The European Banking Authority (EBA) has published its proposal for a new prudential framework for MiFID investment firms. The recommendations have been submitted to the European Commission (‘the Commission’), which is expected to propose legislation by the end of the year. Industry does not anticipate implementation to occur before 2020.
This blog outlines the key aspects of the proposal, and the implications for MiFID investment firms. Our extended briefing provides a more detailed summary of the proposal.
Overview of the finalised proposal
The proposal is intended to create a more risk-focussed prudential regime for MiFID investment firms which will be based on the scale and scope of the activities undertaken.
A tapered three-tier categorisation system will apply with Class 1 firms considered to be systemic in nature, Class 2 firms exceeding specific business-related thresholds, and Class 3 firms being small in nature and subject to a simpler regime.
Elements of the proposed regime will be recognisable from the existing framework, albeit with slight amendments to applicable thresholds. Common Equity Tier 1, Additional Tier 1 and Tier 2 capital limits are familiar terms under the new proposal, as is a Fixed Overhead Requirement (FOR) and a Permanent Minimum Capital Requirement (PMC) reading across to ‘initial capital’.
While Class 1 firms are anticipated to be ‘systemic in nature’ and subject to the existing CRR, and Class 3 firms will have a minimum capital requirement equal to the higher of PMC or FOR, Class 2 firms will be subject to a minimum capital requirement based on the higher of the PMC, FOR and a K-factor calculation.
The K-factors are linked to Assets Under Management, Client Money Holdings, Assets Safeguarded, Client Orders Handled, Daily Trade Flow and Intraday Margining.
It is proposed that Class 1 firms will be subject to full liquidity requirements, with Class 2 and 3 firms required to hold an amount of liquid assets equal to one third of their FOR with additional measurement and monitoring obligations.
Capital adequacy (Pillar 2) self-assessments will be applicable to Class 2 and 3 firms, with competent authorities able to undertake individual firm-specific assessments, in order to apply increased capital and liquidity requirements where applicable.
Implications for Firms
Despite its intention to be ‘capital neutral’, the EBA’s own impact analysis estimates that there will be an overall increase of 10% on current Pillar 1 capital requirements.
However, as the above table demonstrates, the capital increases will not fall evenly across the different types of firms operating in this sector. Many investment advisors, which would not previously have been subject to a risk-based capital requirement, will experience the highest percentage Pillar 1 capital increase of 308%, while custodians and trading firms are anticipated to see a fall in Pillar 1 requirements.
At first glance, this would appear to be beneficial to custodians and trading firms, but their capital requirements have previously been driven by the Pillar 2 assessment. Therefore, as the Pillar 2 framework under the new regime is still expected to consider elements not fully covered by Pillar 1, we do not envisage that overall capital requirements will be substantially reduced for these firms.
For the investment advisors, the 308% increase has to be considered in the context of a relatively low base line, and the EBA estimates that under the reformed framework, only 7% of firms are expected to exhibit a capital shortfall as a result of the proposals. However, this figure does not (for obvious reasons) incorporate the expected implementation costs of other regulations such as MiFID II, GDPR etc. When these and other requirements are taken into account, the expanding regulatory cost base is likely to increasingly challenge investment advisor business models.
Across the EU, the EBA’s analysis shows that 68% of firms in its sampling exercise would fall within the Class 2 categorisation and be subject to the K-factor analysis. However, of the 95 UK firms that were sampled, only 2 were deemed to be categorised as Class 3 firms. Assuming the UK sample was representative, we would expect the majority of UK investment firms to be subject to the K-factor methodology.
The proposals envisage RTS clarification of the definition of Class 1 Investment Firms. The EBA considers these firms to be ‘systemic’ with existing CRR prudential requirements being applied to them. Separately, Commission proposals have set out recommendations to align the regulatory and supervisory treatment of ‘large’ investment firms with large credit institutions. Therefore, if the definition of ‘Systemic Class 1 Investment Firms’ under the EBA proposals aligns to ‘Large Investment Firms’ under the European Commission Proposals, then such firms established in Member States participating in the Banking Union will become subject to supervision by the European Central Bank.