The FCA's New Prudential Regime for MIFID Investment Firms DP20/2: Back to the Future or just Back ? - Palvinder Gill Prudential & Risk Partner ...
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The FCA’s New Prudential Regime for MIFID Investment Firms DP20/2: Back to the Future or just Back…? Palvinder Gill Prudential & Risk Partner Insight Regulatory Consulting
CONTENTS • Insight’s Insights p.3 • Overview p.4 • Background p.5 • Application to investment firms p.7 • Capital Resources, Initial Capital and Permanent Minimum Capital p.8 • Kapital or Krypton? K-Factor Requirements p.9 • Consolidated Supervision and Liquidity p.12 • From ICAAP to ICARA p.13 • Transitioning from Existing IFPRU and BIPRU ICGs p.14 • Regulatory Reporting, Remuneration, ESG Issues, Waivers and CRR Permissions, and Public Disclosure p.15 • IFR Transitional Provisions p.16
• The FCA’s proposed implementation of the IFR/IFD is the biggest change in investment
firms’ regulation for decades – firms need to examine the proposals in detail, quickly assess
the impact on their business and start planning how to implement it.
• The new rules have been 6 years in the making and promise a lot:
• Lower regulatory costs;
• Better alignment of requirements to business models;
• Strengthened supervisory dialogue;
• Improved competition; and
• Better prudential outcomes.
• Whether these promises will be delivered is debatable once you consider the detail and
there will be significant implementation costs.
• There has been limited consultation with the industry, no industry working groups and no
meaningful UK quantitative impact exercise (as there have been with past regulatory
changes of this magnitude).
• The new K-Factor requirements for Class 2 firms are at times illogical and counterintuitive
in the context of the day-to-day risk and business management in firms – for some firms
there will be significant increases in Pillar 1 capital requirements (increases are capped at
double the amount under the CRR).
• Capital is still capital; counterparty risk is still counterparty risk; and market risk is still
market risk. The K-factors are proxies for operational risk requirements.
• The ICAAP becomes the ICARA - Pillar 2 requirements will still apply and firms will need
to adapt their internal processes and risk management focus.
• Firms also need to consider the following each of which would represent a major change
on their own:
• Liquidity risk requirements;
• Concentration risk;
• Consolidated supervision and group capital requirements;
• Regulatory reporting requirements;
• Remuneration requirements;
• Disclosure requirements;
• ICAAPs are replaced by the ICARA process which will change the way the FCA
assesses Pillar 2 requirements;
• Waivers and CRR Permissions which will fall away;
• Transitional provisions; and
• ESG issues.
• Firms should respond to the DP setting out their particular concerns in detail, particularly
the quantitative and implementation implications.
3
OVERVIEW
“A new UK regime would represent a significant improvement in the prudential regulation of
investment firms. For the first time, it would deliver a regime that has been designed with
investment firms in mind, replacing many rules that were largely designed for deposit-taking
credit institutions. The on-going regulatory costs for investment firms should be lower. The
new regime would also re-orient the focus of prudential requirements and expectations
away from risks the firm faces, to also consider the potential for harm the firm can pose to
clients and the market”. From the foreword of DP20/2, by Chris Woolard, Acting CEO of
the FCA
The FCA have set out their new prudential requirements for all MIFID II investment firms in
Discussion Paper DP 20/2: A new UK prudential regime for MiFID investment firms. The changes are
massive for both the regulated and regulators. It will require a lot of work to implement and there
will be consequences in the form of increased capital requirements and systems and controls
requirements for a significant number of firms.
The UK has more investment firms (and varieties of investment firms) than the rest of the remaining
27 EU member states combined – the impact of the new regime will be felt most here, so firms need
to start looking at the detail and plan how to implement it.
DP20/2 is the UK’s proposed implementation of the EU Investment Firm Directive (IFD) and the
Investment Firm Regulation (IFR) which were published in the EU Official Journal in December 2019
for implementation in the EU by 26 June 2021. The UK FCA was central in driving the IFR/IFD policy
discussions that took place in the EU level and whilst post-Brexit the UK is not obliged to implement
EU rules which come into effect after the end of the transition period, the FCA will consider them at
the time and it makes sense that they will apply them. Specific EBA technical standards and
guidelines will be finalised through EBA Level 2 legislation (drafts of which have been recently
published).
The changes are wide-ranging in addition to change in capital requirements, and firms also need to
consider inter alia:
• Liquidity risk requirements;
• Concentration risk;
• Consolidated supervision and group capital requirements;
• Regulatory reporting requirements;
• Remuneration requirements;
• Disclosure requirements;
• ICAAPs are replaced by the ICARA process which will change the way the FCA assesses Pillar 2
requirements;
• Waivers and CRR Permissions which will fall away;
• Transitional provisions; and
• ESG issues.
