New prudential regulation for investment firms in Europe

At the end of nearly two years of legislative work, the reform of the prudential regulation of investment firms completed its final phase with the publication in the Official Journal of the European Union of two new regulatory texts: Regulation 2019/2033 on the prudential requirements of investment firms (IFR), and Directive 2019/2034 on the prudential supervision of investment firms (IFD). The Directive is required to be transposed into national law no later than 26 June 2021. The Regulation is effective from the same date, apart from certain provisions amending the regulation of financial markets.

Why a specific regime?

The objective of the reform is to subject investment firms to a prudential framework more in line with the risks that these firms actually incur, which can be different from traditional banking risks. The vast majority of investment firms are small, and the likelihood that the failure of one of them could have detrimental impacts on financial stability is low. Therefore, in accordance with the principle of proportionality in prudential regulation, investment firms will in future be subject to their own rules.

Proportional regulation

Investment firms are grouped according to size. Large investment firms are those which could present a systemic risk in the event of failure. These remain subject to banking rules contained in the capital requirements regulation (CRR) and capital requirements directive (CRD). Furthermore, in cases where the consolidated assets of a firm exceed EUR 30 billion, they will have to be authorised as credit institutions and will be supervised directly by the European Central Bank (ECB). In this respect, the IFR amends the definition of a credit institution in the CRR.

For smaller investment firms, the IFR provides specific rules for capital, liquidity, concentration, reporting, and disclosures, although with some possible waivers (except in the case of liquidity). The minimum capital requirements of these investment firms correspond to the higher of their minimum capital requirement, a quarter of their fixed overheads, or the calculation of their K-factors.

This last calculation measures the risks in relation to customers, the market and the firm itself. Fixed overheads are calculated using the methodology of the Commission Delegated Regulation 2015/488; the minimum capital depends on the services provided by the investment firm.

Note that the calculation of K-factors is not required for investment firms classified as “small and non-interconnected”. 

Proportional supervision

The IFD sets out the framework for supervision and cooperation between authorities. It lists the expectations regarding internal processes for the identification and measurement of risks, the allocation of capital and liquid assets, and internal control procedures for investment firms not classified as small and non-interconnected. The Directive also provides specific rules for remuneration policy and internal governance. The rules for ring-fencing customer assets are matters of national law.

Finally, the European Banking Authority (EBA) is expected to issue a significant number of level 2 texts and guidelines in areas including the detail of future prudential reporting, pillar 3 disclosure models, the scope of prudential consolidation, and the treatment of exposures to activities associated with environmental, social, and governance (ESG) objectives for the supervisory review and evaluation process.