Revised EU prudential framework for MiFID investment firms

10 January 2018

Following a lengthy review in consultation with the European Banking Authority (EBA) and the European Securities and Markets Authority, the European Commission has adopted legislative proposals for a revised EU prudential framework for investment firms.

The proposals comprise a draft EU Regulation and Directive, which also includes provisions relating to governance and remuneration. While it is possible in a post-Brexit environment that the FCA may not fully implement these proposals, it is likely that UK firms intending to access EU markets will have to meet these proposed new standards in full when they are implemented in the EU.

The revised framework will replace the existing requirements for MiFID investment firms in the Capital Requirements Regulation and Directive (collectively known as CRD IV), which were primarily written for banks. The proposals do not apply to AIFMs and UCITS managers. However, they would apply to MiFID investment firms that provide delegated services to such managers (including, for example, investment managers providing investment management services to a third party UCITS manco and private equity “adviser / arrangers” to offshore structures. The Commission’s proposal follows most of the EBA’s recommendations and aims to differentiate the prudential regime for investment firms according to their size, nature and complexity. Under the proposals, the largest, systemic firms will be supervised and treated as credit institutions while smaller firms will have a bespoke regime. The EBA indicated that the measures are not expected to significantly change the aggregate capital requirements of EU investment firms. However, some firms will see an increase in their capital requirements as risks are captured in their assessment for the first time.

The proposals apply to investment firms established in the EU and will also be of interest to those firms seeking to set up an establishment in the EU prior to Brexit. Furthermore, in light of the UK’s decision to leave the EU, EU regulators are indicating that they will be stricter in third country equivalence assessments than may have been previously the case. This proposal is no exception as the Commission includes enhanced wording into the MiFIR equivalence assessments to require greater detail and granularity.

In whatever way the EU approaches the process of equivalence assessments, the provisions in MiFID II / MiFIR are also adjusted to reflect the changes made by these proposals.

Categorisation of investment firms

Under the proposal, investment firms will be divided into three classes, each of those capturing different risk profiles. The EBA has previously described these as Class 1, 2 and 3 firms.

Class 1

Class 1 firms include investment firms with total assets above €30bn and which provide underwriting services and dealing on own account. These services involve credit risk and market risks as well as being important for market efficiency, therefore firms providing these services on a significant scale are important for financial stability, market efficiency and integrity. As such, the Commission proposes that these “bank-like” firms are treated as credit institutions under CRD IV. This requires firms established in the EU to be authorised as credit institutions and to be regulated by banking supervisors which, in the EU, is the European Central Bank (ECB) under the Single Supervisory Mechanism (SSM).

For Class 1 firms, the corporate governance and remuneration framework under CRD IV would apply in full.

The Commission recognises that most systemic investment firms are currently located in the UK and many are in the process of relocating parts of their operations to the EU-27. 

Class 2

Class 2 firms are those above any of the following size thresholds:

  • assets under management (AUM) under both discretionary portfolio management and non-discretionary (advisory) arrangements higher than €1.2bn;
  • client orders handled of at least €100m a day for cash trades and / or at least €1bn a day for derivatives;
  • balance sheet total higher than €100m;
  • total gross revenues higher than €30m;
  • exposure to risks from trading financial instruments higher than zero;
  • client assets safeguarded and administered higher than zero; and
  • client money held higher than zero.

Class 2 is likely to be the relevant category for a number of asset managers.

To minimise avoidance, the thresholds for AUM, client orders handled, balance sheet size and total gross revenues should be applied on a combined basis for all investment firms that are part of the same group.

Class 2 firms’ minimum capital would be set either as for class 3 investment firms (see next section) or according to a new K-factor approach for measuring their risk, whichever is higher. The K-factors specifically target the services and business practices that are most likely to generate risks to the firm, to its customers and to counterparties. They set capital requirements according to the volume of each activity.

Class 2 firms would continue to be subject to some provisions of the CRD IV regime, including specific governance arrangements and rules on remuneration. However, the proposed new regime will allow for a proportional application which brings it more in line with provisions in the AIFMD and the UCITS Directive. The Commission acknowledges the problem that the UK government has argued for some time: “The lack of flexibility of the rules on remuneration and governance results in a suboptimal level of supervision as it compels supervisors to enforce requirements vis-à-vis investment firms, in situations where this might not be warranted from a prudential supervision perspective.” (Commission Staff Working Document)

Therefore, under the proposals, Class 2 firms do not have to comply with the controversial bonus cap. Instead, Class 2 firms must set and publish limits themselves on the appropriate ratio between variable and fixed components of remuneration. Class 2 firms also have the discretion to choose between the types of instruments used to pay out part of the variable remuneration. Another concession is that the rules relating to deferral and pay-out instruments do not apply to firms the asset value of which is below €100m on average over the four years preceding the date of assessment, and for staff with low levels of variable pay (not exceeding €50,000 and not more than one fourth of an individual’s total annual remuneration). However, competent authorities can override these latter derogations in certain circumstances.

Class 3

Class 3 firms are those firms falling below all of the above thresholds – described as “small and non-interconnected investment firms”. They would be subject to the least complex requirements. A Class 3 firm’s minimum capital would be either the level of initial capital required for its authorisation or a quarter of its fixed costs (overheads) for the previous year, whichever is higher.

For governance and remuneration, MiFID II rules are considered to be sufficient for Class 3 firms.

Next steps

The proposals will be discussed by the European Parliament and the Council. If it is adopted there will be an 18 month implementation period before the new regime applies to firms – this is likely to take implementation through to 2020. There are also detailed transitional provisions.