4
OVERVIEW (cont’d)
“While recognising these potential benefits, we are careful at this stage not to provide
specific numbers on the expected impact of a new UK regime on investment firm types,
or to state exactly how many investment firms would qualify as small and non-
interconnected investment firms (SNIs), should we introduce a similar concept in the
UK".
DP20/2 para 1.8
The new regime has been 6 years in the making and the FCA make a lot of promises about it:
• “Lower regulatory costs – the potential to result in much more proportionate regulatory
reporting and disclosure requirements for investment firms, particularly for smaller, non-
interconnected investment firms;
• Better alignment of requirements to business models – the new K-factor approach better aligns
with the business models used by investment firms than existing regimes. It allows a better
alignment between regulatory prudential requirements and business model risk and management
strategy;
• Strengthened supervisory dialogue – the linking of requirements between business model and
risk of harm should allow FCA supervisors and investment firms to focus during the supervisory
review process on mitigating the risk of harm in a way that aligns with how the investment firm
thinks about its business;
• Improved competition – all investment firms carrying out the same investment activity are
treated in a simpler and more consistent manner. This allows competition for investment business
on a level playing field. This also means the regime will support our competition objective; and
• Better prudential outcomes – the new regime should improve prudential standards for
investment firms overall, for example through the introduction of a proportionate, minimum
liquidity requirement for all investment firms. This should improve overall confidence in the
financial resilience of investment firms and the industry among customers, counterparties and,
where relevant, shareholders”.
It sounds like the FCA have collected all the regulatory infinity stones but they then spoil it all by
saying: “While recognising these potential benefits, we are careful at this stage not to provide
specific numbers on the expected impact of a new UK regime on investment firm types.” Let that
sink in - without the numbers, without considering the consequences (at the very least) and the
consequences of the consequences (in an ideal world), then how can the FCA be sure of the benefits
and shouldn’t they have done this? It’s not really careful at all, it’s careless. It is a disingenuous
statement which covers the fact that despite the new requirements being developed over 6 years,
the FCA has done little education or consultation with UK investment firms and there has been no
UK-specific quantitative impact assessment (the EBA did conduct a limited data collection exercise in
2015). The K-factor requirements and the attached capital coefficients only became public at the end
of 2019 when the IFR and IFD were published. Firms should take the time to respond to the DP and
ensure that the FCA is fully aware on how the requirements affect them especially where they lead
to large increases which may require additional capital resources.
But fear not, because the increase in capital requirements as a result of the K-factors rules can be
capped at double whatever firms had under the CRR.
5BACKGROUND: How and why did we get here?
UK regulators have wrestled for decades with the question
of how to prudentially regulate non-systemic investment
firms. Since the late 1990s and the formation of a single
regulator in the form of the FSA and the implementation of
Basel II in the EU via CAD 3, risk-based capital requirements
(with internationally active banks in mind) came in, which to
a degree meant the broad assumption of “same risk, same
capital requirement” an approach rooted in the This is
especially so as investment firms do not carry out banking
activities such as money transfer, deposit-taking and credit
creation activities which then give banks access to lender of
last resort and deposit-protection facilities.
In the wake of the 2008 financial crisis, Basel 2.5 and Basel 3
led to CRD3, the CRR and then CRD4 in the EU. The UK
regulatory structure was then split between the PRA and the
FCA and in 2013 the FCA duly implemented CRD4 even
though its applicability to most of the investment firms it
regulated was limited. Almost as soon as CRD4 had been put
to bed, the EBA issued calls for advice on the prudential
regulation of investment firms – the FCA played a leading
role in the thinking and formulation of the new
requirements.
The origins story of prudential requirements for investment
firms was set out in the EBA’s 2015 Report on Investment
Firms. This set out conventional rationale for differentiated
prudential requirements that aims to: avoid the failure of
investment firms resulting in a material impact on the
stability of the financial system; prevent harming investors’
rights and assets; deal with the impact of failure; and/or
ensure there is enough time to wind down a firm.
The EBA goes on to say: “Although investment firms may not
present the same level of systemic threat to financial
stability as banks, they pose other significant risks; chief
among these are the risks they present to their customers
and market integrity”.
So far, so good – one cannot disagree with this analysis. The
EBA did a good job reiterating the case for prudential
regulation and the tools available to regulators to mitigate
the risk of prudential or systemic failure (and their limits).
Prudential requirements should then be applied that are:
• Proportionate to firms’ size;
• Act to reduce the risks from those firms’ prudential or
systemic failure;
• Increase the impact of prudential or systemic failure on
the owners/managers of firms;
• Reduce the potential impact of prudential or systemic
failure on the customers/counterparties of firms; and
• Increase public confidence in the soundness of firms.
