The European Commission (EC) adopted a legislative proposal in December 2017 for a regulation (Investment Firm Regulation) and a directive (Investment Firm Directive) to amend the current EU prudential rules for investment firms.
While the academic community has not paid much attention to the EC’s proposed new regime, the financial sector has been watching the progress of the EU legislative process and the negotiations among the EC, the Council of the European Union (the Council) and the European Parliament (EP) that are still going on more than a year on after publication of the proposal.
Introducing a more proportionate and fit-for-purpose regime for investment firms, the proposal presents a significant revision to the existing prudential framework for investment firms set out in the Capital Requirements Directive and Regulation (CRD IV and CRR) and in the Markets in Financial Instruments Directive 2 and Regulation (MiFID2 and MiFIR).
The new prudential regime applies to all MiFID 2 firms and therefore captures all investment firms that carry out activities which include transmission of orders in relation to financial instruments, execution of client orders, dealing on own account, managing portfolios, providing investment advice, underwriting financial instruments and operating trading facilities.
In this post we review some of the most contested aspects of the proposed regime.
The EC’s proposed firm classification system forms the crux of the new regime.
The EC proposes to keep ‘bank-like’ (Class 1) firms subject to CRD IV and proposes to subject Class 1 firms to direct supervision by the European Central Bank (ECB) under the single supervisory mechanism. It also introduces a new and tailored prudential framework for the ‘non-systemic’ (Class 2) firms. On the other hand, it subjects ‘non-interconnected’(Class 3) firms to much lighter prudential rules.
Recent proposals by the Council include lowering the Class 1 threshold to €15bn for those firms that engage in dealing on own account and underwriting. Given this would result in a greater number of firms seeing their capital requirements increase, this idea has not gained popularity among the member states.
The Council also proposes to create an additional sub-category (‘Class 1 minus’) for firms with assets between €5bn and €15bn, for which national competent authorities (NCAs) would be able to impose the CRD/CRR rules subject to certain conditions. Although this discretion would apply only to those investment firms that carry out trading on their own account and provide underwriting services, it depends on the rather subjective judgment of the NCAs as to whether a particular firm’s activities pose systemic risk or not. So it runs the risk of resulting in an unlevel playing field across the EU.
The K-factor formula
The EC proposes a novel approach to calculate the capital requirements for Class 2 investment firms (‘K-factor formula’). This approach comprises a set of factors (‘K-factors’) to capture the potential risk to customers (RtC), risk to market (RtM) and risk to the firm itself (RtF). K-factors are multiplied by prescribed coefficients to calculate the capital requirement as the sum of RtC, RtM and RtF. So, the amount of capital that Class 2 firms should hold depends on the definition of certain elements in the test and these have been subject to debate.
For instance, whether non-discretionary advisory arrangements should be included in the definition of assets under management K-factor (K-AUM) may make a material difference for some firms. So, whether the scope should be narrowed to include only the client assets under management has been subject to negotiations.
Similarly, the definition of client orders handled (K-COH) and whether to allow investment firms to exclude those orders that have not been executed due to timely cancellation has been subject to debate. Even the definition for client money held (K-CMH) has also caused controversy and parties have also been negotiating whether the word ‘controls’ should be removed from the definition.
Negotiations focus on how to make K-factor calculations more proportionate in line with the nature of each firm’s business model. The Council’s recent proposals include modifying calculation details for certain K-factors including daily trading flow, client money held, concentration risk and clearing member guarantee.
Group capital testing
The group capital test requires the top parent EU entity of the groups that consist only of investment firms to hold enough own funds to equal the book value of financial sector holdings and contingent liabilities on a solo basis. However, the definition of ‘own funds’ under the EC’s proposals differs from the definition in the CRR as it requires material holdings held by non-EU subsidiaries to be deducted from the firm’s own funds. This would require firms to double count material holdings as they will have to deduct the capital of non-EU subsidiaries from their group level own funds and compensate the non-EU capital they had just deducted by holding additional own funds.
The compromise text put forward now allows firms to perform a group capital test at the level of every parent undertaking in the group with regards to its direct holdings in investment firms and financial institutions in the investment firm group without requiring them to incorporate a reprocessing of amounts already deducted or of minority interest. This amendment has received positive reactions from the member states. The Council version proposes to require groups to comply at consolidated level but to authorise NCAs to be able to exempt simpler groups from prudential consolidation. It also proposes to remove CRR deductions from the definition of own funds to avoid the potential complications that may arise from the double counting of material holdings.
Third country equivalence
Provisions under the new regime in relation to the MiFID II/MiFIR third country equivalence rules have caused disagreement on the grounds that they treat non-EU investment firms more favourably and fail to ensure adequate investor protection.
Arguing that tighter equivalence rules should be put in place for third country investment firms, some stakeholders have proposed to exclude proprietary trading and underwriting from the list of services that could benefit from a third country equivalence regime. There is also debate on whether the third country investment firms planning to conduct bank-like activities in the EU should set up an EU subsidiary. Given these changes would amount to a more substantial overhaul of the overall regime than intended, which is especially controversial in the Brexit context, most member states have disagreed on grounds that the timing would not be ideal.
The way forward
The EP and the Council have now finalised their positions. While various pinch points and areas of disagreement remain, we expect negotiations to conclude ahead of EP elections in May 2019. This means firms will have to implement the new regime by late 2020 or early 2021. But there will be a transition period of five years during which the capital requirements will be limited to twice the firm’s current capital requirements.
In the UK, it remains to be seen what the prudential regime for investment firms will look like given Brexit. But, considering that the FCA significantly contributed to its development, we expect that the UK regime will be similar to the final EU one.
So while investment firms should continue following the progress of the negotiations, the industry should buckle up for the very substantial changes introduced by the new regime.
Hortense Huez is a Director in PwC’s Financial Services Risk and Regulation practice. Prior to joining PwC she worked for the Bank of England.
Mete Feridun is a Manager in PwC’s Financial Services Risk and Regulation practice. Prior to joining PwC, he worked at the Financial Conduct Authority.
Disclaimer: The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official views and opinions of PwC.