9.2.1.4 Critique on Class 1a and 1b investment firms

383. With the introduction of the IFR and IFD, the European legislators have removed the investment firm specific exemptions and exclusions of the CRR and CRD 2013, which have been discussed in Chapter 7, meaning that a class 1a or 1b investment firm has to comply fully with the CRR and CRD 2013 requirements and that the specific tailoring of requirements to make CRR and CRD 2013 more risk sensitive to investment firm specific risks have been removed. Why the European legislators decided to remove these investment firm specific requirements in the CRR and CRD 2013 while simultaneously keeping some investment firms within the scope of CRD 2013 and CRR, is not further explained by the European legislator and appears to be contradicting the reasoning included in the recitals of the IFR which only state “in order to ensure legal certainty and avoid overlaps between the current prudential framework applicable to both credit institutions and investment firms and [the IFR], [CRR and CRD 2013] should be amended to remove investment firms from their scope”.1 By adding the Class 1a and 1b investment firms that will remain in scope of the CRD 203 and CRR, the European legislator apparently missed that the CRD 2013 and CRR will still be applicable to investment firms and thus the amendments made to remove investment firms from their scope should have been revoked. Unless it was the intention of the European legislator that these Class 1a and 1b investment firms should be subject to the full credit institution regime. That seems, however, in contradiction with the recital that merely states (incorrectly) that the CRD 2013 and CRR are not applicable to investment firms.

384. The amendments to the CRR included in the IFR remove the investment firm specific prudential regimes. This would have made sense if only class 1 investment firms, which are obliged to apply for a license as credit institution, would have been subject to the CRR and CRD 2013 regimes. Given the new Class 1a and the Class 1b discussed above, however, the CRR and CRD 2013 will still apply for certain types of investment firms that will remain authorised as MiFID investment firms. The application of the CRD 2013 and CRR to these Class 1a and Class 1b investment firms will now be without the specific prudential regime to capture the risk profile of those investment firms. It is therefore interesting to read that the EC apparently has not acknowledged the possibility of an investment firm meeting the requirements of article 1(2) of the IFR2 without being part of a banking group, as is highlighted in the recital of the IFR which states “investment firms which are part of a banking group should remain subject to [the provisions of the CRR and CRD 2013]”.3 The fact that investment firms need to comply fully with the requirements for banks in the CRR is made explicit by the amendment of article 2(5) of the CRR4 which now states that competent authorities should treat investment firms that qualify as Class 1a “as if [those investment firms] were ‘institutions’5under [the CRR]”.6 It would therefore appear that the European legislators have not fully acknowledged what the consequences are of both the introduction of Class 1a and Class 1b investment firms and the removal of the investment firm specific exclusions and exemptions in the CRD 2013 and CRR.

385. The EC does not provide an extensive reasoning in the IFR and IFD, nor in the original proposals or the Presidency Compromise versions of the IFR and IFD as to why these new thresholds for Class 1a and 1b have been introduced. In Recital 42 of the IFR the European legislator states, for the Class 1a threshold, that “large investment firms which are not of systemic importance but are dealing on own account or underwriting financial instruments or placing financial instruments on a firm commitment basis may still have business models and risk profiles that are similar to those of other systemic institutions. Given their size and activities, they may still present some risks to financial stability and, although their conversion into credit institutions is not deemed appropriate in light of their nature and complexity, they should remain subject to the same prudential treatment as those institutions”.7 With regard to the Class 1b threshold a similar reasoning is provided: “It is possible that investment firms which deal on own account, which underwrite financial instruments or place financial instruments on a firm commitment basis on a significant scale, or which are clearing members in central counterparties, have business models and risk profiles that are similar to those of credit institutions. Given their size and activities, it is possible that such investment firms present comparable risks to financial stability as credit institutions”.8 What these risks to financial stability are is neither defined nor further explained and is in contradiction with the reasoning provided in the IFR and IFD. In the IFR and IFD proposals the European legislator argues that the risk profile of investment firms is very different from the risk profile of a bank and that only the very large investment firms (with a balance sheet of more than € 30 billion) should be considered bank-like.

386. The argumentation provided by the European legislator for the opt-in Class 1a is even more fragile. “In order to facilitate the application of prudential requirements for investment firms in the EU and to avoid disrupting certain business models the risks of which are already covered by the application of prudential rules, investment firms should be allowed to apply the requirements of [the CRR and CRD 2013]”.9 Why a business model would be disrupted by applying a new, and according to the EC better aligned, prudential regime for investment firms is very questionable. Indeed, this seems to contradict the intention of the IFR and IFD, which were created to better identify, measure and regulate the specific risks of the business models of investment firms.