6BACKGROUND: How and why did we get here? (cont’d)
The flaw in the origins story is the introduction of the
concept of so-called “bank-like” investment firms that is
used to justify the application of the new requirements,
which is unnecessary given that even if a firm is bank-like it is
still not a credit institution as defined currently in the CRD.
“Bank-like” was defined by the EBA in 2014 in its Report to
the European Commission on the perimeter of credit
institutions (i.e. banks) established in the Member States as:
“activities within the scope of credit intermediation. The four
key features of credit intermediation are: (a) maturity
transformation (borrowing short and lending/investing on
longer timescales); (b) liquidity transformation (using cash-
like liabilities to buy less liquid assets); (c) leverage; and (d)
credit risk transfer (transferring the risk of credit default to
another person for a fee)…Examples of entities carrying on
credit intermediation include: money market funds, special
purpose vehicles engaged in securitisation transactions,
securities and derivatives dealers and companies engaged in
factoring, leasing or hire purchase”.
The EBA’s analysis then becomes a long justification why
Basel/CRR requirements are not appropriate for investment
firms and hence the change to the new regime, although on
closer inspection (especially of the final IFR/IFD) there seem
to be a lot more common elements than they let on.
The EBA and FCA conveniently ignore the fact that the
current CRD/CRR regime still allows for different prudential
requirements and categorisation of firms based on the risks
in the business they do. Further individual capital
requirements for firms can be introduced via SREP and Pillar
2 processes.
However, despite this, Art.62 paragraph 3 of the IFR will
result in the CRD definition of credit institution being
amended to accommodate Class 1 investment firms that
conduct so-called bank-like activities. This sets the stage to
come up with a new investment firm regime.
The EBA conducted a limited data collection exercise in 2017
and concluded that overall capital requirements would only
increase by approximately 10% but (as the EBA admit) this
was based on a limited set of data of varying quality and also
hides big variations for different types of investment firms.
The resulting IFR/IFD regime is complex and uneven in its
application and impact. As annoying people say: It is what it
is.
Anecdotally, we are aware of countries and regulators
outside the EU who are looking at this regime and whether it
has applicability for their investment firm population. Insight
would respectfully suggest that this not a regime to cut-and-
paste – there are simpler, better options and choices that
could be made and we would be very happy to discuss these
with regulators outside the EU.
7APPLICATION TO INVESTMENT FIRMS
The new world order classifies investment firms into three categories based on different thresholds:
• Class 1 firms: Large systemically important investment firms and those who pose risks to financial
stability. There are 2 types and these firms will remain subject to the CRD IV and CRR:
• These are investment firms authorised under the CRD that are in the business of carrying out any
of MiFID activities (3) and/or (6) where one of the following also applies:
• the total value of the investment firm’s consolidated assets is equal to or more than
€30bn;
• the investment firm is part of a group where at least one other investment firm also
carries out MiFID activities (3) and (6), each individual investment firm has a total
value of consolidated assets of less than €30bn, but where the total value of the
consolidated assets of these investment firms is equal to or more than €30bn; or
• the investment firm itself has a total value of assets less than €30bn, but is part of a
group that includes another investment firm that also carries out MiFID activities (3)
and (6) with a total value of the consolidated assets of equal to or more than €30bn,
and the consolidating supervisor so decides to require the first investment firm to
also become subject to the CRR in order to address potential risks of circumvention
and financial stability; and
• Investment firms authorised under MIFID and subject to the CRR that are in the business of
carrying out any of MiFID activities (3) and/or (6) where any of the following apply:
• the total value of the investment firm’s consolidated assets is equal to or more than €15bn;
• the investment firm is part of a group where at least one other investment firm also carries
out MiFID activities (3) and/or (6), each individual investment firm has a total value of
consolidated assets of less than €15bn, but where the total value of the consolidated assets
of these investment firms is equal to or more than €15bn; or
• the investment firm’s supervisor has decided (under Article 5 of the IFD) that the firm
should be subject to the prudential requirements of the CRD/CRR.
• Class 3 firms: Small and non-interconnected investment firms (SNIs). These firms will also be
subject to the new IFR regime but can benefit from various exemptions and modifications given
that the risks incurred by them are limited for the most part. The threshold criteria for SNIs are:
(a) Assets under management (IFR Art.17) < €1.2bn on a combined basis;
(b)(i) Client orders handled – Cash trades (IFR Art.20) < €100m /day on a combined basis;
(b)(ii) Client orders handled – derivatives (IFR Art.20) < €1bn/day on a combined basis;
(c) Assets safeguarded and administered (IFR Art.19) Zero on an individual basis;
(d) Client money held (IFR Art.18) Zero on an individual basis;
(e) Daily trading flow (IFR Art.33) Zero an individual basis;
(f) Net position risk (IFR Art.22) or Clearing margin given (IFR Art.23) Zero an individual
basis;
(g) Trading counterparty default (IFR Art.26) Zero an individual basis;
(h) On- and off-balance sheet total < EUR 100 million on a combined basis; and
(i) Total annual gross revenue from investment services and activities < €30m on a
combined basis.
