Hot Topic. Major changes announced for the European prudential regime for investment firms

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1 September 2018 Stand out for the right reasons Financial Services Risk and Regulation Hot Topic Major changes announced for the European prudential regime for investment firms Highlights The new proposed prudential framework for investment firms includes: Classification of all investment firms into three categories and specific categorisation thresholds to determine each category. New K-factor methodology for capital requirement s calculation for class 2 firms. Liquidity requirements in liquid assets and calculation based on fixed overhead requirement. New governance, remuneration, reporting and disclosure requirements. The rules should be finalised early 2019 with implementation expected in The European Commission (EC) published a draft directive and a draft regulation on the new prudential framework for investment firms on 20 December This document provides background on the proposed framework and a summary of what it may mean for your firm. Background The Capital Requirements Directive IV and Regulation (CRD/CRR) were primarily designed for banks. While they contain some concessions for investment firms, the rules are not proportionate to the nature of the risks run by investments firms. An EBA report published in December 2015 highlighted weaknesses in the current arrangements, including the complexity of current requirements, inconsistencies and shortfalls and proposed potential policy options. Based on their risk and systemic importance, the EBA report recommended three levels of firm categorisation Bank-like firms, non-systemic firms and firms with non-interconnected services. For bank-like firms, the EBA report recommended applying the full CRD/CRR rules. For the other two categories, it recommended the development of a tailored prudential framework. The EBA published its proposals for the new prudential framework in November 2016, followed by an opinion paper in September The EC draft directive and regulatory text are broadly consistent with the approach proposed by the EBA in its opinion paper. As proposed, the requirements may see additional capital and liquidity requirements and complexity for some of the investment firms. While implementation should happen in 2020, it is important for firms to being to think through the strategic implications today.

2 Principles of the new framework The EC s new framework is designed to minimise the risk of customer and market disruption. While the EC does take into account the broad nature of the investment firm sector, both in terms of size and type of activity performed by the firm, and does not expect a zero-failure regime, it does expect competent authorities to ensure that firms are able to absorb a certain level of loss. To address this, the EC proposes both capital and liquidity measures, resulting in a new framework including the following components: New categorisation of firms. Capital requirements. Liquidity requirements. Concentration risk requirements. Consolidated supervision. Reporting and disclosure. Governance and remuneration. New categorisation All investment firms will be classified into one of three categories according to their level of systemic risk. These are: Class 1: Firms dealing on their own account or underwriting or placing financial instruments on a firm commitment basis, where the total value of assets of the undertaking >= 30bn. These firms will continue to follow rules set out in CRD/CRR. Class 2: Non-systemic investment firms that do not fall into the definition of Class 1 or Class 3. Class 3: Small, non-interconnected investment firms providing limited services that fall within a series of quantitative thresholds including gross revenues and client money. For a full list of the categorisation thresholds, please refer to Appendix 1. The new prudential framework outlined by the EC proposal and summarised in this document applies to class 2 and class 3 firms, while the governance, transparency and remuneration provisions apply to all investment firms. Capital requirements Class 2 firm s The new framework introduces a new capital calculation, which the EBA believes better captures the risk an investment firm can pose to customers, to market access or liquidity and to the firm itself. For the v ast majority of inv estment firms, especially those which operate on an agent basis, the most important element of risk will be the potential for harm they may pose to their customers. The EC is also concerned by the impact that an investment firm can have on the markets in which it operates. A disorderly failure could lead to an erosion in confidence in the market, which could affect market liquidity. Such effects could impact market counterparties and their customers might also suffer loss or other detriment. The third element to consider is the exposure risk for a firm arising from market price movements, counterparty defaults and credit deterioration, called in the proposal risk to firm. It is important to consider the risk a firm poses to itself because it has the potential to subsequently disrupt customers or markets or both. Capturing all these impacts requires identification of a set of observable proxies or factors to represent those risks and a set of scalars or percentages to reflect the size of a firm. These capital proxies or factors, called K-factors, are attributed to those three risks: risk to customers, risk to market and risk to firm. The capital requirement from the K-factor formula is a sum of risk to customers (RtC), risk to market (RtM) and risk to the firm itself (RtF). To capture each of these three components, firms must use the respective metrics in the table below, multiplied by prescribed coefficients (K-factors). Firms which pose more risk to customers or markets should have higher capital requirements Or higher K-factors. Capital floors The EC considers a capital floor i.e. minimum capital requirements (MCR) to ensure an orderly wind down of a firm, should it get into difficulty. Capital floors are determined by the MCR, which is for class 2 firms the higher of the initial capital requirements (ICR), the fixed overhead requirement (FOR), and K-factor requirements. The FOR is equal to the 25% of the fixed overheads of the previous year. This new regime also revises the ICR to be either 7 50k, 150k or 7 5k based on the type of activities carried out by investment firms. 1 Hot Topic Financial Services Risk and Regulation

