New Prudential Rules
1st May 2020
The good, the bad, the ugly- new prudential rules for investment firms to replace CRD/CRR June 2021 onwards
We at Pillar 4 have spent days and nights reading regulatory texts and discussions papers to figure out the likely impact in terms of the good, the bad, and the ugly for investments firms, stemming from the new investment firm prudential regulatory package known as IFD/IFR. Our research involved preparing several insight documents on the topic of IFD/IFR(below) and preparing capital models to assess the likely impact on the different classes of firms, class 1 (systemically relevant), class 2 (non-systemically relevant) , and class 3 (small and non-interconnected).
So, what’s the good? Credit risk done away with, liquidity simplified, and less onerous reporting regime
Well, for starters it is a good thing that EU wide regulatory action was taken to create a separate prudential regime for investment firms. Investments firms currently in scope of CRD/CRR often find themselves allocating capital against risks that are not reflective of their business models. The CRD/CRR after all was provisioned with banks in mind and is predominantly centred around credit, market, operational, and concentration (large exposures) risk.
Part of the existing CRD/CRR assessments include holding regulatory capital against credit risk on all balance sheet assets unless they are deducted from capital resources. Under the IFD/IFR, the regulators have omitted onerous credit risk calculations for investment firms. This is possibly for the better as it can be argued that investment firms are generally not exposed to the same levels of credit risk as banks. It should however be noted that assessment for counterparty credit risk still applies to firms dealing on own account under the IFD/IFR and there are some substantial rules around allocating capital for this subset of credit risk.
The rules around liquidity have been simplified to one overarching rule which is that ‘liquid assets have to be equivalent to at least one third of the fixed overhead requirement.’ A fixed overhead requirement has to be calculated and applied to all firms in scope of the IFD/IFR. We welcome this as a simplified approach to liquidity and a shift away from the current ‘bank-like’ BIPRU12 liquidity rules that are often onerous for most BIPRU/IFPRU firms to comply.
Whilst there has not been much info on the reporting side of things, it is likely for the new reporting regime to be simpler than before and hopefully firms will end up scratching their heads less when figuring out reporting templates such as Corep templates.
Through the IFD, the regulators have dropped the initial capital requirement (ICR) for MTFs and OTFs from the current level of €730K to a significantly lower €150K. We see this as a shift to possibly help stimulate more OTC trading to take place on electronic platforms with the increased transparency that goes along with it. This drop in ICR might reduce the capital barriers for some of the smaller sized MTFs and OTFs to set up trading venues although fixed overhead requirements and wind down costs are likely to be considerable and exceed ICR for most trading venues.
The bad? Liquidity rule applies to all firms! All firms must have a documented ICARA! Public disclosure to apply!
The FCA is likely to apply the mandatory liquidity rule (‘liquid assets have to be equivalent to at least one third of the fixed overhead requirement’) to all firms in scope of the IFD/IFR, including class 3 SNIs, and it has alluded to this in its recent discussion paper. What this means is that some firms such as exempt-cad firms, will see a liquidity requirement applied to them for the first time.
Under the IFD/IFR, all investment firms in scope will be required to document what is known as an internal capital adequacy and risk assessment (ICARA) to capture capital adequacy, liquidity and stress testing. Currently, only BIPRU and IFPRU firms are required to document an internal capital adequacy assessment process (ICAAP). Whilst this might pose administrative burdens to some firms, we feel it is in the interest of financial prudence and market integrity that all investment firms have a documented capital adequacy process.
Several public disclosures around risk management, governance, remuneration, capital resources, etc apply to all investment firms in scope of the IFD/IFR. Some firms such as exempt-CAD firms will now be in scope of remuneration disclosures that previously didn’t apply to them. Whilst these disclosures might create some administrative burden, we generally welcome them in setting a level playing field for all investment firms.
The ugly – overall our capital models indicate higher regulatory capital requirements for most small and medium sized firms!
Our extensive work and modelling with small and medium firms in mind have led us to conclude that overall, such firms will see a rise in minimum regulatory capital requirements. Of course, no two balance sheets are the same so it is important to conduct your own assessment to figure out the impact on your firm.
It goes without saying that matched principal brokers (MPBs) and local firms will see a significant rise in their initial capital requirements from the current levels of €50K or €125K to a new level of €750K as the IFD has done away with these exemptions to dealing on own account. We anticipate several small and medium MPBs and local firms in particular to be affected by these changes.
How Pillar 4 can help
Prash Fernando, our founder and lead consultant, is a subject matter expert on regulatory risk and capital. He spent several years helping investment firms comply with CRD/CRR including IFPRU730K dealers involved in both cash and derivative asset classes. His background in financial modelling and risk has enabled us to develop and successfully help clients implement practical and workable regulatory capital models. Speak to us for a free initial IFD/IFR assessment of your firm.