• Class 2 firms: Other investment firms that are not Class 1 or 3 i.e. they exceed the thresholds
for SNIs will but do not meet the thresholds for large systemic firms. Class 2 firms will be
subject to the full prudential IFR/IFD regime.
• Class 2 firms that calculate counterparty risk and market risk requirements are the firms that
need to consider the impacts of the DP the most.
8CAPITAL RESOURCES, INITIAL CAPITAL AND THE
PERMANENT MINIMUM REQUIREMENT
It turns out that capital is capital whatever type of firm you are.
The IFR follows broadly the same approach as the CRR on the relevant features for assessing the
quality of capital resources. Any differences are largely due to investment firms’ business models and
how capital requirements apply under the IFD/IFR.
Investment firms will be required to hold CET1, AT1, and T2 capital to the same proportions as set
out in the CRR. This is on the basis that, as with credit institutions, the quality of capital determines
its utility in allowing investment firms to remain financially resilient in the event of unexpected
losses.
The IFR updates the initial capital for authorisation for investment firms (including LLPs) updating the
requirements for the first time since 1993.
Figure 5.1 summarises the new levels of initial capital by activity:
Investment Firm Activity Initial Capital Requirement
Deal on own account and/or underwrite or place financial instruments €750k
Operating an OTF where additional permission to deal on own account €750k
for nonliquid sovereign debt instruments is required
Operating an OTF where additional permission to deal on own account €150k
for nonliquid sovereign debt instruments is not required
Undertaking the following MIFID activities without permission to hold €75k
client money or securities:
• Reception and transmission of orders;
• Execution of orders on behalf of clients;
• Portfolio management;
• Investment advice; and
• Placing of financial instruments without a firm commitment basis.
Any other MIFID activity (including operating an MTF) €150k
The new requirements introduce a new approach to determining minimum capital resources:
• For SNIs (Class 3 firms), this is the higher of the Permanent Minimum Requirement (PMR) and the
Fixed Overhead Requirement (FOR); and
• For Class 2 investment firms, this is the higher of the PMR, FOR or the requirements calculated
under the applicable K-factor calculations.
The FOR is 25% of prior year fixed overheads (i.e. to ensure all investment firms have enough
resources for an orderly wind down).
As the PMR is set at the same level as the initial capital requirement set out in the IFD, this means
that it is the floor for own funds requirements where the FOR or K-factor calculations result in lower
amounts.
These changes will result in significant changes for some firms and to help firms accommodate the
change the IFR introduces a transition period of up to 5 years for investment firms that were subject
to the previous regime.
9KAPITAL OR KRYPTON?
K-FACTOR REQUIREMENTS
The IFR/IFD introduces K-Factors as the new activity-based approach to calculate capital
requirements for Class 2 investment firms. The FCA state in DP20/2 that: “We believe the K-factor to
be one of the most important innovations of the new EU regime. The risk categories it aims to cover
better reflect the potential harm that an investment firm can pose to consumers and markets”.
The aim of the K-factors is to provide a tailored and more appropriate method for setting a risk-
based minimum own funds requirement for all types of investment firm compared to the CRR
regime. Key to this is redirection of risk management to focus the potential to create harm to
consumers and markets.
Although, as it turns out counterparty risk is still counterparty risk and market risk is still market risk.
The K-factors are supposed to be proxies for: operational risk (the IFR does away with the CRR
operational risk calculations); balance sheet risk; off balance sheet risk; leverage risk; and the risks
arising from a firm’s “market footprint."
The new K-Factors are divided into 3 categories and firms must add together the K-Factors that apply
to them: Risk to Clients (RtC); Risk to Market (RtM); and Risk to Firm (RtF). They form the centrepiece
of the new regime and are at times illogical and counterintuitive in the context of the day to day risk
and business management in firms. For example:
• Credit risk is viewed as a banking risk so Credit Quality Steps (CQS) no longer exist for investment
firms although counterparty risk still does but instead of CQS’ the IFR goes back to Basel I in the
Risk Factors used in the K-TCD calculation in Figure 6.2 in DP20/2 i.e. Govt./PSE exposures 1.6%;
Banks and Investment Firms 1.6%; and Others (i.e. corporates) 8%;
• Volatility adjustments for collateral in Fig.6.4 of DP20/2 are a more conservative version of those
in the CRR Art.224 Tables. The concept of Margin Periods of Risk (MPOR) is removed entirely;
• The Potential Future Exposure calculation is essentially a much more conservative version of that
in the SA-CCR;
• K-CON capital requirements only apply to trading book exposures; and
• K-NPR is based on whatever requirement a firm would apply under the current CRR (i.e. pre-
CRR2).