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4 Reporting and disclosure Both class 2 and 3 firms must report annually to their competent authority on own funds, capital requirements, balance sheet and revenue breakdown by investment service. Additionally, class 2 firms must report on CON and liquidity requirements. The EBA will develop an Implementing Technical Standard (ITS) specifying the format, reporting date, definitions and IT solutions to use for reporting. It aims to develop the ITS within nine months of the date of entry into force of these new directive and regulation. Member States shall also subject investment firms to country-by-country reporting of activities of subsidiaries and branches, number of employees and financial information such as profit, loss, turnover and any public subsidies received. Both class 2 and class 3 firms must disclose the following information on the same day they publish their annual financial statements. Risk management objectives and policies, Own funds i.e. features, terms and conditions of capital instruments, prudential filters and deductions applied, and Capital requirements i.e. capital adequacy assessment, capital requirements calculation and return on assets. In addition to the above, class 2 firms must disclose information on remuneration and internal governance arrangements. Governance and remuneration Firms must have a robust governance framework, which should include clear organisational structure, consistent lines of responsibility, and processes to identify, monitor, manage and report risks. There should also be adequate internal control mechanisms, and remuneration policies and practices that should promote effective and sound risk management. In terms of remuneration, firms should set an appropriate ratio between fixed and variable components. The Commission proposes to set a threshold at firm and staff lev el for applying the deferral and pay-out rules. The directive states that the EBA, in consultation with the ESMA, shall issue guidelines on the application of governance requirements. Equivalence regime The EC has also proposed undertaking targeted changes to the existing equivalence regime for third country firms. If the third country regime is deemed not equivalent, the competent authorities could force the affected firms to establish an investment holding company or mixed financial holding company in the EU. With Brexit, any changes to the equivalence regime will have an impact on UK based firms but it is too early to say what these will be. Implementation timeline Over the course of 2018, we expect EU trilogue discussions on the new prudential framework and final rules should be published in Firms will hav e 18 months from the date of publication of final rules to implement the framework, which means firms must implement the new regime in In addition, the capital requirements calculated using the new regime will be limited to twice the level of capital requirements calculated using the current regime for five years from the date of implementation i.e. until Also, firms using the existing capital requirements regulation (CRR) market risk rules (if applicable for their capital requirement calculation) will keep doing so for a period of five years or until the date of application of CRR2 (which is the revised CRR proposed by the EC in 2016 and targeted for publication in 2019) new market risk rules, whichever is earlier. Impact on firms The new rules will start applying in 2020 so firms have about two years to get ready for those, which is short given the significance of the changes. The EC impact assessment indicates that while the new regime would be an aggregate increase in Pillar 1 requirements of 10%, overall this would already be absorbed by Pillar 2 add-ons (discretionary capital add-ons already requested by supervisors). However, it is clear that some firms, such as investment adv isers, will experience a substantial increase in requirements, given the low level of capital some of them currently hold. The proposed changes to the ICR and MCR mean class 3 firms would likely need to maintain a higher level of capital on an ongoing basis, which will increase their capital cost. 3 Hot Topic Financial Services Risk and Regulation

5 Firms must also develop the capability of ongoing capital assessment and planning to ensure capital adequacy. While the calculation of liquidity requirements is simplified, both class 2 and class 3 firms must hold their liquid assets in the form of HQLA. Such a requirement means these firms might need to change their stock of assets to better quality assets, thereby increasing their liquidity cost. Class 2 firms would also experience increased demands on their risk management and data capabilities. They must ensure they have adequate resources, data and infrastructure capability, as well as technical expertise, to implement the different approaches required to calculate their K-factors. For example, the proposal indicates that they must implement the market risk calculation approach from the new CRR2 proposal to calculate NPR and a simplified version of the standardised approach to counterparty credit risk to calculate TCD. Class 2 firms must also have adequate data and infrastructure capability to meet their granular reporting and disclosure requirements. The new consolidation provisions will likely require a strengthening of group functions for firms that are a part of an investment firm-only group. The parent entity will need to have systems to monitor the group s compliance with prudential requirements and mechanisms to address risks related to excessive leverage and capital gearing. It remains to be seen what the regime will look like in the UK, considering that Brexit will overlap to some extent at least with implementation of this new proposed regime. However, considering that the FCA significantly contributed to its development, we expect that the UK regime will be similar to the final EU one. 4 Hot Topic Financial Services Risk and Regulation

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