Likely to come into force by the end of 2019, the prudential framework will hit some firms very hard, requiring them to maintain significantly greater levels of capital.
The prudential framework is a new rule book developed by the European Commission (EC) for investment firms, designed to be simpler and more proportionate to a firm’s operations. But with new rules come new challenges and firms should now take time to assess the impact these rules will have on their capital, liquidity, remuneration and disclosures.
We continue to track the evolution of this framework and are running a series of articles assessing the material areas of change imposed by these new rules. In this first article, we examine the regime’s impact on the capital and liquidity requirements of Exempt-CAD firms.
What does this mean for Exempt-CAD firms?
Amongst those firms likely to be hit hardest are Exempt-CAD firms, which typically only provide investment advice or arrange deals. This category will not exist in the new framework and these firms will need to assess where they will fit in the regime.
Under the current Exempt-CAD requirements, prudential compliance is a relatively simple process. Firms hold capital in excess of a fixed minimum amount and submit reports to the FCA on a periodic basis.
However, under the new framework, the amount of capital they will be required to hold will rise by at least 50% and, in many cases, by significantly more. In addition, the time to ensure compliance with more complex and onerous capital, liquidity, reporting and governance requirements is sure to create a need for additional resources.
Why is this change happening?
Most investment firms are currently governed by the prudential capital framework for banking, as set out by the Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR).
This framework is ill-suited to most investment firms and regulators have long wanted to apply arrangements for calculating regulatory capital in the sector. Progress on finalising new prudential capital rules for investment firms will likely be relatively swift.
When will this change happen?
The European Commission published its proposed directive and regulation in December 2017. This followed on from the circulation of the European Banking Authority’s (EBA) Opinion at the end of September 2017. The new requirements will need to pass through the EU’s normal law-making process, and so we expect that firms will have to be compliant with the regime by the end of 2019.
So, what’s an Exempt-CAD firm to do?
To date, Exempt-CAD firms operated outside the CRD/CRR framework. The new regime will mean increased capital requirements and governance burdens. As a first step, firms should explore the proposals to see which category they will fall under. In particular, Exempt-CAD firms will need to:
- Boost capital
The new minimum, formula-based, requirements will force most Exempt-CAD firms to increase the amount of capital they hold by a significant amount:
- The initial capital requirement (ICR) of €50,000 will increase to €75,000;
- Firms will also have to contend with a Fixed Overheads Requirement (FOR) for the first time; equivalent to a quarter of annual expenditure. Larger firms may face additional capital requirements, calculated with reference to the type and volume of business they conduct.
Every Exempt-CAD firm needs to plan for the increase in capital that will be required to continue doing business after the framework comes into force.
- Implement internal risk-based assessment
Firms will need to carry out an assessment of their capital requirements specific to the risks that they are exposed to. This could mean the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP) frameworks for the first time for Exempt-CAD firms and would require a considerable amount of work. The application of this “Pillar 2” regime could also give rise to the need to hold even more capital – depending on the outcome of the firm’s own assessment work as well as any regulatory review under a SREP.
- Hold liquidity resources
Exempt-CAD firms will need to implement internal policies and procedures that allow them to monitor, measure and manage liquidity and liquidity resources. Firms will have to hold one-third of their FOR as liquidity, as a base-line requirement. Larger firms will have to implement additional liquidity calculations and potentially will need to hold higher levels of liquidity.
The new prudential requirements create both risk and opportunity for firms. Firms need to ensure their business strategies can support the additional investment in people and resources that are necessary to fulfil the enhanced obligations applicable to them. For a small number of firms operating at the margin today, the answer may be that they cannot support the additional costs and capital needs with their current business model.
For others, this will represent a potential business opportunity. The categorisation changes could provoke a strategic shift. Firms could decide to enter into new types of business previously avoided because of the consequential increase in regulatory requirements. Under the new regime, firms would already be fulfilling the same requirements for prudential capital so can try out a fuller scope of activity.
In short, Exempt-CAD firms face a sea change in the prudential requirements that they operate within. These rules have the capacity for substantial positive and negative consequences. What is clear is that firms should begin to review how the required increase in capital will impact their operations as soon as possible.
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About the Author
Michael is Head of Prudential Practice within ACA’s Financial and Regulatory Reporting team, responsible for regulatory reporting and prudential consulting services, technical interpretation of new and existing rules and prudential training sessions for clients.
Michael works with ACA’s clients including alternative fund managers, corporate finance firms, broker dealers and other investment firms, across a variety of strategies to address their obligations. He represents ACA in its Affiliate Membership with the Investment Association on their Prudential Committee.
Michael holds a BSc (Hons) degree in Accounting and Management Information Systems from the University of Hertfordshire, and is an Associate Chartered Accountant with the ICAEW.