9.2.4.1 Group capital test

448. The prudential regime in the CRR contains a specific regime for the parent company of a credit institution or investment firm. This parent company has to comply with the obligations of the CRR on a consolidated basis.1 This consolidated requirement entails that a parent company has to comply with a capital requirement based on its consolidated situation, meaning that the parent company has to calculate credit, market and operational risk according to the framework in the CRR and based on the consolidated balance sheet of the parent company. It should be noted that the consolidated balance sheet of the parent company used for the capital requirement calculations in the CRR is not necessarily the same as the consolidated balance sheet used for the annual financial statement. One can, therefore, distinguish between the accounting consolidated balance sheet used for the annual financial statements and the prudential consolidated balance sheet used for the capital requirement calculations.

449. For investment firms, an alternative method for consolidation had been made available under article 15 of the CRR subject to prior approval by the competent supervisory authority. This derogation allowed parent companies of investment firms not to apply the regular consolidation requirements of the CRR, but to apply an alternative consolidated capital requirement consisting of the sum of the EU capital requirements and the book values of the subsidiaries of the parent company established outside of the European Economic Area (EEA), i.e. the “group capital test”.2 In other words, the parent company would not be obliged to calculate a capital requirement based on its prudential consolidated balance sheet but would simply calculate the sum of the book values for all its subsidiaries established outside of the EEA and add such values to the regulatory capital as required for the investment firms established in the EEA. The parent company does need to ensure under this “group capital test” that, based on the prudential consolidated balance sheet, it has enough own funds to cover the sum of the book values of its non-EEA subsidiaries and regulatory capital of its EEA investment firm, financial institution and ancillary services subsidiaries. The derogation is therefore primarily focused on not having to calculate a separate capital requirement for the parent company using the methodologies described in the CRR, but the parent company can use the calculations of its EEA subsidiaries and simply add those to the values of its non-EEA subsidiaries to arrive at the capital requirement of the parent company.

450. Another aspect of the group capital test will enable certain investment firm groups to benefit from this alternative consolidation method. Under CRR consolidation requirements, without applying the derogation of Article 15 of the CRR, all subsidiaries of an EU parent holding company that are not located within the European Union, but that do need to be consolidated according to the CRR, will end up in the consolidated capital requirement of the EU parent holding company. So, a subsidiary located in the US will, on the consolidated basis of its parent, be fully subject to CRR requirements even though the subsidiary itself will not be subject to these requirements on a solo level. The CRR consolidation requirements will thus have an effect even beyond the borders of the European Union. The group capital test, both under Article 15 of the CRR and under Article 8 of the IFR, has the effect that a parent company having a subsidiary outside the European Union will not have to apply a CRR, in the case of Article 15CRR, or IFR, in the case of Article 8 IFR, capital requirement calculation to the assets of that subsidiary within the prudential consolidated balance sheet of the parent holding company. The IFR will therefore, when Article 8 can be applied by the investment firm, not have an effect beyond the borders of the European Union, as the book values of the non-EU subsidiaries will not be the same as a CRR or IFR capital requirement based on the assets and liabilities of that non-EU subsidiary.

451. One implication of having the IFR capital requirements not apply to those assets and liabilities which are located outside the European Union is that it might give investment firms an incentive to shift those assets or liabilities which generate high capital requirements under the IFR to subsidiaries outside of the European Union. This will naturally only be beneficial if the shifting of these assets and liabilities will decrease the capital requirement of EU subsidiaries by a larger amount than the amount by which the book values of the non-EU subsidiaries would increase as a result of receiving those assets or liabilities. It could, however, also present a second incentive. If an EU subsidiary were to have difficulty in complying with its solo capital requirement under the IFR, but its parent company had no difficulty in complying with the group capital test, the group might shift assets and liabilities from the EU subsidiary that has a capital shortfall to a non-EU subsidiary. The question is whether these incentives create a loophole that should be prevented. From a prudential regulatory perspective, this incentive to shift assets and liabilities to non-EU subsidiaries will increase the complexity of the group, decrease the knowledge local supervisory authorities have of the group’s business and increase the operational risk of the group.

452. Under the IFR proposal, this group capital test was to be the standard for all investment firm groups that fall within the scope of the IFR.3 However, the IFR PC 1 changed this to a discretion for the supervisory authority.4 Class 1 investment firms will remain within the scope of the CRR and will thus remain subject to the consolidation requirements of the CRR. For Class 2 and Class 3 investment firms, the alternative calculation method of Article 15 of the CRR will be an option for those firms where the competent authority “deems the group structure of the investment firm sufficiently simple and if there are no significant risks to clients or to markets stemming from the investment firm group as a whole that would otherwise require supervision on a consolidated basis”.5

453. The European Commission does not give a clear argumentation regarding the consolidation requirements for investment firms in the final texts of the IFR, nor under the original IFR proposals and the Presidency Compromise proposals, but refers back to the reports published by the EBA. Consolidated supervision is a tool for supervisory authorities to assess the risks for an investment firm by being part of a group of firms. Consolidated supervision, therefore, serves as “a supplementary tool to individual supervision, providing a view on the wider risks that an individual form may be exposed to by virtue of its membership in a group”.6 According to the EBA, consolidated supervision purports to “(i) identify group risks; (ii) detect excessive group leverage; and (iii) safeguard against situations of multiple gearing”.7 To capture the risks of an investment firm’s membership of a group, the EBA proposed to keep a consolidated requirement, however, in both its 2015 and 2017 reports the EBA immediately proposes to make the group capital test the default consolidated requirement. Only in its 2017 report did the EBA provide a short reasoning as to why this different consolidated requirement should be used. According to the EBA “the prudential consolidation method prescribed in the CRR can be less relevant to investment-firm-only groups under the new regime based on K-factors and can potentially have a limited scope of application”.8 According to the EBA this group capital test will “reduce the regulatory burden for such groups while maintaining an adequate level of prudency”.9 No reasoning as to why the requirements of the consolidated supervision framework of the CRR were too burdensome for investment firms and no analysis of the differences between the proposed group capital test and the CRR consolidated regime were provided either by the EBA or by the EC. The introduction of a CRR-like consolidation regime is a means to address some of the issues of the group capital test, but the EC still does not provide any reasoning or argumentation as to why the consolidation regime itself included in the IFR is appropriate for investment firms.