What do EBA’s final SREP guidelines and RTS mean for investment firms?

The European Banking Authority’s (EBA) final regulatory products with respect to the Investment Firms Directive (IFD) published on 21 July 2022 are expected to harmonise the supervisory practices regarding the supervisory review and evaluation process (SREP) of investment firms. The new regime spans a broad range of prudential areas ranging from capital and liquidity to Pillar 3 disclosures and remuneration.

The EBA’s publications comprise the final guidelines on common procedures and methodologies for the SREP and the final draft Regulatory Technical Standards (RTS) on Pillar 2 add-ons for investment firms. The final SREP Guidelines, which have been developed jointly with the European Securities and Markets Authority (ESMA) on the basis of Article 45(2) of Directive (EU) 2019/2034, set out the common criteria for the assessment of risks in line with the requirements of the Investment Firms Regulation (IFR) and Investment Firms Directive (IFD). The final draft RTS on Pillar 2 add-ons, on the other hand, have been developed in consultation with ESMA on the basis of Article 40(6) of the same Directive.

These documents primarily set out detailed guidance on the measurement of risks to capital and granular criteria for the assessment of the main SREP elements. They also reflect an implicit supervisory expectation that firms in scope enhance the link between their risk profiles, risk management processes and risk mitigation systems. This will require firms to have in place robust governance and internal control arrangements.

The quality and quantity of the publications reflect the EBA’s regulatory expectations that firms in scope establish sound, effective and prudent strategies and processes to assess and maintain capital commensurate to their risk profiles on an ongoing basis. The main areas captured under the Guidelines include not only risks to capital and capital adequacy, liquidity risk and liquidity adequacy, but also business model, governance arrangements and firm-wide controls. While compliance with the stringent regulatory expectations will present compliance challenges, it should be noted that the procedures and methodologies introduced are generally proportionate to the nature, size and activities of firms in scope.

From a supervisory standpoint, the guidelines collectively represent a step change in the SREP process of investment firms. For instance, application of a scoring system and key indicators is expected to facilitate the much needed comparability across firms while certain provisions put forward on the application of SREP in the cross-border context is expected to result in a more efficient supervision. Likewise, the technical details introduced through the final draft RTS is expected to facilitate a consistent EU wide determination of regulatory capital requirements under the SREP, as well as ensuring standardised supervisory practices throughout the EU with respect to the Pillar 2 processes.

More specifically, these technical details include a number of specific indicative metrics to support supervisors in the identification, assessment, and quantification of material risks and elements of risks not otherwise captured or inadequately captured by Pillar 1 requirements set out in Article 11 of Regulation (EU) 2019/2033. More importantly, the metrics introduced reflect the size, complexity of activities and business models of the various investment firms across the European Union.

The final draft RTS also reflect the EBA’s supervisory expectations that firms have adequate capital and liquidity to ensure a sound management and coverage of their risks, to which they are or might be exposed, as well as those risks that firms may pose to the financial system. They generally set out more detailed and proportionate guidance on the measurement of risks to capital. This means that firms in scope will now have more specific and granular indicative metrics to use for the assessment of materiality and determination of capital level considered adequate to cover their risks.

However, Class 1 investment firms, i.e. systemically important investment firms, are still subject to relevant provisions of Directive 2013/36/EU and Regulation (EU) No 575/2013. This means that Class 1 firms are still treated as credit institutions in terms of own funds requirements and neither the guidelines nor the final RTS applies to them. For class 2 and class 3 investment firms, on the other hand, supervisors are expected to determine additional own funds requirement to cover the risk of an unorderly wind-down, which could pose threats to their clients, counterparties, and the wider markets in which they operate in case of their failure.

Furthermore, for class 2 investment firms only, competent authorities will be required to determine additional own funds requirements to decrease the likelihood of a failure, by covering material risks related to their ongoing activities. This means that supervisors will be focusing more on the risks to clients, to markets, to the investment firms itself, and any other risks that are not addressed by any own funds requirements.

In conclusion, despite the challenges they may introduce, the EBA’s final joint SREP guidelines and final draft RTS on Pillar 2 add-ons generally present a more granular, specific and fit-for-purpose prudential framework for the supervision of investment firms. They also present an important opportunity for change in business strategy and approach for some investment firms in scope, as well as a chance for others to update their internal systems and controls, as well as improving their corporate governance structures.