10.4.2 Prudential requirements to mitigate financial risks

513. The way the financial risks are measured and mitigated in the IFR are problematic. The EC has chosen to use concepts already included in the CRR, in the IFR, such as the large exposure regime, counterparty credit risk and the market risk framework. As discussed in Section 9.2.3, the K-factors used to address RtM and especially RtF contains numerous shortcomings that either mean the wrong risk is measured or the appropriate risk is measured incorrectly. The solutions to amend these shortcomings in the RtM and RtF regimes can be sought in two possible options. Firstly, the amendments and changes made in the IFR to the methods used in the CRR to address large exposure risk, counterparty credit risk and market risk could be removed and the IFR could apply similar requirements as prescribed in the CRR. Secondly, a new means of addressing financial risk could be developed. This could be based on the idea of gone-concern regulation for investment firms, as discussed Section 8.1. Both methods can be viewed as a possible outcome of the review according to Points B, D, F and K of Article 60(1) of the IFR1, which addresses the methods for measuring K-factors and the RtF framework.

514. The problem with the RtF and RtM regimes in the IFR is that the EC tried to accommodate the specific risk profiles and business models of investment firms by amending the requirements of the CRR for those investment firm specificities. This has led, however, to a complicated regime that is actually less appropriate than the regime in the CRR it is replacing. By fully aligning the (revised) IFR with the requirements of the CRR, and thus ignoring or removing the new amendments made to these CRR regimes within the IFR as it is published in December 2019, the errors made in the IFR are corrected. It will mean, however, that the CRR regime, which both the EBA and the EC considered an inappropriate regime for investment firms, will still be applicable to investment firms. This solution, therefore, only solves the problem of the incorrect or inappropriate amendments in the IFR. It does not address the fundamental question of whether the applicable requirements are indeed the most appropriate requirements to address the specific risk profile of an investment firm.

515. Based on the issues discussed in this study, a new regime to address financial risk for investment firms should be developed. The problem with the CRR requirements is that they are intended for large banks and the business models of these banks. As discussed in Section 5.4 and Chapter 8, the prudential regulatory response incorporated in the Basel Accord and the CRR regime is based on a going-concern approach. The CRR regime for market risk, counterparty credit risk and the large exposure regime require banks to capitalize their unexpected losses to ensure that it can withstand financial difficulties. For investment firms, a gone-concern approach seems more useful and therefore using the CRR requirements is not appropriate. As the supervision of investment firms should focus on resolvability, the requirements to address financial risk do not have to provide a detailed and granular approach measuring each financial risk individually. Instead, the regime for investment firms should ensure that the investment firm holds enough capital to be wound down in an orderly way. This orderly wind-down requirement should thus not require a detailed, and subsequently complex, market risk framework as is now included in the CRR or the similar K-NPR requirements in the IFR. What this simpler market risk regime should be, needs to be further investigated and that should be done in conjunction with the establishment of an orderly wind-down regime. It falls within the mandate of the European Commission to recommend changes along these lines in the review it has to conduct, based on Points B, F and K of Article 60(1) of the IFR which address the regulatory response included in the IFR concerning these financial risks. The following section of this study will describe how this orderly wind-down regime can be established.