Prudential regulation of investment firms in the European Union (ZIFO nr. 32) 2021/9.2.3.0:9.2.3.0 Introductie

Prudential regulation of investment firms in the European Union (ZIFO nr. 32) 2021/9.2.3.0

9.2.3.0 Introductie

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400. The prudential regime for investment firms in the IFR is based on a new approach to measuring risks. Whereas under the CRD 2013 and the CRR investment firms subject to the CRR were obliged to quantify their credit, market and operational risk in accordance with risk-weighting methods fundamentally designed for banks, the new prudential regime contains a risk measurement approach based on the actual business models of investment firms. The “K-factor” approach is designed around three main risk concepts: Risk to Customers, Risk to Markets and Risk to Firm.1 To measure the risks to which an investment firm is exposed under these three risk concepts, the risks of certain business models needs to be captured. These business model risks are labelled “K-Factors” and address risks related to activities such as portfolio management, execution of orders and giving investment advice. The K-Factor approach also capitalizes market risks under the Risk to Market K-Factors and counterparty risk and certain operational risks under the Risk to Firm K-Factors. The intention of the new regime was to design a set of K-Factors that capture the majority of business models applied in the investment firm sector, and the inherent risks of these business models for investment firms. To measure these risk concepts, the IFR contains a number of K-Factors that address certain risks associated with the business of an investment firm. These K-Factors are described in the following table included in the Staff Working Document of the EC proposal:

Table 1: List of K-Factors

Risk Type

K-Factor

Metric

Rationale

Risk To Customer

K-AUM

Assets under management

The risk of harm to clients from incorrect discretionary management of customer portfolios or poor execution, providing customer reassurance in terms of the continuity of service of ongoing portfolio management and advice

K-CMH

Client money held

The risk of harm where an investment firm holds the money of its customers, regardless of whether they are on its own balance sheet or segregated in other accounts.

K-ASA

Assets safeguarded and administered

The risk of safeguarding and administering customer assets, and ensures that investment firms hold capital in proportion to such balances, regardless of whether they are on its own balance sheet or segregated in other accounts.

K-COH

Customer orders handled

The risk to clients of a firm which executes their orders in the name of the client, and not in the name of the firm itself, e.g. as part of ‘execution-only’ services and in the reception and transmission of orders.

Risk To Market

K-NPR

Net position risk

The risk of trading exposures in financial instruments, FX and commodities based on the CRR

K-CMG

Clearing member guaranteed

The margin posted with a clearing member against trading risks

Risk To Firm

K-TCD

Trading counterparty default

The risk to an investment firm of counterparties failing to fulfil their obligations, multiplying exposures by risk factors based on the CRR, taking into account the mitigating effects of effective netting and the exchange of collateral

K-CON

Concentration risk

Individual or highly connected private sector counterparties with whom firms have exposures above 25% of their capital and resulting in capital add-ons in line with the CRR.

K-DTF

Daily trading flow

The operational risks in large volumes of intra-day trades based on the gross value of settled cash trades and notional value of derivatives.

401. It should be noted that the “rationale” provided by the EC in this table is not always a rationale. For certain K-factors in this table, the rationale is more of a short description. In the following sections of this study the rationale for these K-factors will be further discussed, starting with a discussion on the elaborations established by the EBA in its work towards defining the prudential framework.

The EBA concluded in its report that “there is a clear need to develop a single, harmonized set of requirements that are reasonably simple, proportionate and more relevant to the nature of investment business than the existing requirements, to cover the broad range of all types of investment firms”.2 According to the EBA “the K-factors need to be based upon readily observable metrics, preferably the sort of information a firm might generally wish to know and hold about its business (rather than capturing something that has a meaning only for the purpose of calculating its regulatory capital requirements)”.3

Risk to Customers (RtC) is defined by the EBA in its 2017 report as a means to “capture the on-going impact that an investment firm can have on others. […] the most important element of risk will be the potential for harm they may pose to their customers (e.g. where they do not carry out the relevant investment services correctly)”.4

The EBA defines Risk to Market (RtM) as “the impact that an investment firm can have on the markets in which it operates. For example, should the firm fail or otherwise need to exit that market, particularly if this occurs suddenly, a temporary dislocation in market access or market liquidity may be observed and market confidence could be questioned”.5 The EBA intended the RtM K-factors “to act as a proxy for the ‘market footprint’ that the investment firm might have”.6 According to the EBA, the market risk concepts in the CRR most closely resembled the idea of market footprint, and as such the EBA recommended incorporating the market risk framework into the net position risk K-Factor.

Risk to Firm (RtF), according to the EBA, comes from “a firm that is financially weak or in trouble itself can be more susceptible to poor behaviour, weaker controls and greater risk-taking as it seeks to correct its fortunes. This in turn suggests that any RtF could increase the probability that RtC or RtM occurs, and/or amplify its impact if it does occur, and so should not be overlooked”.7 The EBA “believes that counterparty credit risk and single name concentration [are] important exposure risks for firms that deal on their own account or trade in their own name when executing clients’ orders and should, therefore, be addressed within the overall framework as RtF. Moreover, RtF should also address the operational risks that stem from the activity of dealing on one’s own account or trading in one’s own name when executing clients’ orders”.8

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