated supervision, reporting and disclosure, as well as governance and remuneration. But it sets to apply these proportionately in line with the scale and complexity of different types of investment firms, which should help to provide a level playing field across the EU. The new regime requires firms to report on the level and composition of their own funds, their capital requirements, the basis for the calculation of their capital requirements, their activity profile and size in relation to the parameters for considering investment firms as small and non-interconnected, their liquidity requirements and their adherence to the provisions on concentration risk. But the regime exempts Class 3 firms from reporting on concentration risk and requires them to report on liquidity requirements only where these apply to them. They are also exempted from the public disclosure requirements, except where they issue Additional Tier 1 capital instruments. 

For Class 2 firms, the regulatory reporting and disclosure regime will be more burdensome. Firms in this category will be required to publicly disclose their levels of capital, their capital requirements, their governance arrangements and remuneration policies and practices to provide transparency to their investors and the wider markets. They will also have to submit a quarterly report to the competent authorities including the level and composition of own funds, capital requirements, capital requirement calculations, the level of activity in respect of the balance sheet and revenue breakdown by investment service and applicable K-factor, concentration risk and liquidity requirements. 

A key reporting requirement for Class 2 firms will be the concentration risk reporting. Firms in this category are required to report at a very granular level including on the level of concentration risk associated with the default of counterparties and with trading book positions (both on an individual counterparty and aggregate basis), the level of concentration risk towards credit institutions, investment firms and other entities where client money is held, level of concentration risk towards credit institutions, investment firms and other entities where client securities are deposited, level of concentration risk towards credit institutions where the firm’s own cash is deposited; and level of concentration risk from earnings.

Firms dealing on own account and/or underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis will also be required to verify the size of their total assets monthly but  report quarterly if the total value of the consolidated assets exceeds €5 billion. The new regime will also allow NCAs to impose additional or more frequent reporting requirements, including reporting on capital and liquidity positions, as long as the information to be reported is not duplicative. The EBA is expected to develop draft implementing technical standards to specify the formats, reporting dates and definitions and associated instructions by one year from the date of entry into force of the regime in consultation with European Securities and Markets Authority (ESMA). Firms with on-and off-balance sheet assets of over €100 million will also be required to make additional disclosures on environmental, social and governance (‘ESG’) objectives. Again, the EBA is expected to introduce further technical guidance within two years from the implementation date of the regime.

Differences in the application of the current prudential framework in different Member States had threatened the level playing-field for investment firms across the EU. In the absence of a harmonised prudential framework for the regulation and supervision of the investment firms, some national regulatory authorities had resorted to adjusting the application in national law depending on the services these firms provide, granting exemptions from liquidity, large exposures and leverage rules, while others had chosen to apply large capital add-ons to larger investment firms to address the specific risks they face. 

The prudential framework for investment firms had been based on the regulatory standards set for large banking groups by the Basel Committee and had therefore focused predominantly on the prudential regulation of banks. Application of these standards in the EU through the Capital Requirements Regulation and the Directive therefore, had also aimed to address risks faced by banks, rather than regulating investment firms. So they had only partially taken into account any specific risks inherent to investment firms, which could differ widely depending on many factors such as whether they act as principals to the trades or as agents for their clients. The new regime is expected to address these issues.

The regime will take effect 18 months after it has been published in the Official Journal, currently expected in October 2019. While there isn’t any legislative stage remaining where these requirements can be refined, amended or removed the experience from the implementation of other European Directives is that implementation process may take a significant length of time and prove to be more challenging than planned. 

The regime will be implemented through a transition period of five years for capital requirements, during which capital requirements will be limited to twice the firm’s current capital requirements under CRR, or twice their fixed overheads, in the case of firms which were not subject to capital requirements under CRR. In addition, CRR market risk rules will continue to apply for five years or until the application of CRR2 market risk rules, whichever comes later. The EBA is expected to draft technical standards on a number of areas such as the calculation of fixed overheads, the calculation for setting capital requirements equal to the total margin required by clearing members, and the templates for the public disclosures and regulatory reporting requirements. The EBA is also expected to set the criteria for NCAs to apply when exempting investment firms from the liquidity requirements in consultation with ESMA. 

So a number of important rules remains to be  determined through secondary legislation by the EBA and ESMA up to 18 months after the entry into force of the regime, including:

• Supervisory guidelines such as the details on the supervisory colleges, guidelines on the common procedures and methodologies for the supervisory review and evaluation process, the requirements for the type and nature of the information to be exchanged among NCAs, as well as the criteria for them to use when deciding to apply the CRR to certain investment firms and guidelines for exempting investment firms from the liquidity requirement
• Details with respect to the disclosure and reporting requirements such as standard forms, templates and procedures for the information sharing requirements, disclosure templates for investment policy and guidelines for the provision of information by branches of third-country firms, as well as  details on the obligation to provide information to the NCAs
• Technical standards on the calculation of the fixed overheads requirement and certain K-factors, methods for prudential consolidation of an investment firm group,  as well as details on the classes of instruments that satisfy the conditions to turn into CET1 capital and the information to be provided for the authorisation of a credit institution and calculating the thresholds to be a credit institution
• Guidelines on the application of sound remuneration policies, the implementation of information provision on high earners, gender-neutral remuneration policies, ESG-related risks, as well as the criteria to identify the categories of individuals whose professional activities have a material impact on the investment firm's risk profile

With the final EBA standards in these areas are yet to be published, it remains to be seen to what extent the new regime may impact the activities of investment firms and the behaviour of market participants. The UK’s exit from the EU also adds another layer of uncertainty as to whether the regime will take effect in the UK. But firms should start preparing by at least reviewing the rules and undertaking a gap analysis to identify any necessary changes to their internal risk and governance processes, while keeping a finger on the pulse of the planned secondary legislation and the final technical standards by the EBA and ESMA.

Disclaimer: The views and opinions expressed in this blog are those of the author and do not necessarily reflect the official views and opinions of PwC.