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We are delighted to publish the second insight of our series of articles on the new prudential regime exploring some of the key changes that can be expected for investment firms, in particular their firm classification, capital requirements and additional regulatory matters.
The FCA’s most recent discussion paper confirms that a new prudential regime, the Investment Firms Prudential Regime (IFPR), will be implemented in line with the EU’s new regime, the IFR/IFD. The proposed introduction of the IFPR in the UK is expected to be effective in the summer of 2021, and for many UK investment firms, this will be the biggest overhaul to how they are regulated since the introduction of the Capital Requirements Regulations and the updated Capital Requirements Directive (together called CRD IV) in 2014.
If you missed the first article in our series it can be found here.
The extent to which investment firms will be affected will depend on the systemic impact of asset size and operational set up, ‘interconnectedness’ and underlying risk of activities carried out. Key to understanding the full impact of the IFPR will be to identify a firm’s classification correctly, which in turn will determine a firm’s overall capital requirements.
The proposed IFPR outlines four types of investment firms. Systemically important firms will continue to be authorised as credit institutions will continue to be subject to the EU’s CRD IV that contains prudential rules for banks & building societies.
Certain large firms (those with total value of the consolidated assets >_EUR 5bn) that hold the permission of dealing on own account and/or underwrite on a firm commitment basis will be classified as MiFID investment firms and will be subject to the CRR.
The remaining investment firms will be subject to a further classification test (as referred to in the flowchart below) to establish whether they meet the thresholds of a Small and Non-interconnected investment firm (SNI). These firms will be regulated using a reduced version of the IFPR. All other investment firms (those that exceed the thresholds) will be subject to the full regime, for which the newly introduced K-factors will be applicable.
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As a result of the IFPR, the current Exempt-CAD, BIPRU and IFPRU firm classifications will cease to exist.
It should be noted, that investment firms who currently hold the permission of dealing on own account but with the matched principle exemption, will now be treated in the same way as all firms that deal on their own account. Unless considered large, these firms are expected to be classified as investment firms under IFPR and will be subject an increased permanent minimum requirement of €750,000.
We are delighted to publish the second insight of our series of articles on the new prudential regime exploring some of the key changes that can be expected for investment firms, in particular their firm classification, capital requirements and additional regulatory matters.
The FCA’s most recent discussion paper confirms that a new prudential regime, the Investment Firms Prudential Regime (IFPR), will be implemented in line with the EU’s new regime, the IFR/IFD. The proposed introduction of the IFPR in the UK is expected to be effective in the summer of 2021, and for many UK investment firms, this will be the biggest overhaul to how they are regulated since the introduction of the Capital Requirements Regulations and the updated Capital Requirements Directive (together called CRD IV) in 2014.
If you missed the first article in our series it can be found here.
The extent to which investment firms will be affected will depend on the systemic impact of asset size and operational set up, ‘interconnectedness’ and underlying risk of activities carried out. Key to understanding the full impact of the IFPR will be to identify a firm’s classification correctly, which in turn will determine a firm’s overall capital requirements.
The proposed IFPR outlines four types of investment firms. Systemically important firms will continue to be authorised as credit institutions will continue to be subject to the EU’s CRD IV that contains prudential rules for banks & building societies.
Certain large firms (those with total value of the consolidated assets >_EUR 5bn) that hold the permission of dealing on own account and/or underwrite on a firm commitment basis will be classified as MiFID investment firms and will be subject to the CRR.
The remaining investment firms will be subject to a further classification test (as referred to in the flowchart below) to establish whether they meet the thresholds of a Small and Non-interconnected investment firm (SNI). These firms will be regulated using a reduced version of the IFPR. All other investment firms (those that exceed the thresholds) will be subject to the full regime, for which the newly introduced K-factors will be applicable.
As a result of the IFPR, the current Exempt-CAD, BIPRU and IFPRU firm classifications will cease to exist.
It should be noted, that investment firms who currently hold the permission of dealing on own account but with the matched principle exemption, will now be treated in the same way as all firms that deal on their own account. Unless considered large, these firms are expected to be classified as investment firms under IFPR and will be subject an increased permanent minimum requirement of €750,000.
The IFPR aligns the capital definitions for all investments firm to those currently in use under the CRD IV, and there are three classes of capital:
The capital ratios to be maintained are:
Own funds requirement is the higher of the ‘Permanent minimum requirement’ or ‘Fixed overheads requirement’ or ‘K-factors requirement’ as applicable depending on the classification of firms.
As with the previous Capital Requirements Regulation (CRR) and Capital Requirements Directive IV (CRD), initial capital requirements for authorisation, which will be the same as the ongoing permanent minimum requirement (PMR), will continue to serve as the base capital for all investment firms. The new levels have increased to €75,000, €150,000 and €750,000 depending the activities of a particular investment firm.
To support investment firms as they increase their PMR to meet the new prudential requirements, there are transitional provisions in place including: five years to build up the initial capital (with an annual minimum of €5,000 per annum) and a provision for an extension of up to five more years.
For all investment firms, there will now be a requirement to calculate a Fixed Overhead Requirement (FOR). While the FOR, which is based on a quarter of fixed overheads of the previous financial year, is already in place for a lot of MiFID firms, smaller firms that are classed as SNIs will also have to calculate this.