This is like going back to the future (but unlike Biff Tannen) not taking back what you currently know
to make the future better. The investment firms that apply these requirements under the CRR have
the wherewithal and knowledge to carry on doing so but instead end up with more conservative
requirements depending on their business. Credit risk and non-trading book exposures are a
particular blind spot but firms will still have to look at these risks in Pillar 2.
Investment firms who trade cash products and derivatives need to have a careful look at the K-
Factors because market risk requirements will stay the same, counterparty risk requirements will be
more conservative and the remaining K-Factors may end up delivering significantly increased capital
requirements over current operational risk requirements.
It would not be a surprise to see smaller trading firms ending up on higher requirements than much
larger firms and banks doing the same business and taking the same risks but who calculate their
capital requirements under the CRR.
10K-FACTOR REQUIREMENTS SUMMARY
Risk Category K-Factor Input and Capital Coefficient/Requirement
Risk to Client (RtC) K-AUM AUM = The rolling average of the value of the total monthly AUM measured on the last business day of each of the previous 15 months
converted into the entities’ functional currency at that time, excluding the 3 most recent monthly values.
Sum the requirements Assets under management
AUM shall be the arithmetic mean of the remaining 12 monthly values.
IFR Art.17
that apply Capital = AUM * 0.02%
K-CMH CMH (segregated) = the rolling average of the value of total daily client money held, measured at the end of each business day for the
previous 9 months, excluding the 3 most recent months.
Client money held (segregated)
CMH shall be the arithmetic mean of the daily values from the remaining 6 months.
IFR Art.18
Capital = CMH (segregated) * 0.4%
K-CMH CMH (non-segregated) = the rolling average of the value of total daily client money held, measured at the end of each business day for
the previous 9 months, excluding the 3 most recent months.
Client money held (non-segregated)
CMH shall be the arithmetic mean of the daily values from the remaining 6 months.
IFR Art.18
Capital = CMH (non-segregated) * 0.5%
K-ASA ASA = the rolling average of the value of the total daily assets safeguarded and administered, measured at the end of each business day
for the previous nine months, excluding the three most recent months.
Assets under safeguarding and administration
ASA shall be the arithmetic mean of the daily values from the remaining six months.
IFR Art.19
Capital = ASA * 0.04%
K-COH COH (cash trades) = the rolling average of the value of the total daily client orders handled, measured throughout each business day
over the previous 6 months, excluding the 3 most recent months. COH shall be the arithmetic mean of the daily values from the
Client orders handled (cash)
remaining 3 months.
IFR Art.20
Capital = COH (cash) * 0.1%
K-COH COH (derivative trades) = the rolling average of the value of the total daily client orders handled, measured throughout each business
day over the previous 6 months, excluding the 3 most recent months. COH shall be the arithmetic mean of the daily values from the
Client orders handled (derivatives)
remaining 3 months.
IFR Art.20
Capital = COH (derivatives) * 0.01%
Risk to Market (RtM) K-NPR Capital as per the CRR: Simplified; Standardized; or IMA approach.
(apply K-NPR or K- Net position risk on own account trading book
positions (unless K-CMG applies)
CMG if applicable) IFR Art.22
K-CMG Capital = 3rd highest total daily margin requirement over last 3 months x 1.3
Total margins required by firm’s clearing member
IFR Art.23
Risk to Firm (RtF) K-TCD Capital = ∑(1.2 x Exposure Value x Risk Factor x CVA)
Exposure Value = Maximum [0, Replacement Cost + PFE – Collateral
Sum the requirements Trading counterparty default (own account trading
Risk Factors: Govt./PSE exposures 1.6%; Banks and Investment Firms 1.6%; and Others (corporates) 8%
book exposures for cash and derivatives trades).
that apply IFR Art.25
CVA = 1.5 or 1
K-DTF DTF = the rolling average of the value of the total daily trading flow, measured throughout each business day over the previous 9
months, excluding the 3 most recent months (using absolute value of buys and sells).
Daily trading flow for cash trades or derivatives
Capital = DTF * 0.1% for cash trades
(trading book own account transactions + transactions
Capital = DTF * *0.01% for derivatives
executed for clients in firm’s name).
IFR Art.33
K-CON Capital = ∑(exposure capital requirement/exposure value)x exposure value excess
Firms must monitor and report on all sources of concentration risk as identified in the IFR. K-CON applies for trading book exposures
Concentration risk on own account trading book
transactions. above the IFR prescribed thresholds in line with CRR approach.
IFR Art.35 11KAPITAL OR KRYPTON?
K-FACTOR REQUIREMENTS
(cont’d)
The K-factor capital requirements are simple to calculate but there is a lot of work to get the inputs
right.
