The EBA is close to finalising its report into a new prudential regime for investment firms. This is in response to a call for advice from the European Commission (EC).
On 3 July 2017, the EBA held a public hearing in London on its progress thus far, specifically in relation to firm classifications, capital and liquidity requirements and reporting.
How to categorise firms
The EBA has recommended three categories:
- Class 1 – Investment firms that are systemic and ‘bank-like’. These firms are subject to full bank prudential requirements
- Class 2 – Firms that are not systemic or ‘bank-like’
- Class 3 – Firms that are very small with ‘non-interconnected’ services.
The EBA have now updated their recommendation leading to some potential winners and losers. This is due to the blurring of lines between Class 1 and Class 2 and the tightening of thresholds between Class 2 and Class 3:
- Some non-systemic firms may be deemed Class 1 based on the size of the firm
- Some systemic and non ‘bank-like’ firms may be excluded from Class 1
- Classification of Class 2 and 3 firms will be determined by thresholds designed to capture the largest firms in class 2
- Any firm that holds client money, safeguards or administers client assets or deals on own account will automatically be classified as class 2.
Once the EBA have finalised the details of classification, firms will need to pay careful attention to this aspect of the regime and be prepared to adjust their prudential frameworks accordingly.
Proposed capital requirements
Class 1 firms will continue to follow the Capital Requirements Regulation (CRR) whilst the proposed capital requirements for Class 2 firms are determined by the K-factors formula based on the types of activity a firm undertakes. These activities cover Risk to Customer (RtC), Risk to Market (RtM) and Risk to Firm (RtF). The capital requirement is calculated as follows:
The EBA provided their proposed calibration of the coefficients (a to e) to be used with the K-factors. NPR and DTF will only apply for firms trading on their own account.
NPR will be based on the CRR2 methodology for market risk, TCD on a simplified version of the mark to market method for counterparty credit risk and CON will use the large exposure methodology for the trading book.
These factors are subject to final calibration and the EBA are currently seeking to collect further data to facilitate this.
The EBA proposed that the Liquidity Coverage Ratio (LCR) will apply to all class 2 firms. However, the Net Stable Funding Ratio (NSFR) would not be applicable since the NSFR design is still under development.
A liquid asset requirement of one third of the fixed overhead requirement (FOR) will apply to Class 2 and 3 firms. Liquid assets will have to meet the definition of high quality liquid assets (HQLA) under the LCR and can be supplemented by firms’ own cash.
The EBA also stressed that liquid assets can be used by firms in exceptional and unexpected circumstances even if this results in liquid assets falling below the required minimum. Firms should have a plan for restoration of the buffer.
A simplified and more proportionate reporting framework for Class 2 and 3 firms is being proposed. This will include the key attributes of solvency, capital composition and requirements, liquidity requirements, concentration risk and specific business model requirements. The EBA suggested that reporting for Class 3 firms should be less granular than under Class 2. The EBA also proposes that Pillar 3 requirements should be minimal for Class 2 firms whilst Class 3 firms should be exempt.
For many firms this will result in a change to their existing reporting framework and for smaller firms there may be a lightening of the regulatory reporting burden.
What happens next?
The EBA are holding a round table in Brussels on 17th July 2017 to gather further feedback from stakeholders, particularly in relation to classification thresholds. They are also gathering additional data to support the calibration of the K-factors. The EBA expects to submit its final report in September 2017 with a legislative proposal expected by end of 2017.
What do you need to do?
The EBA’s recommendations represent the biggest shake-up of prudential regulation for investment firms to date.
- Now is the time for firms to plan for the potential impacts, which could be significant. Investment firms should carefully consider the likely impact on their capital adequacy and plan for any potential capital shortfalls as a result of the new regime.
- Firms may also wish to take part in the EBA’s data collection exercise.
Our specialist prudential practice can carry out an assessment of how the new regime may affect your firm and can help you make the necessary preparations.