One of the major reporting changes is that all firms will need to report on their calculation of the FOR, and clearly establish the methodology and any deductions made in arriving at the figure. The calculation will be subject to a materiality test, whereby firms can adjust their FOR, with the approval of regulator, if there is a significant change to the business (this is expected to be a change of 30% in a firm’s fixed expenditure).
The most significant change from CRR/CRD is the introduction of K-factors (KFR) - a methodology for calculating the activity risk-based capital requirements.
K-factors are a quantitative capital requirement metric that take in to account a firm’s risk profile, size of balance sheet, client assets and volume of trading and investment activities, representing the range of risks the firm can present. These indicators are broken down into three main groups: risk to customers/clients (RtC); risk to market access and liquidity (RtM); and risk to the firm itself (RtF).
The K-factor requirement (KFR) is calculated as RtC + RtM + RtF (see table), but these calculations are further complicated by the requirement of a time dimension for some K-factors, for example relating to risk to customers.
Definition |
Capital Requirements and relevant coefficients |
|
K-Factor group: Risk to Customers (RtC) |
|
|
Assets Under Management (AUM) or advice (on a consolidated basis across the group) |
K-AUM x 0.02% |
|
Client Money Held (CMH) or controlled |
K-CMH x 0.45% |
|
Assets Safeguarded and Administered (ASA) |
K-ASA x 0.04% |
|
Client Orders Handled (COH) Value of orders received/transmitted/executed |
K-COH x 0.1% (cash) x 0.01% (derivatives) |
|
K-Factor group: Risk to Markets (RtM) |
|
|
Net Position Risk (NPR) Value of transaction in trading book |
Higher of K-NPR |
|
Clearing Member Guarantee (CMG) Amount of initial margin posted with clearing member |
or K-CMG |
|
K-Factor group: Risk to Firms (RtF) |
|
|
Trading Counterparty Default Risk (TCD) relative to the exposure in the trading book |
K-TCD Exposure value x 1.6% |
|
Daily Trading Flow (DTF) relative to daily transactions or execution of orders |
K-DTF x 0.1% (cash) x 0.01% (derivatives) |
|
Concentration Risk (CON) Value of exposures in trading book that exceed certain thresholds |
K-CON |
Many investment firms, including SNIs, will have to set up new K-factor monitoring and reporting systems to make sure that thresholds are not breached as assets under management or advisory or business complexity grows.
For this reason, K-factors are likely to result in increased costs as well as capital required, particularly if group-wide tests are triggered.
CPMIs (Collective Portfolio Management Institutions) with both the MiFID permission of managing investments and the permission of managing an unauthorised AIF will have to conform to both the IFPR and AIFMD regimes. For the purposes of calculating the AUM threshold and if applicable the K-AUM, such firms are expected to only include assets managed under their MiFID permission (managed accounts in most cases).
The FCA plan to introduce the concept of an ‘investment firm group’, whereby the whole group including an investment firm will now be included in the scope of consolidated supervision. This would mean that, previously unregulated parent undertakings of an investment firm will now be subject to consolidated own funds requirements, as well as liquidity, concentration risk, disclosure and reporting.
The IFPR also introduces a new Group Capital Test (GCT), to ensure that there are adequate financial resources at the group level as opposed to just the at the individual level. This will address situations where a parent entity of an investment firm is leveraged and the own funds of that investment firm is essentially funded by debt.
This will be used, at the FCA’s discretion, as a derogation from the investment firm group to have to comply with all of the requirements of the prudential consolidation, and for such groups with simple structures in the UK, the FCA expect that most firms would be able use the GCT instead of prudential consolidation.
Although the regulation does not come into effect until the summer of 2021, assessing what systems and processes to put into place for data collection (including sufficient historical data), reporting and analysis needs to start soon. There are also a number of significant additional requirements that firms will need to take into consideration, some of which are discussed below.
Pillar 2 & ICARA (the new ICAAP)
With regards to financial resources requirements, the IFPR maintains the rules-based approach for the calculation of the own funds and minimum liquidity requirements (Pillar 1 requirements) and the risk-based approach, whereby firms should maintain adequate financial resources to meet those risks not captured by the rules based requirement (referred to as Pillar 2).
The FCA are likely to introduce the concept of an internal capital and risk assessment (ICARA), which would essentially replace ICAAPs for non-SNI investment firms. However, all firms, including SNIs, will need to have an internal review process in place to ensure they and are financially viable and have sufficient financial resources in place. For certain SNIs, the FCA will consider whether it is necessary to impose the ICARA (or parts of it) depending on the scale and complexity of their business.
Wind-down planning in line with the current guidance in the FCA’s Handbook (WDPG) issued by the FCA will also become mandatory for all firms post IFPR.
Firms will need to hold sufficient liquid assets, equal to one third of the fixed overheads requirement, on an ongoing basis.
Although the aim of the IFPR is to create a simplified risk-responsive regulatory structure for investment firms that are not considered systemically dangerous, in the short run the regime is likely to impose additional operational and/or compliance burden and potentially additional capital requirements. Accordingly, it is imperative that firms start assessing the impact of this on their structure and business.
There are a number of other requirements for investment firms which we will address in our subsequent articles in this series. Stay tuned for more information on Remuneration, Governance, Regulatory Reporting and Disclosures, as we well as additional details on the ICARA and SREP processes.
26 June 2020
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