New Prudential Regime for Investment Firms

On 23 June 2020, HM Treasury confirmed that the UK will  introduce its own prudential regime for investment firms, the Investment Firms Prudential Regime (IFPR), based on the EU’s proposals (Investment Firm Directive (IFD) / Investment Firm Regulation (IFR)). This will be the first dedicated prudential regime for investment firms. The IFD/IFR and IFPR should be in force by Summer 2021. At the same time, the FCA published Discussion paper DP20/2 on “A new UK prudential regime for MiFID investment firms”. The key elements of the proposed regime as framed by the FCA would be, as follows:

  • The new regime would replace categories such as BIPRU and IFPRU firms with two new firm type categoriessmall and non-interconnected investment firms (SNIs), for whom the requirements under the new regime are more proportionate; and non-SNI investment firms.
    • Typical SNI criteria includes, for example, AUM < €1.2bn; annual gross revenues < €30m; or daily client orders (cash) < €100m. Investment firms holding client money or assets will not qualify as an SNI, although most firms currently within the exempt CAD prudential category should do so. Systemically important; and larger investment firms which carry on own account dealing or underwriting / placing will remain subject to the CRD / CRR. 
  • New minimum capital requirements:
    • For non-SNI firms: the higher of: Fixed overheads requirement (FOR); Permanent minimum requirement (PMR); or a new K-factor requirement (KFR).
    • For SNI firms: the higher of: FOR or PMR
      • PMR: A firm’s PMR is the same as the initial capital. This would increase respectively from €50k, €125k and €730k; to £75k, £150k and £750k. 
      • KFR: A requirement is calculated for each activity for the potential harm that an investment firm can do to its clients, itself and the markets in which it operates; and the sum of these is the KFR. There are a wide range of different K-factors which apply according to whether an investment firm undertakes the relevant investment service or activity. For example, K-factor “K-AUM” is related to the assets under management for clients, to which a coefficient of 0.02% would be applied to the relevant rolling average, the current calculation of which is set out in the IFR. Although the KFR does not form part of the own funds requirements of SNIs, they are still advised to consider the relevant metrics. 
  • For the first time, liquidity requirements would apply to all firms with the definition of liquid assets expanded compared with that in the CRR, with no limit as to their composition. The requirement is to hold an amount of certain types of liquid assets equivalent to at least one third of the amount of the FOR.
  • Some types of capital, e.g. short-term subordinated debt will no longer be acceptable; and there are changes to the way in which deductions from own funds are to be made.
  • A new internal capital and risk assessment (ICARA) process would apply – replacing the current ICAAP process where it applies. The new risk assessment framework differs from ICAAP in that it is not focused on prescribed risk categories (e.g. operational risk, and credit risk etc) but looks at broader risks in a firm’s business model and activities (e.g. risk to clients and markets, and changes in the book value of assets etc). While IFR applies the ICARA requirement to non-SNI firms only, the FCA states that it would, as allowed for in IFD, also require all SNI investment firms to put in place an ICARA process, albeit in an “operationally efficient and proportionate means for smaller investment firms”. Further, in line with its recently published Finalised Guidance, ‘Our framework: assessing adequate financial resources’, the FCA states that it is minded to replicate the effect of the discretions available in the IFD to undertake a SREP on SNI investment firms and require the holding of additional own funds, where appropriate. 
  • Prudential consolidation: An investment firm which is part of a group must consider and manage the risks it may be exposed to or may pose to clients and to markets, both directly and indirectly, due to its membership of that group. Unlike the CRR, the obligations under a prudential consolidation in IFR would now fall upon parent undertakings (including an investment firm where it is a parent undertaking), rather than the authorised entity. This means parent undertakings which may otherwise be unregulated will have to meet regulatory obligations. Further, prudential consolidation treats the whole investment firm group as if it was an investment firm. Consolidated own funds requirements will be determined on the basis of a consolidated PMR, consolidated FOR and a consolidated KFR.
    • The IFR has a Group Capital Test (GCT), which would serve as a derogation from the requirement for an investment firm group to have to comply with all the obligations of prudential consolidation. Its purpose would be to ensure that an investment firm in a group is not exposed to unnecessary financial strain due to its membership of that group. It seeks to address a situation where an investment firm may appear to have sufficient own funds at individual level, but its parent entity is leveraged and  has funded the own funds instruments of the subsidiary with debt. Unlike the CRR, the obligations under a GCT would fall upon each entity in the group that is a parent undertaking, rather than an investment firm which is not a parent. This extends regulatory obligations to parent undertakings which may otherwise be unregulated. It also means that the GCT would be applied at more than one level in a group that has a multi-layered structure.
  • Public disclosure: Investment firms will generally have to publish information on risk management, governance, own funds, remuneration, and investment policy.  In due course, they will also have to publish information relating to environmental, social and governance risks (ESG).
  • There will be a transition period of up to 5 years for some of the requirements.