387. With regard to the actual level of the thresholds, €5 billion for Class 1b and € 15 billion for Class 1a, no justification or reasoning whatsoever is provided in the IFR and the IFD, nor in the proposals of the EC of the Presidency Compromise version of the proposals.

388. The introduction of these new thresholds for Class 1a, Class 1b and the opt-in Class 1a appears to be driven only by political motives, as no theoretical justification is provided and indeed the little reasoning that is provided contradicts with the justification for introducing the IFR and IFD in the first place. Furthermore, since the investment firm specific exemptions and exclusions of the CRR and the CRD 2013 have been deleted, Class 1a, Class 1b and opt-in Class 1a investment firms will be subjected to the same requirements as banks. A consequence of this is that the requirements designed to capture investment firm specific risks, as included in the IFR and IFD, will not be applicable for those investment firms. These investment firms will therefore be subjected to banking requirements, only because that part of their business that, according to the EC, is similar to banks exceeds a certain thresholds. The EC thereby ignores that the CRR and CRD 2013 are, now that al the investment firm specific exemptions and exclusions are deleted, not able to capture the specific risks of the business of investment firms.

389. A further point of interest is that the difference in capital requirements for the, according to the EC, “bank-like” part of the business of an investment firm between the CRR and CRD 2013 regime and the IFR and IFD regime can be negligible. The method of calculating the own funds requirement for market risk under the CRR and under the IFR are very similar, as will be discussed under Section 9.2.3. The outcome of the own funds calculation for market risks under the IFR approach for a Class 1a or Class 1b should not differ significantly from the outcome of the own funds calculations for market risks under the CRR approach. Since the CRR does not adequately addresses the business model risks of investment firms, it may even be that the CRR approach will result in a lower capital requirement than under the new IFR approach, as the operational risks of an investment firm which are captured in the IFR under Risk To Clients, as will be discussed in Section 9.2.3, are not included in the CRR regime whatsoever.

390. The conclusion that the EC has not convincingly argued why the combination of providing the activities of “dealing on own account” and “underwriting” and having a total balance sheet size of €30 billion or higher, or the additional thresholds of €15 billion and €5 billion, should lead to an investment firm being subject to the CRD 2013 and CRR regime instead of the IFD and the IFR, does not have to lead to the conclusion that having the Class 1 regime itself is inadequate. The intention of having investment firms that, for all intents and purposes, are “bank-like” remain within the CRD 2013 and CRR regime, is something to be supported. The means, however, whereby the EC is trying to capture these “bank-like” investment firms can be further refined.

391. As discussed in Paragraph 340 of Section 8.4, determining the thresholds for Class 1 investment firms based on the funding profile of that investment firm and its subsequent complexity would be a more logical method to set the quantitative threshold for a Class 1 firm. It could, for instance, measure the amount of wholesale funding such a “bank-like” investment firm needs, either in an absolute amount or a relative position. The Class 1 threshold could also be set on metrics that measure the credit-granting or maturity or liquidity transformation these “bank-like” investment firms provide. What the optimum level of the Class 1 threshold should be is indeed more of a political discussion. Given the harmonization and centralization of prudential supervision of banks within the Eurozone, the political decision to have this Class 1 threshold set at the level above which the SSM would be the responsible supervisor seems logical.

392. The method of assessing what a Class 1 investment firm should be, based on the assessment of systemic relevance of investment firms proposed in Section 8.4, can also be applied to the Class 1a and Class 1b investment firms. If European legislators do indeed see the need to introduce an intermediate phase between “regular” Class 2/3 investment firms and the systemically relevant Class 1 investment firms, the same measurement methodology for assessing the shadow banking likeness, as discussed in Sections 3.1 and 8.4, of an investment firm could be used to identify this in-between phase. However, it should have been investigated if deleting the investment firm specific exemptions and exclusions in CRR and CRD 2013 has indeed actually reduced the capital requirements for these Class 1a and Class 1b investment firms. Especially since the EC has argued strongly, in its proposals for the IFR and IFD, that the CRR and CRD 2013 were not adequately capturing the specific risks of investment firms. This rationale is even more relevant now that the investment firm specific exemptions and exclusions in the CRR and CRD 2013 have been deleted.