FOGAIN (WORKING GROUP OF SPANISH INVESTMENT FIRMS)

The criteria set forth in the Discussion Paper (DP) seem correct, subject to our observations in response to the following question.
We consider the establishment of specific rules for investment firms to be highly positive. It constitutes a major step in the regulation of this type of institutions that do not perform banking operations and which essentially – aside from dealing on their own account in certain cases – are service providers. Therefore, it is not so much the quality of their assets that should determine their level of risk and hence the required coverage with own funds, as in the case of banks; it is rather the operational risk, a broad concept, that would require such coverage.

In this regard, we believe that the DP accurately identifies this reality. The identification of the specific risks, such as risk to customers, risk to markets and risk to firm is seen as a sound analysis of the potential sources of risk, effectively identifying liabilities for the institutions stemming from their business activity as service providers.

However, we believe that the conclusion reached by the DP in the sense that it should be the sum of a percentage of each and every one of the risks, should be qualified. In this regard, we have the following observations to make:

- Operational risk is hard to measure. We believe provision should be made for a realistic and evidenced-based assessment of the level of own funds required to cover such risk. In this regard, the current regulation on own fund requirements to cover operational risk sometimes involves sums much higher than the losses reported in recent years.

- The DP does not specifically consider fraud risk. Admittedly, this is an aspect of operational risk, but it is also true that, when compared with other risks, it can cause the level of own funds of a small or medium-sized institution to be irrelevant, since a fraud situation can also lead to the total disappearance of the entity’s own funds.

- It is not realistic to consider that an entity can be wound down in a period of fourth months. It usually takes a much longer time, even years. Moreover, during the period of time required by the winding down of an entity, many costs are not incurred that would normally be incurred by an actively operating entity (salaries, suppliers, etc.). However, though not very precise, the criterion based on a percentage of the fixed overheads would indeed be an indicator of the volume of operations of an entity and as such – taking into account its limitations – a valuable metric. However, we propose that this metric be maintained for all class 2 and class 3 investment firms, which would imply the same regime for these two classes.

- Operational risk can be reduced very significantly through suitably supervised organisational and internal control measures. Such measures involve a cost for the system in general – institutions and supervisor – that should be compensated for with lower own fund holding requirements, thereby allowing for a better conduct of business and for the growth of institutions furnishing proof of good internal control and compliance. Moreover, the cost of investment guarantee systems, directly aimed at reducing the risks to customers in the event of insolvency, could also be reflected in a lower own funds requirement in this regard. These two considerations could result in a down-lift factor, and not only an up-lift factors as discussed in the DP.

- Care must be taken to avoid that the own funds regime should prevent the growth of small and medium-sized investment firms. An own fund requirement representing an unnecessarily high percentage over total operations may have the effect of restricting the growth of these institutions’ business operations. Such restrictive impact must be avoided by considering realistic amounts based on evidence, so as not to prejudice growth, with a potentially beneficial impact on the market as a whole.

- An example of regulation, in this regard, would be the minimum own funds regime applying to UCITS investment firms, which specifies a de minimis amount, plus a very small percentage of the sums managed.

- In order to obtain a clearer overall picture of this subject, we would propose (i) reviewing the events of insolvency of investment firms in the EU, assessing the causes, the consequences and the role played by own funds; and (ii) evaluating the level of losses actually caused by each activity to the investment firms in the EU, as a result of operational risk. This aspect – reviewing past evidence – is of great importance.

- The foregoing is extremely important, as a more precise definition of the type of risks affecting these institutions should not lead to an increased own funds requirement that would compromise their viability. A rigorous comparative calculation should be made of the amounts resulting from the application of the current versus the new regime, for specific scenarios, with a view to analysing whether or not such amounts would be justified. For such purpose it is likewise very important to review past evidence.
- As regards the adaptation to investment firms of other prudential requirements (liquidity, consolidation, governance, remuneration…) we shall refer to them in our responses to each specific question.
The criteria for distinguishing between Class 2 and Class 3 are not easy to implement, and we believe that small firms in the start-up phase – classified as small on the basis of the volume of assets under advice, assets under administration, assets traded and assets safeguarded – should be allowed to grow.