Questions do arise about what the point of it all is. How firms are meant to view the requirements
on a day-to-day basis and what are boards meant to do with the additional information?
The inputs for the K-Factors (excluding K-CMH, K-TCD, K-NPR and K-CON) use a variety of different
rolling averages that have different smoothing and lagging effects. The EBA explained the use of
rolling averages as being there to :
• Help firms’ capital planning and give them time to adjust their capital resources to the new
capital requirements;
• Help monitoring by supervisors; and
• To avoid undue swings in those K-factors that are not within the direct control of firms.
Apparently, the EBA say this is meant to be very like the use of “through-the-cycle” PDs and LGDs in
the CRR as opposed to a “point-in-time” approach – Is it? Really? There are simpler, less onerous
ways to design more static capital requirements.
Looking at K-AUM, for example, say you have a superstar fund manager who sets up his/her own
fund and in the early years attracts billions of pounds of new funds from retail investors, the K-AUM
number will gradually track upwards. After a few years, the superstar fund manager makes some bad
investments and takes a reputational hit – investors start to take their funds out very quickly, so
much so that the fund manager stops redemptions and locks in investors. In this situation, even
though the firm may be in crisis, this would not necessarily be apparent from the K-AUM because of
the built in smoothing and lagging effects. The reality is that the senior management and board
would know that the firm is in crisis and would be acting accordingly (no doubt they would tell their
supervisors), which leads one to question the usefulness of the capital requirement.
The EBA has recently published draft Regulatory Technical Standards as stated in the IFR/IFD and
given the FCA have been central to the construction of the new regime, it is likely that these will be
applied in the UK in due course. A couple of interesting things do pop out in the draft RTS’:
• K-DTF – the EBA have discovered that: “given the DTF is calculated based on the volume of
transaction, the capital requirement bears the risk of a reduction on trading activities, leading to a
risk of less market liquidity, with potential detriments to financial stability. Consequently, where
circumstances lead to extreme volatility, the K-DTF coefficients should be adjusted in a way which
incentivises trading activities…Therefore, for the purposes of this Regulation the adjustments to
the K-DTF coefficient should be calculated on the basis of the volumes of trades during
circumstances that lead to extreme volatility.” i.e. trades during periods of extreme volatility are
excluded from the K-DTF calculation because the EBA does not want to disincentivise trading; and
• K-CMG – the requirements are clarified to avoid arbitrage between the K-NPR and K-CMG; and in
situations where the margin requirement changes intra-day resulting in more than one margin
requirement in one day i.e. during stressed market conditions, the margin requirement used for
the purposes of calculating K-CMG is the highest for any given day.
Perhaps these issues highlight fundamental flaws in the design of the K-Factors.
Firms also need to remember that Pillar 2 assessments will still be required to capture those risks not
captured by the K-Factors.
12CONSOLIDATED SUPERVISION
AND GROUP CAPITAL
The IFR introduces Consolidated Supervision
(or as the FCA call it Prudential Consolidation)
for investment firm only groups and sub-groups
i.e. the requirements do not apply to groups
that include credit institutions (or insurance
firms subject to certain conditions being met).
Investment firm groups must consider and
manage the risks it may be exposed to or may
pose to clients and to markets, both directly
and indirectly, due to its membership of that
group, and treats the whole investment firm
group as if it was a single investment firm.
The IFR also goes further than the CRR in that LIQUIDITY REQUIREMENTS
the new requirements also cover parent
undertakings rather than the authorised entity.
This means parent undertakings which may be The IFR replaces CRR liquidity and requirements
unregulated will have to comply with the sets the minimum quantitative liquidity
requirements on a consolidated basis. adequacy requirement for all investment firms
as an amount of certain types of liquid assets
Consolidated own funds requirements will be equivalent to at least one third of the amount
determined on the basis of a consolidated PMR, of their FOR.
consolidated FOR and a consolidated K-factor
requirement. Consolidated liquidity and The intention is that, by basing the minimum
reporting requirements will also apply. liquidity requirement on a proportion of the
fixed overhead requirement, an investment
Further the IFR introduces the Group Capital firm should be able to meet its relevant
Test (GCT), the purpose of which is to ensure overheads for at least a month by using such
that an investment firm in a group is not liquidity, even if other sources of cash-flow are
exposed to unnecessary financial strain due to unavailable.
its membership of that group. It seeks to reduce
the risk that being part of a group may lead to The IFR approach seems odd in that lack of
potential sources of harm to clients, markets liquidity in its many forms is often at the root of
and to the investment firm itself, but without investment firm failures.
needing to apply all the relevant provisions of a
prudential consolidation. The assets and haircuts applied to them will be
familiar from the CRR. Liquidity will be assessed
Group structures need to be sufficiently simple, as part of the ICARA Pillar 2 process.
with no significant risks to clients or to market
from the investment firm group that would Firms should still be aware of liquidity risks and
otherwise require supervision on a consolidated risk drivers applicable to them in setting their
basis. liquidity risk appetite and tolerances.
