The prudential framework is a new rulebook developed by the European Commission (EC) for investment firms. It is designed to be simpler and more proportionate to a firm’s operations. But with new rules come new challenges, and firms should take time now to assess the impact these rules will have on their capital, liquidity, remuneration and disclosures.
This framework requires the vast majority of investment firms to adapt to a new set of capital and liquidity requirements as well as a new reporting regime. Likely to come into force by the end of 2019, some firms may be hit very hard with requirements to maintain significantly greater levels of capital.
We are running a series of articles to assess the material areas of change imposed by new prudential framework rules on different firm types. Last month we looked at the impact on Exempt CAD firms. Now in the second in our series, we examine the regime’s impact on the capital and liquidity requirements on MiFID managers.
What does the prudential framework mean for MiFID managers?
While it’s considered that MiFID managers in the UK (encompassing BIPRU firms and IFPRU Limited Licence firms) may have an easier time adapting to the new EU prudential capital framework than many other firm types, it’s no time for them to be complacent.
BIPRU firms (investment firms that are regulated under the UK Financial Conduct Authority’s (FCA) Prudential sourcebook for Banks, Building Societies and Investment Firms), as well as IFPRU firms (those organizations who are in scope for the FCA’s Prudential sourcebook for Investment Firms) still will have quite a lot of work to do before the implementation deadline.
To begin with, these firms will likely need to increase their capital reserves once the new rules come into effect. The rules will also mean investment firms move away from bank-like capital requirements, such as credit risk, in favour of a new suite of risk-based measures more suited to their business known as ‘K-factors’.
These K-factors will focus on:
- risk to customers (based on the type and volume of business a firm conducts);
- risk to the market (typically for firms operating a trading book); and
- risk inherent to the firm itself.
Compliance teams need to review the EU’s proposals and understand how the changes could influence their business strategy decisions in the short and medium-term.
Why is this change happening?
Most investment firms are currently governed by the prudential capital framework for banking, as set out by 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.
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 in September 2017. The new requirements will need to pass through the EU’s normal law-making process, so we expect that firms will have to be compliant with the regime by the end of 2019.
So, what’s a MiFID manager to do?
MiFID managers currently either operate within the CRD/CRR framework (for IFPRU firms) or under the FCA’s simplified BIPRU framework. The new regime will mean a new set of capital and liquidity requirements as well as a new reporting regime for all MiFID managers. As a first step, firms should explore the proposals to see which category they will fall under.
In particular, under the new rules, MiFID managers will need to assess the impact on their firm of the following key aspects:
- Capital requirements
Firms will need to adjust their capital requirements, but in theory, these should be simpler for firms to calculate under the new regime. Most will focus their energies on the “risk to customer” area of calculation, unless their business model is more diverse. Compliance teams should explore potential capital changes and start building the necessary infrastructure to monitor the variables on an ongoing basis.
- Liquidity risk
The method for calculating liquidity risk will be more quantitative, rather than qualitative. On one hand, this could reduce uncertainty for firms in this area – but on the other, it could result in an increase in the amount of liquid assets that need to be held and a change in the types of instruments that hold the capital.
XBRL (mandated reporting language under CRD IV typically necessitating the use of specialist software) has been a thorn in the side of IFPRU firms for some time. So, while reporting for these firms may become simpler, BIPRU firms will need to adjust to this new method – if this is the approach the EU directive adopts. So for many firms, reporting could become technologically and operationally more complex.
- Overlay with other regulations
MiFID managers need to be mindful of how the new prudential capital framework could interact with other sets of regulations. For example, those who are also in scope for the Alternative Investment Fund Managers Directive (AIFMD) may need to continue to calculate capital under both the AIFMD and the new prudential framework.
It’s important that compliance teams at MiFID manager firms take some time to consider the potential impact of this new prudential capital regime. While the change in capital held could be modest for some firms, others could potentially see a significant swing in their required capital figure – and could be caught out.
Firms should also consider if the shift in the prudential capital framework creates an opportunity for a change in business strategy or approach. For example, it may make sense for some firms to adjust or add to services offered given that a potential change in prudential category would previously have served as a disincentive. By engaging in proactive analysis now, compliance teams can actively add value to their organization’s medium-term approach to developing its client base and generating revenues.
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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.