9.2.6 Own funds requirements

462. When determining the available capital of an investment firm, the IFR uses the definition of ‘own funds’ in the CRR regime.1 Article 9 of the IFR2 refers to the definitions of Common Equity Tier 1, Additional Tier 1 and Tier 2 capital included in Part Two of the CRR. “In order to allow investment firms to continue to rely on their existing own funds to meet their capital requirements under [the IFR and IFD], the definition and composition of own funds should be aligned with [the CRR]. This includes full deductions from balance-sheet items from own funds […] such as deferred tax assets and holdings of capital instruments of other financial sector entities”.3 However, certain exemptions to the CRR own funds definition have been made to better align the own funds definition with the investment firm sector. One of the exemptions is to allow investment firms to “exempt non-significant holdings of capital instruments in financial sector entities from deductions if held for trading purposes in order to support market-making in these instruments”.4 This exemption ensures that investment firms that are, for instance, market makers, and as such can acquire larger non-significant holdings of a listed company for short periods of time, are excluded from deducting these holdings of capital instruments in financial sector entities from their available capital. The CRR requires firms to fully deduct5 these non-significant holdings, thereby making these market making activities in such products very costly from a capital perspective. As such, the provision in the CRR definition of own funds that regulate these non- significant capital holdings of other financial sector entities is excluded6 from the own funds definition for investment firms as set out in IFR.

463. There are, however, aspects of the own funds requirements in the IFR that require further discussion, some of which have been addressed in the Presidency Compromise proposals. The elements of own funds in Part Two of the CRR contain several references to the credit risk framework in the CRR7 and at those points require a risk weighting of certain elements of own funds. This cross-reference to the credit risk framework is, for instance, included in Article 36(1)(k) of the CRR, which defines several exposures that qualify for a 1250% risk weighting to be (fully) deducted from the own funds as an alternative to that risk weighting. For a bank, which is also subject to the credit risk regime of the CRR, this is a logical system where the bank either has to deduct the exposure from its own funds or has to hold capital for that exposure under the credit risk regime. Investment firms are no longer subject to the credit risk regime, which results in an illogical application of this Article 36(1)(k) of the CRR. The investment firm can now choose between a risk weighting and a deduction of this exposure. Since the credit risk regime is no longer applicable, however, the risk weighting option will have no capital consequence whatsoever. By not correcting these cross-references between Part Two of the CRR and other Parts of the CRR (most notably Part Three of the CRR containing the capital requirements), the IFR introduces less logical rules into its own funds definition and possible regulatory arbitrage by referring to parts in the CRR which are no longer applicable to investment firms after the entry into force of the IFR and IFR regime.

464. The IFR introduces a new possibility in the own funds definition which is beneficial for smaller investment firms. Some smaller investment firms are not organized as a legal person or joint-stock company and as such can have difficulties in complying with the Common Equity Tier 1 definition of the CRR, which is based on joint-stock credit institutions.8 The IFR contains a discretion for competent authorities, after consultation with the EBA, to “permit [other] instruments or funds to qualify as own funds for these investment firms”.9 This is a continuation of the possibility which existed in the CAD 200610 but which was not included in the CRR regime.

465. With the references to the CRR own funds definitions, investment firms are limited to the own funds instruments11 included in Part Two of the CRR; the Common Equity Tier 1,12 Additional Tier 113 and Tier 2 instruments.14 However, under the CAD 2006, investment firms were also allowed to use an investment firm-specific own funds calculation, so-called Tier 3 capital.15 The EC argued when drafting the CAD 2006 that it “[was] appropriate for the definition of own funds as laid down in [CRD 2006] to serve as a basis, and to provide for supplementary specific rules which take into account the different scope of market risk related capital requirements”.16 As these specific own funds calculations of the CAD 2006 were specifically created to address the specifics of investment firms, it would seem logical to have a similar set of own funds calculations in the IFR proposals. It would have been beneficial for the prudential regime for investment firms if the EC would have given this aspect further thought in the IFR and IFD.