The GCT requirements fall on the parent Firms should still know their main sources of
undertaking in the group, rather than an funding and they will still have some sort of
investment firm which is not a parent. This cash management process.
extends regulatory obligations to parent Stress testing and contingency funding will
undertakings which may otherwise be remain useful tools at most firms.
unregulated.
13FROM ICAAP TO ICARA: Pillar 2 v.2.0
There will be big changes to the SREP and Pillar 2 processes as a result of the IFR/IFD. Pillar 1 is described
as rules-based and Pillar 2 is risk-based.
ICAAPs will go and be replaced by the Internal Capital Adequacy and Risk Assessment (ICARA) process. This
aims to change how investment firms, approach internal risk assessment and governance process under
the new regime, as well as how the FCA will approach the supervisory process. The ICARA is in line with
the approach in FG20/1 Assessing Adequate Financial Resources and the framework in Figure 11.3 looks
at:
• Identifying and assessing harm to clients and markets;
• Additional risks that affect a firm’s capital;
• Additional risks affecting liquid resources;
• Viability and sustainability of business model and strategy; and
• Wind-down planning.
The ICARA should document how a firm:
• Reflects the risks to which the firm is exposed and the amount of risk it poses to clients and to markets;
• Applies a forward-looking approach to consider how these risks could evolve throughout the economic
cycle;
• Determines the appropriate level of financial resources required to cover these risks beyond what is
covered under Pillar 1:
• Considers business model viability and the sustainability of the firm’s strategy, including through
reverse stress testing, to determine vulnerabilities in the business model: and
• Considers the necessary financial resources and planning to allow for a credible wind-down of the firm
if it closes.
The FCA state that while superficially similar to the ICAAP, there will be key differences in how they expect
firms to think about risks as part of their ICARA process. The table in Figure 11.3 maps to the specific risks
required in an ICAAP and reclassifies them with generalities although the FCA say they will provide further
detail on their expectations.
Investment firms will still need to have robust governance and internal review processes to support the
ICARA and ensure they have enough financial and non-financial resources to reduce the risk of harm to
clients and markets, and in the case of failure be able to exit the market with minimal harm.
The way that the FCA set Pillar 2 capital and liquidity requirements will also change. Where there is
currently an ICG, this will be replaced by a legal minimum requirement (P2R) and where appropriate,
additional buffers to sit on top of the minimum requirements (P2G). The FCA helpfully set out what the
new capital stack would look like in paras. 11.91-11.94.
14TRANSITIONING FROM
EXISTING IFPRU/BIPRU ICG
The FCA envisage that those investment firms with ICGs currently in force would undertake the
following:
1. Calculate their total capital requirement under the current BIPRU or IFPRU regime according
to their most recent FCA SREP letter, as at the date immediately prior to the new regime
coming into force.
2. Calculate the new ‘Pillar 1’ requirement as at the date the new regime comes into force.
3. Compare the absolute capital figures. Where the new Pillar 1 requirement is higher than the
absolute amount under the previous regime, the current guidance would be considered no
longer valid. The investment firm would assess the appropriate level of additional Pillar 2
capital as part of its ICARA process under the new regime. In due course, the FCA would
inform investment firms of any new Pillar 2R requirement and, where applicable Pillar 2G,
which the FCA have determined as part of their future supervisory work.
4. Where the absolute amount under the old regime is higher than the new Pillar 1
requirement, the FCA envisage that investment firms would take the difference between the
new rules based amount and the additional necessary to meet the old absolute amount. They
would then use this to generate a new percentage multiplier above the Pillar 1 requirement
which would apply for the purposes of the new regime.
5. The investment firm would then apply to the FCA for a VREQ to confirm its rebased capital
requirement, for the purposes of transitioning the existing ICG when the new regime takes
effect.
Thereafter, investment firms would continue their ongoing assessment of the appropriate level of
additional Pillar 2 capital as part of their ICARA process, which would be subject to review as part of
our future supervisory work. For those investment firms that have capital planning buffers (i.e. not
buffers introduced by the CRD), we expect that these would remain in place.
15REGULATORY REMUNERATION
REPORTING
The IFPRU and BIPRU remuneration codes in
COREP and FINREP will be replaced by simpler SYSC19 will be replaced with a code based on
new reporting requirements are set out in IFR the IFD, which aims to create a proportionate
Art.54. Class 3 (SNI) firms must meet annual remuneration regime for investment firms
reporting requirements and all other which furthers the objectives of ensuring
investment firms must meet quarterly reporting alignment between risk and individual reward,
requirements of the following items: discouraging excessive risk-taking, and
promoting effective risk management.
