New capital requirements for investment firms

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New Capital requirements for investment firms

Investment Firm Directive/Investment Firm regulation

In December 2017 the European Commission adopted a proposal for a regulation and a proposal for a directive to amend the current EU prudential rules for investment firms. This review aimed to introduce more proportionate and risk-sensitive rules for investment firms. With this new regulatory regime, the vast majority of investment firms in the EU would no longer be subject to rules that were originally designed for banks. At the same time, the largest and most systemic investment firms would be subject to the same regime as European banks.

As of now the prudential rules for investment firms are part of the wider EU prudential framework which mainly applies to banks. Currently, the requirements are set out in Directive 2013/36/EU and Regulation (EU) No 575/2013 on capital requirements for banks and investment firms (also known as “CRD IV/CRR”).

Some EU non-bank investment firms authorised under the EU Markets in Financial Instruments Directive (MiFID) are treated similarly to Basel prudential requirements, which apply to deposit-taking credit institutions. In contrast, there are many EU investment firms that are exempted from CRR (such as large numbers of asset managers and advisory firms) and are subject to initial capital requirements under CRD but are otherwise prudentially supervised under national regimes, such as the BIPRU and IPRU regimes operated by the UK Financial Conduct Authority (FCA).

The Investment Firm Directive (IFD) and Investment Firm Regulation (IFR) will amend the existing prudential framework for investment firms, set out in the Capital Requirements Directive and Regulation (CRD IV/CRR) and in the Markets in Financial Instruments Directive and Regulation (MiFID2/MiFIR).

These prudential rules aim to ensure that investment firms have sufficient resources to remain financially viable and do not cause undue economic harm to their customers in the case of a wind-down.

In April 2019, the European Parliament reviewed the prudential rules for investment firms.

Once the IFD and IFR are adopted, some firms will find that their capital requirements increase significantly. In addition, there are provisions dealing with consolidation, liquidity, remuneration, reporting, governance and equivalence.

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General Principles – Firm Categorisation

The new prudential framework for investment firms is based on a new categorisation of these undertakings into three categories. They will be categorised in the following 3 categories:

  • systemic and ‘bank-like’ investment firms, also called Class 1 firms,
  • other investment firms (Class 2 firms) and
  • very small investment firms with ‘non-interconnected’ services (Class 3 firms).

Class 1 – the recommendation highlights that such systemic and bank-like investment firms are exposed “to credit risk, primarily in the form of counterparty risk, and market risk for positions taken on own account, be it for the purpose of external clients or not”. For these undertakings, the capital requirements should be set in order to avoid contagion to other institutions and the system as a whole.

These are large systemic investment firms which take on principal trading risk and have assets over €15 billion; they will remain subject to the current CRD/CRR regime, as their risk profiles are considered to be similar to those of significant credit institutions. Very large Class 1 firms with total assets over €30 billion will even be treated, and be required to apply for authorisation, as credit institutions. In addition, investment firms which are part of banking groups will be allowed (subject to regulatory approval) to continue to apply the CRD/CRR regime.

Class 2 and 3 – For investment firms that are not considered ‘systemic and bank-like’, a less complex prudential regime seems appropriate to address the specific risks that these firms pose to investors and to other market participants. In addition, the EBA Report also recommended a proportionate solution for very small investment firms with ‘non-interconnected’ services.

Class 2 – would be a firm that does not fall in Class 1 or the small firm test for Class 3 and will be subject to all measures under IFD/IFR without limitations.

Class 3 – these firms will have less burden compared to Class 2 firms.

  • Client money held is zero.
  • Assets safeguarded and administered are zero.
  • Client orders handled (COH) are less than €100 million a day (cash trades) or €1 billion a day (derivatives).
  • Assets under management (AUM) are less than 1.2 billion.
  • Principal trading (known as daily trading flow) is zero.
  • Trading book position is zero.
  • Clearing margin given is zero.
  • Trading counterparty default exposure on OTC derivatives (and various other trade types) is zero.
  • Balance sheet (on and off) total is less than €100 million.
  • Total annual gross revenue from investment services/activities is less than €30 million (average of previous two years).

The thresholds for  AUM, COH, balance sheet size and total gross annual revenues should be applied on a combined basis for all investment firms that are part of the same group in to reduce the incentives for investment firms to restructure their operations, so attempts to exceed the thresholds above which they do not qualify as small and non-interconnected investment firms, are minimised.

