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18th February 2016

CRD IV requirements being reviewed for Investment Firms

The EC is undertaking a complete overhaul of the prudential regime for investment firms which will have important implications on the capital and liquidity of those firms that are affected.

The prudential regime for MiFID investment firms has grown into a complex framework primarily designed for banks – the Capital Requirements Directive (CRD IV) and Capital Requirements Regulation (CRR). This has for some time been seen within the industry as being overly burdensome for non-bank investment firms and one that does not necessarily address the specific risks of these firms.

The provisions of the CRR allowed for the European Commission to undertake a review of the overall prudential framework for investment firms (‘The Investment Firm Review’). As such, the European Commission called for advice on the suitability of certain aspects of the prudential regime for investment firms.

At the end of last year (December 2015), the European Banking Authority released its first report on the Investment Firm Review in response to the EC’s request and, in co-operation with ESMA, sets out their recommendations and findings on what that they believe will lead to a more proportionate and risk-based prudential regime for investment firms.

The EBA report identifies a number of issues in the current application of the CRD/CRR requirements for investment firms, including a lack of adequate risk sensitivity and the complexity of the framework stemming from the current categorisation and suggests a new approach to categorisation.

Current CRD IV Categorisation of Firms

At the moment, the prudential framework that applies to investment firms is based upon a firm’s categorisation under the CRD IV framework, which is primarily determined by the investment services it offers and the activities that it undertakes under Annex I of MiFID.

Whilst the number of services and activities under MiFID totals eight, when MiFID II is implemented in January 2017, this will increase to nine.

A1 Reception and transmission of orders in relation to one or more financial instruments        

A2 Execution of orders on behalf of clients

A3 Dealing on own account A4 Portfolio management

A5 Investment advice

A6  Underwriting and/or placing of financial instruments on a firm commitment basis

A7  Placing of financial instruments without a firm commitment basis

A8  Operation of multilateral trading facilities (MTFs)

*A9, Operation of organised trading facilities (OTFs). (*Applicable with MiFID II)

The EBA’s new recommendations for categorisation would distinguish between systemic and ‘bank-like’ investment firms to which full CRD/CRR requirements should apply, and other investment firms that are not considered ‘systemic’ or ‘interconnected’.

It is yet to be determined which qualitative and quantitative parameters would be used to define the new categories. However, the EBA then recommends that for those firms that fall within ‘non-systemic’ or ‘non-interconnected’ - for which the EBA expects the vast majority of firms to do- new prudential requirements should be developed that are tailored to reflect the risks specific to their activities.

“It is recognised that a small minority of MiFID firms are substantial undertakings that run ‘bank-like’ intermediation and underwriting risks at a significant scale. Such activities expose these institutions to credit risk, primarily in the form of counterparty risk, and market risk for positions taken on own account, be it for the purpose of external clients or not.

For other investment firms, however, a less complex prudential regime seems appropriate to address the specific risks that investment firms pose to investors and to other market participants with regards to investment business risks such as credit, market, operational and liquidity risk.

In the last tier, small and non-interconnected firms warrant a very simple regime to wind them down in an orderly manner. Such a regime could be based mainly on fixed overhead requirements (FORs) that fulfil the objective of setting aside sufficient capital for ensuring safe and sound management of their risks. These firms could also be subject to simplified reporting obligations.” EBA, 14 December 2015

Whilst it is still too early to determine the actual changes that may take place, it is likely to assume that for much smaller firms and those not running ‘bank-like’ activities, such as market making or taking margin on credit risks that the situation is likely to change considerably for the better.

Going forwards, the EBA will now focus upon expanding their framework for new categorisations of investment firms within scope as well as the prudential regime for ‘non-systemic’ and ‘non-interconnected’ firms and undertake further research for a second more detailed report.

CRD IV Requirements reviewed for Investment Firms