7.2.3 Definition of capital for initial capital requirement

277. In order for investment firms to ‘use’ their capital to fulfil the capital requirements, that capital has to qualify under the criteria set out in Part Two of the CRR.1 Part Two contains the definition of capital and defines the conditions and criteria for issuing capital instruments which could qualify as regulatory capital. Part Two follows a clear and logical structuring of the three tiers of capital instruments and the prudential filters and deductions for the various tiers. This structure has been greatly improved compared to the CRD 2006. The first title of Part Two, which contains the elements of own funds, is divided into Chapters, one for each capital tier.2 Each of these Chapters starts with the instruments which qualify for that capital tier, followed by the prudential filters and finally the deductions for that capital tier.

278. The CRR and the CRD 2013 make a distinction in the ‘type’ of capital which has to be used for the initial capital requirement and the ‘type’ of capital which has to be used for the own funds requirement. The capital an investment firm should have in order to fulfil its initial capital requirement is defined in the first Paragraph of Article 28 of the CRD 2013.3 This provision refers to Article 26, Paragraph 1, Points a through e4 of the CRR for the instruments that should constitute the initial capital.5 The instruments which constitute the initial capital are only positive instruments. The prudential filters and deductions which should be applied for the own funds requirements are not applicable to the initial capital requirement. This means that the initial capital requirement overestimates the actual regulatory capital an investment firm has available. The prudential filters and deductions, which are not applied to the initial capital, are meant to adjust the capital of an institution for items on the balance sheet which have no prudential, supervisory or regulatory value.

279. The capital which should be used to comply with the own funds requirements has to fulfil all requirements of Part Two of the CRR. All deductions and prudential filters therefore have to be applied to the capital instruments of the investment firm to arrive at the actual regulatory capital an investment firm has available to meet its own funds requirement.

280. If the CRD 2013 and the CRR are viewed as a market entry directive for a “clean sheet” financial sector (no investment firms or credit institutions are in existence before the entry into force of the CRD 2013), this distinction between initial capital and the own funds requirements makes sense. A firm which starts when it obtains its licence has a ‘clean balance sheet’ and will usually have a balance sheet without items (such as goodwill or other intangible assets) which constitute a deduction or prudential filter. These balance sheet items will “appear” on the balance sheet after the firm has been operational for some time. It therefore makes sense to differentiate between the initial capital (capital used for the initial start-up of the firm) and the own funds (capital used on a going concern basis) in this “clean sheet” situation.

281. In reality, most firms which are granted a licence were operational before they obtained it. Therefore, the initial capital requirement based on a clean balance sheet without any prudential filters has very little value in the financial sector we have today. Most firms have been operational for quite some time and therefore have balance sheet items which should be deducted.

282. As mentioned before, Article 93, which provides a minimum level of the own fund’s requirement on the level of the initial capital, is most relevant to investment firms. This does lead to the difficulty of determining which definition of capital should be used. The initial capital of an investment firm is only defined as the positive instrument without deductions. For calculating the own funds requirement of an investment firm, the firm has to apply to deductions to its own funds. Given that Article 93 of the CRR is formulated as a minimum level of the own funds requirement, one must assume that the amount of initial capital has to be met with regulatory capital which complies with Part Two6 as a whole, including the deductions. The CRR text, however, does not make explicit which capital definition should be used for compliance with Article 93. The regulatory capital used for the initial capital requirement is calculated without deductions, whereas the regulatory capital used for the initial capital floor of the own funds requirements is calculated with deductions. This leads to situations where at the same point in time, an investment firm has enough regulatory capital to comply with the initial capital requirement but has a substantial amount of deductions which cause it to have insufficient regulatory capital to comply with the own funds requirement.

283. Another interesting situation caused by this deviation between initial capital and own funds can be seen in the case of a new start-up firm, for example. This firm has to comply with its initial capital requirement, even though it has a large balance sheet item representing intangible assets (software for instance). This intangible asset does not have to be deducted when calculating the initial capital requirement at the moment of granting the licence. The day after granting the licence, the firm has to calculate its own funds requirement and is therefore obliged to deduct the intangible assets from its regulatory capital.7 Unless the firm issues new capital to compensate for the deduction of the intangible assets, the firm does not comply with the capital requirements the moment after it received its licence.

284. One can argue that the difference in regulatory capital to be used for the initial capital requirement and the own funds requirement should be avoided. This would strengthen the regulatory capital a new start-up firm has available and would mitigate the lack of clarity of Article 93 for investment firms as to which type of regulatory capital they should use to comply with Article 93.