10.4.3 Orderly wind down requirements

516. As discussed in Section 8.3, the prudential regulatory response for investment firms could benefit from a requirement to establish recovery and resolution plans. Under the current regime of the BRRD, only certain larger investment firms, or at least investment firms that the EC has considered bank-like because they carry out own-account dealing or underwriting activities, have the obligation to draft a recovery plan and their competent authority has the obligation to draft a resolution plan. Recovery and resolution requirements for all investment firms should be introduced, and this should be the primary regulatory response. If an investment firm can be wound down in an orderly fashion, and its clients will face minimal disruption in the service they receive, albeit from a different investment firm than the firm that is being wound down, or counterparties are not exposed to problems in the transactions entered into with the investment firm, the main goals for prudential supervision of investment firms to protect investors and financial markets, as set by IOSCO, the EC and the EBA in their respective principles, directives and regulations or reports, have been achieved. As such, the resolution framework provided by the BRRD should be further applied to investment firms. Subsequently, the need for a going-concern prudential capital requirement will be reduced, obviating the need for the complex framework of RtM and RtF in the IFR. This orderly wind-down function should also include an asset or business transfer tool, as discussed in Section 8.3.3. This orderly wind-down requirements should be part of the review on Points B, D, F and K of Article 60(1) of the IFR.

517. Although introducing an orderly wind-down regulatory regime for investment firms would appear as a significant deviation from the IFR and IFR proposals, those proposals do already contain (implicitly) requirements which could aid an orderly wind-down. The fixed overhead requirement is, as discussed in the fixed overhead section of Section 7.2.2, a requirement that is already based on the assumption of an orderly wind-down. The investment firm should hold capital of at least 25% of its fixed costs, which should provide competent authorities with a three month period for winding down the investment firm. This can be coupled with the RtC capital requirements, which address the operational risk of the business of investment firms. This RtC capital requirement ensures that the investment firm can ‘survive’ an (expected) operational risk event and the simultaneously applicable fixed overhead requirement provides competent authorities with the capital needed to wind- down the investment firm in an orderly fashion if an (unexpected) operational risk event would cause the investment firm to fail.

518. The RtC capital requirements in the IFR are drafted in more general terms and try to capture the risk of a business model instead of a more granular approach which purports to capture the risk of underlying positions, such as the RtM and RtF capital requirements in the IFR try to do. The main deviation between an ‘orderly wind- down regime’ and the regime in the IFR and IFD will be in those K-Factors under RtM and RtF. These requirements could be significantly simplified by not trying to assess the risk of each underlying position, but by measuring the more general risk that the business activity of dealing on own account (for own risk and account, or by not matching client orders precisely, or by being counterparty for its clients) or underwriting could expose the investment firm to. The RtF and RtM requirements in an orderly wind-down regime should contain a capital requirement that ensures investment firms can ‘survive’ a financial risk event for the period needed by competent authorities to wind down the business in an orderly fashion.

519. The underlying assumptions directing the requirements of RtM and RtF seem to be that a going-concern approach should be taken. Meaning that an investment firm subject to the requirements of RtM and RtF should be able to ‘survive’ expected an unexpected losses. This would, however, appear to be in contradiction to the underlying principle of RtC and the fixed overhead requirement which are more gone-concern orientated.

520. Applying this gone-concern approach to RtM and RtF would thus entail a risk measurement approach to calculate what capital would be required for an orderly wind-down. For instance, the concentration risk requirement included in K-CON will not be necessary as the possible failure of the investment firm due to a concentration in a single counterparty would then be, primarily, a risk the management of the investment firm should be concerned with. As long as prudential regulations provide supervisory authorities with a capital requirement that will enable an orderly wind-down of that investment firm, and thus preventing any other counterparties or clients of that investment firm from harm, it will not be relevant for that supervisory authority to calculate a concentration risk capital requirement.

521. This gone-concern approach to the regulation of investment firms in the European Union will bring that regulatory framework more in line with the Regulatory framework in the United States. As discussed in Chapter 5, the Net Capital Rule applied in the US, is a regulatory framework that assesses if the investment firm “maintain[s] at all times sufficient liquid assets to (1) promptly satisfy their liabilities - the claims of customers, creditors, and other broker-dealers; and (2) to provide a cushion of liquid assets in excess of liabilities to cover potential market, credit, and other risks if they should be required to liquidate”.1 The framework in the US is therefore also a framework that encompasses this gone- concern approach. Although the actual methods of assessing the risk profile of an investment firm will still differ between the US regulatory framework and the framework in the European Union, both frameworks will now be starting that risk assessment on the same approach: a gone-concern approach.