The new prudential regime – tough capital requirements

Anthony Ma Anthony Ma

Investment firms that are authorised under MiFID II are currently subject to the same regulations as credit institutions, namely CRD/CRR.

But these two types of firms have inherently different risk profiles and the regulations are not sensitive enough to adequately govern both.

In recognition of this, the EBA proposed a more proportionate prudential regime for investment firms which involves a degree of re-classification.

Systemically important, bank-like investment firms will be reclassified as credit institutions (Class 1) and remain under CRD/CRR. The remainder of investment firms, non-systemically important firms (Classes 2 and 3), will be governed by a new prudential regime, consisting of:

  • The Investment Firms Directive (IFD)
  • The Investment Firms Regulation (IFR)

Although the changes are radical, the rules are complex and may bring significant challenges for affected firms, particularly around capital requirements.

A costly enterprise

Under the proposed new rules, Class 1 firms will face a significant rise in initial capital requirements. Class 2 and 3 firms face changes to both the initial capital requirement and the fixed overhead requirement – to be calculated using a complex K-factor methodology. The jump in regulatory capital for classes 2 and 3 is not extreme, but for Class 1 firms it will rise from €730,000 to €5 million. Consequently, there will be an implementation period to help firms to build up the necessary capital.

During this time, investment firms may face resourcing challenges around revamping their current internal prudential reporting system so they can compute the capital requirements using the K-factor formula. Large investment groups should consider how this can be applied to the whole group.  For firms which are AIFM with MiFID top-up permissions, they need to consider how to implement both AIFMD and the new capital requirements.

As with any large-scale change, the cost of implementation itself may be high. The K-factor calculations are complex, demanding skilled resources and appropriate data systems. And these calculations aren’t a one off, they will raise running costs on an ongoing basis. With such strict categorisation, all investment firms must constantly monitor their threshold conditions between the different classes and maintain evidence for the regulators.

If the threshold conditions do tip into the next category up, a firm’s running costs will again increase and smaller firms may be more affected. Just one transaction could push a firm from Class 2 to Class 3, raising the cost of compliance. In the long term, this could make expansion more expensive and reduce competitiveness across the sector.

Smaller firms may face tougher challenges

BIPRU firms are currently subject to the less stringent CRD III, so the transition to the new prudential regime will be a greater shock than for IFPRU firms. BIPRU firms should consider a range of issues. How will K-factors apply? What MI is needed to track K-factors initially, and on an ongoing basis? IFPRU firms, which are subject to CRD IV, are already subject to rigorous requirements, so the key issue for them will be fulfilling the capital requirements.

Working to a moving timeline

Timescales are a problem. The proposed regime is still undergoing the legislative process and it is expected to be approved before the end of the current European Parliament term (mid 2019), but it may be delayed to the following term. Brexit is another consideration, but it’s likely that the FCA will implement most, if not all, of the regulations as set out in IFR/IFD.

In reality, the new rulebook is no simpler than the old one. Firms must assess the implication on their capital, liquidity and wind-down planning and include it in their regulatory reporting. It is also important to review how the K-factors will be embedded into the risk profile and risk appetite – and how it will be monitored by the board.

For more information on the new prudential regime, please contact Anthony Ma.