10.3 Prudential regulatory regime for investment firms in the EU

499. The prudential framework for investment firms in the EU is, until June 2021, included in the CRD 2013 and the CRR. Investment firms are subject to the requirements of this directive and regulation. The regime of the CRD 2013 and the CRR, as discussed in Chapters 5 and 6, is based upon the Basel Capital Accord, which is intended for large and internationally active banks. To better align these requirements, which are established to address the credit and market risks of banks, with the risk profile of an investment firm, the CRD 2013 and the CRR contain numerous exemptions and exclusions for investment firms, or investment firm-specific requirements. This results, as discussed in Chapter 7, in a very complex supervisory regime which recognizes at least 11 categories of investment firms.1 The European Commission acknowledges this by stating that “[the CRD 2013 and the CRR do] not effectively capture the actual risks faced by the majority of EU investment firms […]”2 and that the prudential regime for investment firms in the CRD 2013 “can be shown to be disproportionate and a source of excessive complexity and administrative and compliance costs for most investment firms”.3 The prudential regime for investment firms included in the CRD 2013 and the CRR therefore does not capture the actual risk profile of an investment firm, and the numerous exemptions and exclusions might result in an underestimation or overestimation of the actual risks of the investment firm.

500. These shortcomings of the prudential regime for investment firms in the CRD 2013 and the CRR were reasons for the EC to introduce a new regime, published in December 2019 and coming into force on 26 June 2021, specifically designed to capture the risk profile of an investment firm in a more appropriate and proportional manner. This new regime included in the IFR and IFD has been discussed in detail in Chapter 9.

501. What the IFR and IFD contribute to the establishment of an appropriate and proportional regime for investment firms, is the way they address the so-called Risk to Client (RtC). Although not explicitly mentioned in the recitals of the IFR and the IFD, nor in the Commission Staff Working document,4 the concept of RtC measures the operational risks of certain investment firm business models. The RtC measures the (operational) risk of asset management. RtC also measures the operational risk of safeguarding client money and securities and it measures the operational risk of transmitting and executing orders. What the IFR and IFD fail to recognize is that the operational risks of these activities will not follow a linear curve;5 the increase in operational risk will be much greater if the assets under management increase from €1 million to €1 billion than if the assets under management increase from €400 billion to €401 billion.6

502. The other aspects of the IFR and IFD are more problematic, however. The way Risk to Market (RtM) and Risk to Firm (RtF) are measured are based entirely on a banking-oriented approach. In particular the requirements for concentration risk, trading counterparty default, and daily trading flow do not address an actual risk that investment firms might be exposed to. This is even more disconcerting as these requirements appear to have been introduced at the last minute by the EBA and the EC seems to have adopted these requirements without any thought or consideration.

503. The IFR and IFD, therefore, do not contain an appropriate means of measuring and mitigating the financial risks of investment firms. By simply retaining requirements or risk measurement concepts included in the CRR regime, the EC has ignored the conclusion of the EBA and its own conclusions in the Commission Staff Working document that these CRR requirements are inappropriate for investment firms and might lead to inaccurate capital requirements.

504. Another issue with the IFR and IFD is the way they categorize all investment firms and specifically how larger and, possibly, systemically important investment firms should be regulated. Under the IFR and IFD, investment firms are categorized in three classes of investment firms. Class 2 and Class 3 are fully subject to the new IFR and IFD regime and will thus no longer be subject to the CRD 2013 and CRR regimes. Class 3 is intended for smaller and non-interconnected investment firms and Class 2 captures all investment firms that are neither a Class 1 nor a Class 3 investment firm.

505. The problem lies, however, with Class 1, and especially the changes made in Class 1 with the Presidency Compromise proposals of the IFR and the IFD.7 Class 1 captures those investment firms that perform the investment activities of dealing on own account or underwriting and that have a consolidated balance sheet of more than €30 billion. These investment firms will have to apply for a licence as a credit institution and will thus be fully subject to all the requirements of the CRD 2013 and CRR regime, without any of the investment firm specific exemptions or exclusions that the CRD 2013 and the CRR currently contain.

506. The Presidency Compromise proposals complicate this three-class regime significantly by introducing a Class 1a, an opt-in Class 1a and a Class 1b. Al three new subcategories of Class 1 will remain authorised as investment firms. Class 1a consists of investment firms that have a balance sheet that exceeds € 15 billion, and they will be fully subject to the CRD 2013 and CRR regimes, in which all of the investment firm specific exemptions and exclusions are removed, and not be subject to any requirement of the IFR and IFD regimes. Whereas Class 1a investment firms are automatically subject to the CRD 2013 and CRR regime, opt-in Class 1a investment firms that meet all the conditions of Article 1(5) of the IFR8 may choose to be subject to the CRD 2013 and CRR regime. Class 1b investment firms have a balance sheet between € 5 billion and € 15 billion, and competent authorities may choose to subject these Class 1b investment firms to the CRD 2013 and CRR requirements.

507. The European legislator did not include any reasoning as to why these Class 1a and Class 1b investment firms should be subject to the CRD 2013 and CRR requirements, and as discussed in Section 9.2.1, the application of the CRR and CRD 2013 regime might even result in lower capital requirements than those of the IFR and IFD regimes. These new categories of investment firms also contradict the reasoning of the EC for introducing the IFR and IFD in the first place, as the EC considered the CRD 2013 and CRR regime inappropriate for investment firms. Furthermore, all Class 1, 1a and 1b investment firms seem to be defined on the “systemic risk” dimension proposed by Moloney. And as highlighted in the discussion of Moloney’s framework, the European legislator incorrectly assumes that providing underwriting services or dealing on own account automatically incurs systemic risk per se. The provision of these investment activities does not mean the investment firm is automatically a risk to the financial system. By simply stating that these activities are bank-like, and should, therefore, be subject to similar rules to those applying to a bank, the new Class 1 regimes does not adequately reflect the actual risks of these activities. Some of these investment firms might indeed pose a systemic risk, but this does not mean all the investment firms that provide these activities do. What makes an investment firm incur systemic risk is thus influenced by other factors. This study will propose a more appropriate method for assessing this systemic risk of investment firms in the last part of Section 10.4. The EC should address these concerns in its review on the appropriateness of Class 1 investment firms, in accordance with Points H, N and O of Article 60(1) of the IFR9 and Point H of Article 66 of the IFD10