Changes to the capital adequacy requirements and related prudential regulation applicable to investment firms will come into force in the EU in June 2021 and in the UK in January 2022. Affected investment firms will need to be aware of the regulatory impact the changes will have on their business.
The new regime
The new prudential regime is set out in the UK Investment Firm Prudential Regime (IFPR) and is regulated by the FCA. It is anticipated that the IFPR will come into force in January 2022.
However, the IFPR is closely aligned with the EU Investment Firm Regulation and Investment Firm Directive (the FCA was an advocate of the EU regime and legislation before Brexit); the EU legislation will come into force in June 2021 and so firms, particularly those with an EU presence, will need to be aware of the new regime and the changes it brings to capital adequacy requirements.
The new regime divides investment firms into three classifications, Classes 1 – 3. Class 1 captures systemically important investment firms with assets greater than €30bn, this will include major financial institutions. Classes 2 and 3 capture non-systemic investment firms. Class 2 will include larger non-systemic firms with a balance sheet total greater than €100million while Class 3 captures smaller investment firms not fitting within Class 2.
The capital adequacy requirements for Class 1 firms is essentially unchanged by the new rules and those firms will continue to adhere to rules set out in the Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR). There are, however, significant changes for Class 2 and Class 3 firms. It is important that firms carefully consider their obligations under the new regime.
The capital requirements under the UK IFPR will be introduced on a phased basis and transitional provisions will be provided.
New risk factors
The new regime introduces ‘K-factors’ for Class 2 and 3 firms. K-factors are a method of measuring risk posed by an investment firm and they are separated into three groups covering risks to the customers (RtC), the market (RtM), and the firm itself (RtF). For example, one of the RtC K-factors referred to as ‘K-CMH’ relates to client money held. This K-Factor provides a coefficient percentage and investment firms must calculate capital requirements using the coefficient.
The new classification system will extend to many investment firms and it is possible that a large number of firms will be required to increase their capital to comply with the new requirements.
There is a substantial amount of detail in the new rules and firms will need to review and amend processes and policies to comply with the new requirements. Some headline points to note are:
- Class 2 and Class 3 investment firms will need to familiarise themselves with, and implement, risk K-factors to determine capital requirements.
- Investment firms will need to prepare a wind-down plan to demonstrate that there is sufficient capital for an orderly wind-down of the business. Investment firms will also be required to maintain liquid assets for at least one month of fixed overheads.
- Class 2 and 3 firms will no longer have disclosure and reporting obligations under CRD and CRR. However, the new prudential regime imposes reporting obligations, including an annual report to regulators. The reporting and disclosure obligations are less onerous for Class 3 firms.
- The regime also sets out various governance and remuneration requirements to ensure that firms have a proportionate and robust approach to dissuade management from taking undue risks.
For Class 2 and Class 3 firms in particular, the changes implemented by the UK IFPR undoubtedly present a significant shift in the regulatory landscape and will require those firms to carefully review their finance and compliance framework in respect of capital adequacy requirements. Investment firms will need to ensure that their policies and procedures effectively identify risks and facilitate the gathering of information required for application of K-factors in order to correctly calculate capital requirements.
Much of the new regime is novel and regulated firms are encouraged to obtain professional advice in order to ascertain whether they are caught within the new regime and, where applicable, to ensure that that the requirements are correctly followed.