7.2.2.3 Article 95 of the CRR

266. The CRR contains a second alternative calculation of the risk exposure of investment firms in Article 95.1 The first Paragraph of Article 95 specifies that investment firms which do not provide the investment activities of ‘dealing on own account’ and ‘underwriting of financial instruments on a firm commitment basis’2 are subject to the alternative calculation of Article 95. The second Paragraph of Article 95 enlarges the scope of this Article to include a subset of the firms which have been excluded from the definition of CRR investment firm.3 Firms which qualify under the exclusion of the CRR definition of investment firm, but which provide the investment services of ‘execution of orders’ and/or ‘portfolio management’, are subject to the alternative calculation of Article 95 and therefore a substantial part of the CRR framework, even though these firms are not included in the scope of the CRR itself. Effectively, after applying the scope of the first and second Paragraph of Article 95 of the CRR, the scope is the same as under the CAD 2006. Under the second paragraph of Article 95 those firms that were excluded from the CRR definition of investment firm are brought back within the scope of this article4 and the solvency capital requirements pursuant to this provision.

267. The alternative calculation of Article 95 differs from the alternative calculation in Article 96. Whereas Article 96 calculates the sum of the different risk exposures, but excluding operational risk, and including the fixed overhead requirement,5 Article 95 creates a ‘higher of’ calculation.6 Investment firms and firms subject to Article 95 should calculate their risk exposure according to Article 92, Paragraph 3, but excluding operational risk,7 and compare this to their fixed overhead requirement. The higher of the two is the applicable own funds requirement.

268. Although this ‘higher of’ calculation appears to be a concession to investment firms, which are typically smaller than credit institutions, the actual wording of Article 95 creates an additional burden on these investment firms which negates the attempted concession.8 When comparing Article 95 of the CRR with Article 20 of the CAD,9 from which Article 95 originated, the major difference is the deletion of the supervisory discretion to apply the alternative calculation. Under the provision in the CAD, it was up to the national supervisor to determine10 whether an investment firm was allowed to calculate its capital requirement using the alternative approach as described above, or the calculation used by banks as described in Article 92 of the CRR. This meant that before allowing an investment firm to use the alternative approach, the supervisor could assess whether its capital requirement for fixed overhead would be larger than its capital requirement for credit and market risk. After permitting the use of the alternative approach, investment firms could then comply with the capital requirements by only calculating the fixed overhead requirement. The ‘higher of’ assessment had already been carried out by the supervisor. Investment firms themselves could also assess which approach they would prefer to apply, since the national supervisors could apply this supervisory discretion based on the request of the investment firm. If an investment firm, for whatever reason, decided it would prefer to use the full capital requirement calculation (similar to banks), this was allowed.

269. Under Article 95 of the CRR, this supervisory discretion has been removed and the mandatory use of the alternative calculation for investment firms has been included. Investment firms are now not allowed to use the full capital requirement calculation as described in Article 92 of the CRR. Instead, investment firms and firms subject to the application of Article 95 are obliged to use the alternative calculation. Because this alternative calculation has now become an obligation, supervisors can no longer allow investment firms to calculate only their fixed overhead requirement, even if this fixed overhead requirement is (expected to be) the highest capital requirement. This, therefore, results in investment firms now having to calculate their risk exposure for credit and market risk and their capital requirement for the fixed overhead to estimate which of both produces the higher amount. Although Article 95 is intended to be a lighter capital regime for investment firms, the method of calculating this alternative approach has become a more difficult, detailed and intensive calculation under the CRR. Because investment firms now face the obligation to always calculate their exposure to credit and market risk, the intended concession for investment firms has become more burdensome from a compliance perspective.

