[29664]
January 26, 2016
TO:
INTERNATIONAL COMMITTEE No. 8-16
ICI GLOBAL REGULATED FUNDS COMMITTEE No. 8-16
RE:
EBA/ESMA REPORT ON THE PRUDENTIAL REGIME AND INVESTMENT FIRMS IN THE EU
On December 14, 2015, the European Banking Authority (“EBA”), in consultation with the European Securities and Markets Authority (“ESMA”), published a paper titled “Report on Investment Firms” (“Report”) in response to a December 2014 call for advice from the European Commission (“EC”) (“EC Call for Advice”). [1] The EC Call for Advice sought input on the suitability of the current prudential regime for investment firms. [2]
The Report recommends developing a new approach to categorize investment firms for prudential regulation based on systemic importance. The new approach also would help to address the complexity and divergence in the regulatory treatment of investment firms and the applicability of prudential rules to these firms across the European Union (“EU”). [3]
We understand that the timeline for the EC to act on this Report is unclear. In addition, the Report indicates substantial work is needed to develop the new categorizations. The Report is significant, however, as it proposes prudential requirements at varying levels depending on the systemic significance of an investment firm. [4] The Report describes the objectives of EU prudential regulation to be preserving financial stability, protecting investors and ensuring orderly failure. [5]
There are more than 6,500 investment firms authorized and regulated by the Markets in Financial Instruments Directive (“MiFID”), with the substantial majority in the United Kingdom, Germany and France. MiFID has an array of regulations, including related to governance, consumer protection, market functioning, as well as rules on passporting services, such as investment advice to clients, management of client portfolios and execution of client orders. Many MiFID services may be performed by banks, too. The prudential rules that govern the exercise of investment services are based on the Capital Requirements Directive (“CRD IV” or “CRD”) and the Capital Requirements Regulation (“CRR”). Depending on the services, their combination and size, some investment firms are exempt from prudential regulation, some are subject to a “lighter” form, and some are subject to the full CRD/CRR regime. It is in this context that the EBA and ESMA considered the EC’s Call for Advice.
Currently, whether or how the prudential framework applies to a firm in the EU depends on the firm’s categorization within the CRD IV framework. This is primarily based on the MiFID services and activities of the firm and whether it holds client money and securities. [6] Issues have arisen due to the different interpretation of investment services and the treatment of client money among Member States, resulting in the treatment of similar investment firms, such as asset managers, differently across the EU. Also, the challenges and complexity with compliance have resulted in situations where investment firms may be going through calculations and processes similar to banks to calculate capital for risks that are not material or relevant to their businesses.
The Report examines these topics and provides the following recommendations:
- Recommendation 1: Recommendation for a new categorization of investment firms distinguishing between systemic and “bank-like” investment firms to which the full CRD/CRR requirements are applied; [7] other investment firms (“non-systemic”) with a more limited set of prudential requirements; and very small firms with “non-interconnected” services (only need a “simple regime”). [8]
- Recommendation 2: Recommendation for the development of a prudential regime for non-systemic” investment firms.
- Recommendation 3: Extend the waiver for commodity trading firms until December 31, 2020.
On a rationale for applying prudential standards to investment firms, the Report acknowledges such firms present different risks than banks; however, they pose other significant risks with chief risks posed to their customers and the market. For example, customers may suffer losses from unreliable investment advice or poor management. If a firm fails, consumers may encounter disruption or the loss of continuity. In such instance, prudential rules may assist the firm in achieving an orderly wind-down and more efficiently transfer client accounts and assets. Market integrity also may be compromised by problems at a firm. [9]
The work by the EBA and ESMA suggests that the current regime for categorizing firms across the EU under CRD IV and MiFID needs to be changed and harmonized. The Report concludes that the risks posed by investment firms have not been well analyzed or identified and that there has been divergent MiFID implementation across Member States. The Report also identifies significant complexity and the need for simplification to assist industry and supervisors.
Consequently, the central recommendation is to replace the list of investment services and activities with indicators related to systemic importance for purposes of prudential categorization. The goal is to pursue the general objective of enhancing proportionality through systemic risk indicators and the ability to run bank-like activities. There would be both qualitative parameters and quantitative parameters. Further work on qualitative criteria is needed, including related to interconnectedness and activities undertaken, in order to identify firms that should comply with requirements similar to those for credit institutions. More exploration of quantitative criteria also is necessary with the possibility of setting nominal thresholds for application across the EU, relative thresholds, such as percentages, for application across the EU, or providing Member States with more flexibility to define thresholds to take account of their local markets and the characteristics of the main firms in their markets. The advantages and disadvantages of how such approaches would work across the EU must be considered to determine the appropriate approach. It is important that the framework operate in a common manner and fairly across the EU. Substantial work remains to be done. [10] Section 3 of the Report examines the risks of investment firms and prudential risks, comparing in some cases how risks are addressed under MiFID versus CRD IV as well as describing the existing prudential regime for investment firms.
Generally, the concept is that firms falling in the first tier – posing material risks or running bank-like activities – would be subject to current CRD IV prudential requirements (similar to banks); however additional work may be needed to tailor the rules for these firms given there are differences with banks. In addition, there are questions as to whether this is consistent with the EU treaty principle of proportionality. Firms falling under tier 2 or tier 3 would be under a modified regime to better consider proportionality and risk sensitivity. An overall aim would continue to be improving the single rulebook and harmonizing regulation across the EU. [11]
Eva M. Mykolenko
Associate Chief Counsel - Securities Regulation
endnotes
[1] EBA and ESMA, Report on Investment Firms, Response to the Commission’s Call for Advice of December 2014, EBA/Op/2015/20, available at https://www.esma.europa.eu/press-news/esma-news/report-investment-firms.
[2] To date, the EC Call for Advice is not public.
[3] Report at 22-26.
[4] Types of prudential requirements generally identified include initial capital, “own funds” requirements, capital buffers, leverage ratios and public disclosure. Report at 11.
[5] Report at 5-6.
[6] See Report at 14-17 (description, table and chart of current categorization).
[7] The Report states that a small number of MiFID firms are substantial entities that run bank-like intermediation and underwriting risks at a significant scale, exposing them to credit risk (primarily from counterparty risk) and market risk for positions taken on their own account, be it for external clients or not. Report at 7.
[8] The Report concludes that to draft this modified regime requires more work and that this work will be complex. As such the Report recommends this work occur in a second phase and notes that it will take substantial time and resources. Report at 85.
[9] Report at 11.
[10] Report at 22-30.
[11] Report at 29-30.