• Level and composition of own funds;
Although in principle it will be broadly similar in
• Own funds requirements; its aims and structure, there will be changes.
The FCA will add further guidance to help
• Own funds requirement calculations; and investment firms better understand their
• The level of activity for the conditions set out expectations.
in paragraph 1 of IFR Art.12 para 1, including:
• Balance sheet;
• Revenue breakdown by investment
service;
• Applicable K-factors; WAIVERS AND CRR
• Concentration risk; and
• Liquidity requirements.
PERMISSIONS
In general, unless the IFR makes specific
ESG ISSUES reference to the CRR, waivers under the CRR
will generally fall away when the new regime
comes in.
The EBA will investigate whether any ESG- So waivers from consolidated supervision, large
specific adjustments to the K-factors or their exposure limits and liquidity related waivers will
coefficients should be developed in future to no longer apply.
ensure the appropriate prudential treatment of
ESG-exposed assets. Some waivers relating to CET1 (CRR Art.26(s)
and 26(3)) and permission to reduce own funds
In the meantime, all investment firms in the UK (CRR Arts.77-78) will remain.
are encouraged to consider material ESG-
Firms with permission to use models to
related risks when calculating their capital and calculate delta-equivalent positions for options
liquidity requirements. and warrant on various underlyings and interest
rate sensitivity pre-processing models, will be
able to continue using them.
PUBLIC DISCLOSURE Under IFR Art.25, firms will need to apply for
permission to exclude intra-group transaction
from the K-TCD calculation (this is equivalent to
There will be a public disclosure regime that a 0% risk weighting for intra-group exposures
aims to better reflect investment firms’ but the IFR does not use risk weights nor
business models and their potential risk of harm require credit risk calculations).
including new requirements around
remuneration and ESG.
16IFR TRANSITIONAL PROVISIONS: Double or quits.
DP20/2 chapter 20 lists the transitional provisions that the FCA will apply as per IFR Art.57 for 5 years
to help ease the change from any existing own funds requirements, or other type of capital
requirements, to the full application of own funds requirements under the IFR. The most important
for firms to take note of are:
1. IFR Art.57(3): Lower own funds requirement than the higher of IFR’s FOR and K-Factor
requirement for certain investment firms
IFR Art.57(3) which allows BIPRU and IFPRU firms to choose, for five years from the date of
implementation of the IFR in the EU (i.e. from 26 June 2021 until 25 June 2026), to limit their own
funds requirements compared to those that would otherwise apply in respect of the FOR and K-
Factor requirements to twice their relevant own funds requirement as calculated in line with the
provisions of the CRR as it stood before the CRR2 amendments package, as if these had continued
to apply.
However, the FCA will require those firms applying this transitional “to re-calculate the comparison
of its own funds requirements according to the provisions of the CRR on a regular, updated basis
(and at least as frequently as it reports its own funds requirements) over the whole of the period for
which it makes use of the transitional provision. A single, historic calculation cannot be relied upon
and is not permitted”; and
2. IFR Art.57(4): Determining the level of Permanent Minimum Requirement
IFR sets out three transitional provisions for calculating an investment firm’s Permanent Minimum
Requirement (PMR) under point (b) of paragraph 1 of Article 11 of the IFR, applicable for five years
from IFR implementation (i.e. from 26 June 2021). These provisions allow certain investment firms to
determine their PMR during the transitional period increasing the PMR by €5k each year to meet the
IFR minimum requirements when the 5 years ends.
3. IFR Art.1(5): Quits – opting in to the CRD/CRR
IFR Art.1(5) gives a derogation to national supervisors to allow investment firms that part of a
banking group to opt-in to the CRD/CRR. At the moment the FCA do not intend to use this discretion
although if they did they would charge firms additional fees to cover the cost of maintaining COREP
reporting systems.
The FCA should allow all investment firms to opt-in to the CRD/CRR regime especially where the new
IFR/IFD rules result in big capital increases for no other reason than the fact that they are not a Class
1 investment firm and hence a Credit Institution as per the revised CRR definition.
The new requirements will work for many firms but there will be a significant number for
whom the IFD/IFR requirements will not align to their business model because they
deliver a worse prudential outcome, meaning higher regulatory costs (because capital is
expensive), will distort competition by tilting the playing-field in favour of large
investment firms and banks, and will not necessarily deliver the kind of stronger
supervisory dialogue that the FCA want.
17At Insight Regulatory Consulting we can help firms deal with the changes in the new prudential regime. We have a team of expert prudential and regulatory reporting consultants with: • The regulatory knowledge to help firms assess the impact and implications of the new requirements; • The industry expertise to help firms plan implementation; and • The common sense project management experience to successfully implement the new requirements. Palvinder Gill palvinder.gill@insight-regulatory.com +44 (0)7811-371884
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