Prudential regulation of investment firms in the European Union (ZIFO nr. 32) 2021/9.1.1:9.1.1 Why a new prudential regime?

Prudential regulation of investment firms in the European Union (ZIFO nr. 32) 2021/9.1.1

9.1.1 Why a new prudential regime?

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352. The linkages between the prudential regime in the European Union for investment firms and credit institutions were first established in 1993 with the introduction of the CAD 19931 and were further tightened with the introduction of the CRD 2006 and the CAD 2006.2 As of the financial crisis which started in 2007/2008, the prudential regime for credit institutions has been further strengthened. There has not been a thorough analysis, however, of whether this strengthening of prudential principles for credit institutions was a useful addition to the prudential regime for investment firms, nor was this justified or supported by sufficient evidence about the appropriateness of this amended regime for investment firms. Historically, a part of the prudential regime for investment firms was designed in a more or less identical way to the regime for credit institutions, without considering the implications and without fully understanding the specifics of the risk profiles of investment firms. The result was that every reiteration of the CRD and the CAD and eventually the CRD 2013 and the CRR3 for investment firms required numerous exemptions or different treatments for investment firms to remove the most obvious conflicts for this type of business.4 Chapter 7 explained in more detail the inappropriate scope of the prudential regime for investment firms as laid down in the CRD 2013 legislative package.

353. The European Commission, in its Staff Working Document5 accompanying the December 2017 proposals, acknowledged this convergence of the prudential regimes for banks and investment firms and stated that “[the CRD 2013 and the CRR do] not effectively capture the actual risks faced by the majority of EU investment firms […]”.6 The European Commission therefore concluded, based on the report and opinion of the EBA, that the prudential regime for investment firms in the CRD 2013 “can be shown to be disproportionate and a source of excessive complexity and administrative and compliance costs for most investment firms”.7

354. To achieve a prudential regime that is better aligned with the specific risk profiles of investment firms, the European Commission identified three objectives, to address three underlying problems that the prudential regime should mitigate. The Commission included the following summary in its Staff Working document:8

Problem

Objective

Complex and disproportionate regime

A framework that accommodates investment firms for the business they conduct and avoids regulatory arbitrage

Lack of risk-sensitivity

More appropriate, risk-sensitive requirements

Differences in application by Member States

A streamlined regulatory and supervisory toolkit

355. In the Staff Working Document the European Commission evaluated the proposals made in the EBA opinions and concluded that “the EBA recommendations are considered to be an appropriate and proportionate means of achieving the objective of the review in an effective and efficient manner. More generally, the EBA advice is a clear positive step towards a prudential framework for investment firms which can both underpin the safe functioning of investment firms on a sound financial basis while not hindering their commercial prospects”.9 A further elaboration on the need for a new prudential regime for investment firms can be found in the EBA report.

The EBA, in its 2015 report, identified several “main issues”10 with the CRD 2013 / CRR framework for investment firms, which would have to be solved in a new regime. It concluded that the CRD 2013 / CRR framework lacked risk sensitivity.11 For instance, not all MiFID investment services and activities are explicitly mentioned in the CRD 2013 / CRR,12 and therefore the prudential regime for these investment services and activities has to be implied from other more general requirements in the CRR. Hence the specific risks of these activities are not adequately captured by the CRR. The CRR regime for investment firms was also too complex.13 The complexity of the CRR regime is described in Chapter 7.

The EBA also concluded that not all of the investment services and activities as included in Annex I of MiFID are defined in detail in MiFID itself. “As a consequence, the implementation of provisions on some services and activities might give rise to diverging applications […] on a national level”14. Because the CRD 2013 / CRR regime for investment firms was primarily based on the MiFID services and activities an investment firm is allowed to perform, these ‘diverging applications’ of the MiFID services and activities between member states can also mean that investment firms providing a similar business activity are treated differently between various member states. As member states have different interpretations of which (investment) business activities constitute a certain MiFID investment service or activity, a similar business activity might result in different MiFID-licenced activities between member states, and thus, as the CRD 2013 / CRR use these MiFID activities as a starting point, lead to different capital requirements between member states for a similar business activity.

For instance, until November 2017 proprietary traders in the Netherlands were subject to a national prudential regime based on the “local firm”15 exemption in the CRD 2013 and the CRR. In other European countries, investment firms with a similar business have not been able to use this local form exemption and have therefore been fully subjected to the capital requirements of the CRR and other requirements of the CRD 2013.

Furthermore, differences in interpretations between member states as to what constitutes “holding client money or securities”16 have led to asset managers being faced with significantly different capital requirements between various member states. Investment firms holding client money or securities are required to hold an initial capital of €125,00017 and are fully subject to all relevant requirements of the CRR. Investment firms not holding client money or securities are required to hold an initial capital of €50,00018 and are only subject to Article 95(2) of the CRR for their own funds requirements. The question of when an investment firm is considered to hold client money or securities is therefore highly relevant.19 As this is not defined in MiFID II, the CRD 2013 or the CRR, it is up to member states to assess when an investment firm is indeed holding client money, which is in turn fully dependent on the way investment firms are required to safeguard those monies and securities of their clients, as has been discussed in Chapter 4. This means that an investment firm can be considered to be holding client money or securities in one country, whereas it would be considered to be not holding client money or securities in another, even though the business activities and asset segregation method do not differ.

These main issues led the EBA in its 2015 report to the conclusion that a new prudential regime should be drafted. The objectives of the European Commission, which are mentioned above and which are based on the objectives of the EBA in both its 2015 and 2017 report, aim to address these main issues.

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