The New EU Prudential Regime for Investment Firms and What It Means for Firms

Courtesy of Mete Feridun 

Disclaimer: The views and opinions expressed in this blog are those of the author and do not necessarily reflect the official views and opinions of PwC. 

The Official Journal of the European Union published the prudential framework for investment firms (Investment Firms Review – IFR) on 5 December 2019. Applying to all MiFID investment firms, IFR will introduce strategic, operational, and regulatory challenges for firms in scope. Consisting of the Investment Firms Regulation and the Investment Firms Directive, IFR sets tailored and proportionate rules for investment firms on capital requirements, capital composition, group consolidation, liquidity requirements, reporting, disclosure, governance, remuneration,and supervision of investment firms. 

The regime introduces a tailored and proportionate approach, with all investment firms seeingan increase in their minimum capital requirements regardless of the types of their activities. The new prudential rules will take effect on 26 June 2021, with a transition period of five years for capital requirements. Given this transition period, it is no surprise that the most frequently asked question regarding the new regime is whether it willresult in an increase in capital requirements for all investment firms. The answer: Not necessarily. IFR may result in an increase in capital requirements for some investment firms, but it includes a transition period of five years. During this transition period, any increased capital requirements will be capped to twice their current levels. However, this means that firms’ capital requirements may double,so firms should undertake careful capital planning in line with their business strategies. 

IFR will also introduce liquidity requirements in the form of high-quality liquid assets. Firms will have 18 months to upgrade their existing stock of liquid assets with better quality assets that meet the definition of Level 1, 2A, and 2B assets under the EU Liquidity Coverage Ratio Delegated Act. Given that the market demand for these assets will be higher in the industry due tomargin requirements and bankliquidity ratios,the cost of liquidity will be higher for all firms. Liquidity requirements will also require some firms to put in place costly treasury or Asset and Liability Management functions to monitor and manage their liquidity.

The regime will allow smaller firms to use certain lower quality assets subject to conditions—including a 50% haircut—and the National Competent Authorities (NCAs) may exempt smaller firms from the liquidity requirement. Under the new regime, NCAs are allowed to apply exemptions subject to certain criteria that are currently unknown. The European Banking Authority is expected to provide more information on this in consultation with the European Securities Markets Authority. Until then, there will be a certain degree of uncertainty in the market,but firms will need to prepare for all possible outcomes.

IFR is likely to apply in different ways to different firms. Firms holding client money must carefully consider the impact on clients; however, businesses which have been through substantial acquisition processes or rely on waivers from the consolidation rules should consider how the rules may impact their future growth strategies. Given the new classification system, firms will need to review their business models to decide if it will be more feasible for them to stay in a lower category where less stringent rules will apply. This will also have strategic implications, as future business model changes may lead to a substantial increase in their capital and liquidity costs.

Firms that will be required to apply the new ‘K-factors’ approach, which is a completely new methodology to calculate capital requirements, will face challenges in adopting this new methodology, as well as capturing the data required for those calculations. The new regime requires firms to continue calculating their net position risks using the current Capital Requirement Regulation market risk rules for five years (until June 2026), or until the Fundamental Review of the Trading Book (FRTB) capital rules take effect if this happens later than June 2026 (currently expected in January 2025). Implementing FRTB will entail further implementation challenges, so firms should take those into account while adopting the K-factors approach. 

Implementing IFR will challenge investment firms’ systems, as they will be required to monitor a wider set of metrics, andnot just assets under management or client assets. And with the need to evaluate some of that data over the 15 months before June 2021, part of the implementation challenge starts in Q1 2020. Thus, it would be a mistake for firms to focus on the 2021 implementation date. Despite the transition period of five years, to comply with some elements of IFR, investment firms in the EU will need 15 months of data by June 2021, so they would be well advised to take action by March 2020.

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