Hence, as pointed out earlier, the fixed overhead criteria could also be applied as the basis for Class 2 institutions, which would lead to the same treatment of Class 2 and Class 3 for such purposes. Thus, when they exceed certain thresholds, a percentage would be calculated over these volumes – with supporting evidence for such amounts – and the minimum required amount would be set as the higher of the following: the percentage of the fixed overheads or the percentage of the volume of t.
Please refer to our response to the previous question.

Additionally, as regards the aspects allowing one class to be distinguished from the other, we have the following observations:

- Points a) and b) should be under the same heading, since client money and securities are only held when performing the asset safeguarding and administration service. This is a service whose impact on the calculation of own funds should be included in the general regime finally applied.
- With regard to point h) it is not clear what the effect of the firm being a member of a wider group would be. This should not affect solvency requirements at an individual level. However, the measures proposed in the DP in that regard (paragraphs 152 and 153) would apply.
- As regards point i) it does not seem appropriate that in a single EU capital market the use of the MiFID passport should be “penalised” with a higher own funds requirement.
- With regard to letter j), the use of tied agents is an aspect which, though requiring additional internal control measures, it cannot be easily evaluated whether it entails a higher level of risk as regards the application of a Class 2 or Class 3 regime, since the quantitative risk they add would already be accounted for in the total amount.
As pointed out earlier, we believe the risks are clearly identified; however, the difficulty in evaluating the actual amount of risk it entails in terms of solvency – and hence the financial firms’ ability to fulfil their obligation to clients and the market – should lead to avoiding percentages that prevent an unjustified limitation for the development of the entities’ business. In this regard we refer to our reply to question 2.

On the other hand:
- We believe that trading should not be measured by the number of trades. A unique order can be executed by means of several transactions in the market and this method is thus, difficult to evaluate. Besides, it would depend largely on the type of product traded. A more sensitive criterion would be that based on the traded volume.
- We consider the RtM criteria to be excessively theoretical and not granular enough. This type of risks are usually guaranteed and previously netted. Both in the case of OTC transactions under master agreements and in the case of transactions with central counterparties or markets. Therefore, these risks should be assessed in a more granular approach in each case.
- With regard to RtF we wish to reiterate that, as this is an operational risk, whose reduction can be efficiently achieved by qualitative rather than quantitative methods, a method must be found of assessing a “down-lift” apart from an “up-lift”.
Please refer to our replies to questions 2 and 5.
Additionally, we believe the own funds requirement for securitisation risk-retentions is appropriate.
We consider the methodology and underlying idea set out in the DP in this respect to be correct.

However, this same idea should also lead to possible “down-lift” measures, as pointed out earlier. A small firm with adequate internal controls effectively in place terms significantly limits its operational risk. It should be possible to reflect this in the solvency risk, which, precisely, focuses very much on the assessment of operational risk.
Please refer to our replies to questions 2 and 5.
While there are a number of possible valid options in this regard, we believe that using the FOR as a reference criterion is positive, since it is an element that indicates the level of activity and operating capacity of the institution.
In Spain there are no investment firms of that size. However, the criterion in this case is based on counterparty risk, which should be assessed after netting the legally nettable positions and reducing all the existing coverage instruments (collateral).
Yes, but always subject to the extremely important considerations and limitations set out in our replies to questions 2 and 5.
The criteria in such cases should approximate to those for the rest of investment firms.
In Spain this would only apply to institutions consisting of natural persons acting as Financial Advisory Firms, which have their own solvency regime.
Investment firms tend to be small or medium-sized institutions using as capital instruments the share capital and reserves. Therefore, we have no specific comments as to the usefulness or not of other capital instruments.
The treatment of goodwill, holding of capital instruments in other financial institutions, and the regime for pension funds, as mentioned in the DP, do not call for additional comments.
In line with the DP, it is more appropriate to have a specific regime for the definition and quality of capital for investment firms that would clearly distinguish this prudential regime from the one applying to the banking industry.
We believe that the definitions of initial capital and regulatory capital should be aligned.
Currently, initial capital is tied to the type of business activities that each investment firm can perform. This is a sound criterion; however, should the current criteria be reviewed, these amounts would have to be properly assessed in order to ensure that they do not unnecessarily disincentivise the development of new institutions – particularly within the scenario of the Capital Markets Union – while maintaining a suitable solvency level for institutions in the start-up phase.
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No. The availability of liquidity to meet its maturing obligations is something that each investment firm must assess in its day-to-day management of the business. However, the current regime requiring them to hold 10% of their obligations – excluding the clients moneys with their own investment regime – does not present any problem.
Please refer to our answer to question 20.
Cash and marketable securities should be considered liquid assets. The considerations contained in Annex 4 appear reasonable; however, their application would call for a sufficient level of specificity not involving complex calculations or access to costly information by the investment firms, or information that is hard to find or evaluate.
As pointed out earlier, the liquidity ratio is not so necessary for investment firms, as this should fall upon the management of the firm. However, if implemented, such a regime such be as simplified as possible.