270. One other aspect of the alternative calculation which raises questions is the ‘higher of’ equation itself. The equation compares a capital requirement for credit and market risk with a capital requirement for fixed overhead (an aspect of an operational risk capital requirement, see the subparagraph on fixed overhead below). Looking only at the resulting capital requirements, this comparison obliges an institution to hold the highest capital requirement applicable to the institution. However, when looking at the risk concepts themselves, this comparison compares risk concepts which are not similar.11 The capital requirement for the fixed overhead requirement is intended to mitigate the risks the institution faces in its day-to-day operations. The capital requirements for credit and market risk are intended to mitigate the risks the institution faces in its investment portfolios and its exposures to counterparties. Conceptually, comparing the capital requirements for credit and market risk with the capital requirement for operational risk and choosing the highest of those requirements results in institutions maintaining a capital level which is not related to their risk profile according to the various risk exposures they have calculated. From the viewpoint of the different risks to which an investment firm is subject, the investment firm cannot comply with the capital requirement for its credit and market risk by maintaining a higher capital amount for its fixed overhead requirement.

271. This ‘higher of’ equation contains another, implicit comparison between the various risk concepts. The first Paragraph of Article 20 of the CAD12 subjected investment firms to the full capital requirement calculation, as in the case of banks. This meant that every investment firm was obliged to calculate its capital requirement based on its credit risk and market risk but also on its operational risk. The second Paragraph of Article 20 of the CAD13 introduces the ‘higher of’ calculation, as described above. Because the second Paragraph of Article 20 of the CAD is a supervisory discretion and is an alternative to the obligatory calculation included in the first Paragraph, it implicitly compares the capital requirement based on the operational risk with the fixed overhead requirement as set forth in Point b of the second Paragraph of Article 20 of the CAD. The second Paragraph of Article 20 of the CAD compares the capital requirement for credit and market risk with the fixed overhead requirement, whereas the first paragraph encompasses the capital requirement of credit and market risk (similar to the second paragraph), but also includes the capital requirement for operational risk. When applying the second Paragraph of Article 20 of the CAD, a supervisor would then implicitly compare the operational risk requirement with the fixed overhead requirement. A prudent supervisor would only allow an investment firm to use the alternative calculation if this would result in a higher or more appropriate capital requirement when compared with the full capital requirement calculation, which included the operational risk requirement.

272. This (prudent) double layering of the capital requirements in Article 20 of the CAD14 (first the full capital requirement and then the comparison with the alternative calculation which is itself a comparison between credit and market risk with the fixed overhead requirement) has not been introduced in the CRR. Article 95 of the CRR15 does not contain the obligation for investment firms to use the full capital requirement calculation as set forth in Article 92 of the CRR. Article 95 merely contains the alternative approach which leads to the situation that investment firms falling within the scope of Article 95 of the CRR are never required to calculate their capital requirement for operational risk framework included in the CRR.16 Under the CRR regime, supervisors are therefore not able to fully assess the risks of these investment firms. They are obliged to use the alternative calculation of Article 95 of the CRR and have no supervisory tools under the CRD 2013 framework to apply the operational risk framework of the CRR to these investment firms. This results in Article 95 containing only the afore mentioned ‘higher of’ comparison between credit and market risk versus the fixed overhead requirement.

273. When we reflect back on the scope of Article 95 of the CRR, it can be argued that the capital requirement for credit and market risk is indeed a burden for these types of investment firms. Investment firms falling within the scope of Article 95 are not allowed to trade on own account or place instruments on a firm commitment basis. Article 29, Paragraph 2 of the CRD 201317 allows investment firms which are not permitted to perform the investment service of trading on own account, under several strict conditions mentioned in Article 29,18 to hold instruments for their own account if this in relation to any client activities. This ‘own account business’ for Article 29 CRD 2013 and Article 95 CRR investment firms and firms is limited to 15% of the investment firms initial capital19 (which is either €125,000 or €50,000). Therefore, the investment firm can only have a very limited exposure to credit or market risk. It would therefore almost always result in the fixed overhead requirement being the higher capital requirement. The alternative approach in Article 95 of the CRR therefore seems to impose more demanding compliance efforts on investment firms instead of actually creating a lighter capital regime, especially now that the supervisory discretion contained in the CAD 2006, which could be used to remedy some of the negative aspects of this alternative approach, has been removed.