Initial Capital – Permanent Minimum Capital Requirement

The initial required capital – this is the absolute amount of capital that is required of a company at the point of authorisation. The permanent minimum capital required for a firm performing any of the following activities is 750,000 EUR:

  • Dealing on own account;
  • Underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis

The initial capital requirement for a firm performing any the following services in its portfolio is 75,000 EUR:

  • Reception and transmission of orders in relation to one or more financial instruments;
  • Execution of orders on behalf of clients;
  • Portfolio management;
  • Investment advice;
  • Placing of financial instruments without a firm commitment basis

And the initial capital requirement for firms performing any of the following activities is 150,000 EUR:

  • Operation of an MTF;
  • Operation of an OTF

The above requirements apply to firms in Class 2 and 3, it depends on the range of activities they have authorisation for.

Firms which are authorised to take principal risk and/or deal on own account – are subject to an initial capital requirement of €750,000.

Firms which are not authorised to take principal risk, do not operate a trading facility (multilateral or organised) and do not hold client money are subject to a minimum capital requirement of €75,000. All other the firms have a PMC requirement of €150,000.

Firms classified as Class 1 permanent minimum capital (PMC) requirement will continue to be, as described above, and as dictated by the CRD IV.

The fund requirements are a sum of:

  • Credit risk
  • Market risk
  • Operational risk

Class 2 firms’ PMC requirement – will be the highest of:

  • Permanent Minimum Capital requirement (PMC) according to the new regime
  • Fixed Overhead Requirement (FOR)
  • K-factor capital requirement

Class 3 firms’ PMC requirements are simpler – the highest amount of the following two:

  • PMC
  • FOR

The FOR is calculated as one quarter of the fixed overheads in the preceding year.

These changes will potentially affect many firms, for example those which are classified as exempt CAD (certain advisers/arrangers) as of now and other firms which have a €50,000 flat capital requirement under the CRD/CRR regime.

Additional Capital Requirement

With the initial capital requirement as an absolute minimum, there are also own fund requirements which an investment firm will need to satisfy at all times.

As under the CRR, additional own funds must be held by investment firms. Firms must meet own funds requirements, which have to be no less than the initial capital amount.

Definitions of Common Equity Tier 1 (CET1), Additional Tier 1 (AT1) and Tier 2 remain as per CRR.

As a proportion of the own funds requirement:

  • At least 56% of the sum (of Tier 1 and Tier 2 capital) is CET1
  • Up to 44% of the sum (of Tier 1 and Tier 2 capital) may consist of AT1
  • Up to 25% of the sum (of Tier 1 and Tier 2 capital) may consist of Tier 2

The formula for Fixed Overhead Requirements (FOR) remains the same as in the current regime – a quarter of the fixed overhead of the preceding year.

Capital Requirements

Initial capital requirements will continue to serve as the absolute minimum, but there will be a greater emphasis on Fixed Overhead Requirements. To calculate the new capital requirement, firms must apply a new risk-based K-factor methodology.

The K-factor approach is risk-based and would capture the on-going impact an investment firm can have on others. The K-Factor Requirement is one of the biggest changes in the new regime and firms are supposed to measure it as accurately as possible.

All investment firms should calculate their own funds requirement by reference to a set of K-factors which capture the Risk-To-Client (RtC), Risk-to-Market (RtM) and Risk-to-Firm (RtF). The K-factors under RtC capture: client K-AUM and ongoing advice (K-AUM), client money held (K-CMH), assets safeguarded and administered (K-ASA), and client orders handled (K-COH). The K-factor under Risk-to-Market (net position risk or clearing margin given); and risk to firm (trading counterparty default, daily trading flow and concentration risk).

The possible range of K-factors could be:

  • Assets under management (AUM)
  • Assets under advice (AUA)
  • Assets safeguarded and administered (ASA)
  • Client money held (CMH)
  • Liabilities to customers (LTC)
  • Customer orders handled (COH)


The IFR/IFD prescribes certain remuneration requirements that will apply to investment firms. Firms will have to disclose certain aspects of their remuneration policy and practices, including those related to gender neutral remuneration, for those categories of staff whose professional activities have a material impact on the investment firm’s risk profile

Small and non-interconnected investment firms should, however, will be exempt from those rules because the provisions on remuneration and corporate governance laid down in Directive 2014/65/EU are sufficiently comprehensive for those types of investment firms.


Despite being primarily concerned with MiFID investment firms, the IFD also makes changes that will affect UCITS management companies and alternative investment fund managers. In a nutshell, those changes ensure that such entities can never hold own funds of less than the IFR’s fixed overhead’s requirement.


If the UK is still in the EU or in the transition period by June next year, they will have to implement the new rules as stipulated by IFD/IFR.

An FCA consultation paper on the prudential regime for MiFID firms was included in its plan for the first quarter of 2020 and it is still pending.


The IFD/IFR were published in the Official Journal on 5 December 2019; the new regime will take effect from 26 June 2021.

What next?

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