On 29 September 2017, the European Banking Authority (EBA) published an opinion on the design of a new prudential framework for investment firms. The new regime will apply to all MiFID firms, including those that will be brought into scope by MiFID II.
The EBA makes a total of 62 recommendations in the following areas:
|· Capital and liquidity requirements||· The need of macroprudential tools|
|· Consolidated supervision||· Remuneration requirements|
|· Reporting requirements||· Governance rules|
|· Commodity derivatives firms|
The EBA believes that implementation of its recommendations will simplify current structures and promote a proportionate and risk-sensitive approach whilst simultaneously:
- Strengthening the stability of financial markets;
- Protecting customers; and
- Ensuring an orderly wind-down of failing investment firms.
New Classification for Investment Firms
The rules define three new ‘classes’ of investment firm:
- Class 1: “global systemically important institutions” (G-SIIs) and “other systemically important institutions” (O-SIIs) which are exposed to the same types of risk as credit institutions;
- Class 2: Other non-systemic investment firms above specific thresholds, including larger investment firms, trading firms and firms that hold client money/assets; and
- Class 3: Small and non-interconnected investment firms providing limited services in terms of number and size, which would have a lower impact if they failed.
At a high level, the recommendations seek to develop a consolidated single rulebook for all Class 2 and Class 3 firms. Class 1 firms will remain subject to almost all of the requirements of the Capital Requirement Regulation (“CRR”) and the CRD IV Directive (“CRD”). Overall, the EBA anticipates that (a) there will be approximately 9 Class 1 firms, and (b) roughly two-thirds of the ‘non Class 1 market’ would be in Class 2, whilst the remaining one-third will fall to be classified as Class 3 firms.
The EBA insists that the new framework is not designed to “increase capital requirements significantly beyond the currently level in the overall system”. Rather, it is to create “clear and transparent rules with a stronger link to risk-sensitivity”. As such, and in order to ensure a stable transition to the new regime, increases in capital requirements will be limited to twice the level applicable under the current regime for a three-year transitional period.
Perhaps the most significant development proposed by the EBA is the introduction of a new type of risk proxy – the “k-factor”. K-factors are quantitative criteria used to classify firms as either Class 2 or Class 3. To this extent, it is recognised that both classes of firm will have to monitor their k-factors on a continuous basis.
There should be no overlap between k-factors, so no risk of double-counting of capital requirements. Some classification factors are assessed on a solo basis, whereas others are viewed on a consolidated basis. This is to guard against the risk that a group may deliberately structure itself in a way as to avoid classification as a Class 2 firm. In addition, the EBA recommends that competent authorities should have the power to consolidate any investment firm-only group where (a) they have evidence that the group has deliberately structured itself into separate entities to avoid higher capital requirements based on solo k-factors, or (b) where the group is “inter-connected” in terms of its operations or its risk-management. Non-investment firm-only groups should be subject to the new prudential regime on a solo basis as well as the CRR requirements on a consolidated basis.
If a Class 3 firm exceeds any k-factor, it will be classified as a Class 2 firm.  Upward reclassification can occur either immediately or after a three-month grace period.  Class 2 firms must meet the criteria for Class 3 firms for at least 6 months before downward reclassification occurs.
The full list of k-factors are detailed in Annex 2 to this article. Of note is the fact that the EBA regards the holding of client assets and own-name trading as activities which involve increased risk. As such, a number of k-factors which can be regarded as proxies for this type of activity have a zero threshold. Therefore, any firm holding any amount of client money or conducting any volume of own-name trading will automatically qualify as a Class 2 firm.
K-factor Capital Requirements
K-factors are also used to determine on-going capital requirements for investment firms. They are designed to be relatively simple to calculate, relevant to the nature of investment business and proportionate to the risk that an investment firm can have on customers and markets. In order to avoid high volatility in terms of capital requirements, most (but not all) k-factor calculations are to be based on rolling averages.
In addition to ‘k-factoring’, the EBA felt it appropriate that ‘large firms’ should be classified as Class 2 firms due to their increased potential impact. As such, it has included additional classification thresholds based on “total gross revenues” and “balance sheet size”.
IC, PMC and FOR
Initial Capital (IC)
Revised initial capital requirements will apply to all investment firms and are summarised in Annex 3.
Permanent Minimum Capital (PMC)  and Fixed Overhead Requirements (FOR)
The EBA envisages that PMC and FOR will act as a floor below which overall capital requirements cannot fall. PMC requirements are EUR 5 million for Class 1 firms and equal to initial capital requirements for both Class 2 and Class 3 firms. FOR is a minimum of 25% of the previous year’s fixed overheads and is designed to allow investment firms to be wound down in a more orderly manner.
However, FOR requirements have relevance as more than simply regulatory capital minima. They also relate to the overall recommendations of the EBA with respect to liquidity. Liquidity requirements demand that a firm keep a proportion of regulatory capital invested in liquid assets. This is to enable the firm to have sufficient liquidity to keep operating for a limited period of time, if only to wind-down. The EBA opinion proposes that this should be one-third of the investment firm’s FOR. In effect, this means that an investment firm would have to hold one month’s worth of regular expenditure in the form of a ‘buffer’ of liquid assets. Investment firms should be allowed to use the liquidity buffer only in “exceptional and unexpected” circumstances and should rebuild it within 30 days.
The EBA’s recommendations may well result in a more streamline prudential framework for investment firms. Certainly CRD IV is a complex beast, representing a sledgehammer to crack a nut in the case of many smaller market participants. Nonetheless, there is likely to be quite a lot of work involved in adjusting to the new rules, and regulatory classification and capital levels will have to be monitored even during any transitional period. Moreover, in placing two-thirds of investment firms within Class 2, it is questionable whether the EBA has drawn the dividing line in the correct place. Putting all firms which hold client money into Class 2, whatever the amount and even if they have delegated actual custody of that money to another entity also seems rather harsh. Whilst one imagines that the new rules will not become law before the early part of 2019 at the earliest, this is definitely a conversation to watch as it develops.
A summary of the EBA’s main recommendations may be found here- Annex 1
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 Recommendation 3
 Regulation 575/2013
 Directive 2013/36/EU
 Recommendation 2
 A group which does not include any credit institutions or Class 1 investment firms (Recommendation 8(a))
 Recommendation 9
 Groups which include one or more credit institutions and/or Class 1 firms
 Recommendation 10
 Recommendation 5
 Although the calculation of capital requirements will be based on smoothed k-factors so as to limit any ‘cliff-edge’ effect
 3-month period only applies where the K-factor thresholds for K-AUM or K-COH are exceeded
 Recommendation 7
 Recommendation 21
 Recommendation 19