This would not prevent, in certain cases, the competent authorities from requiring, broader compliance with the ratio that finally be established or even, higher requirements.
We do not believe it is necessary.
We agree with the EBA’s position as set out in the DP.
We agree with the EBA’s position as set out in the DP.
We do not see any particular difficulties; however, the consolidation procedure would have to be regulated.
Please refer to our answers to questions 2 and 5.
At present, investment firms performing simple activities, or those of small or medium size, are required to complete numerous Statements, containing credit risk items that do not apply to their institution. They must determine which items are applicable and which are not, by means of cumbersome statements that are difficult to complete, with disaggregation levels that should not apply to them.

This leads to a feeling of costliness, to errors, and to a feeling of mismatch of the regime to the actual business activity of the firm, which in addition, does not result in more or better information for the supervisor.
As pointed out earlier, internal control and compliance measures are effective instruments for a significant reduction of operational risk. This should have implications on the level of own funds requirement.

As regards disclosure to the supervisor and to the public – by means of an ad hoc document – of the solvency ratios, this is necessary in the former case and advisable in the latter.

Class 2 and 3 investment firms should be expressly excluded from the recovery and resolution regime, and should not be required to contribute to the corresponding fund.
The current requirement in this regard is clearly disproportionate. Not only taking into account the size of these investment firms, but also on account of the type of activity, type of institution, business model, etc. which also calls for proportional application, leading in this case to such firms not being subject to the recovery and resolution regime.
We believe it is appropriate, as set out in the DP, that investment firms should have robust internal control and compliance systems, as well as meeting suitability requirements for shareholders and board members and senior management.

However, all the corporate governance requirements should be reviewed in greater detail, in light of this new prudential regime for investment firms.

For example, the same restrictions regarding multiple board membership cannot be required of small firms, nor should the requirements be unnecessarily raised, with the result that market conditions would make it very hard for small and medium-sized companies to hire Directors.

As regards the application of remuneration policies, please refer to our answers to questions 32 and 33.
Investment firms, given the nature of their business, sometimes perform activities that can only be remunerated on a variable basis. The current regime prevents this. This prevents the development of lawful business models that do not affect the future viability of the institution and which simply have not been suitably analysed prior to imposing a remuneration regime essentially designed for large banking institutions.

We therefore agree with the EBA’s position as set out in the DP, of demanding form investment firms remuneration policies linked to compliance with rules of conduct, but not linked to corporate government, which is disproportionate.
Please refer to our answer to question 32.
Maintaining a simplified CRR regime has certain advantages, as pointed out in the DP (experience, coherence in banking groups).

However, it would clearly be a better option to have a specific regime for investment firms, in order that these institutions would have their own specific regulation at the EU level, allowing for greater risk sensitivity and, at the same time, a more efficient supervision.

The foregoing would be based on the principle that the capital requirements be appropriate and adequately supported, and allow the proper development of business. This issue – quantitative implications of the new regime- not discussed in the DP, is of extreme importance.

The CRR system is complex, cumbersome and not suited to investment firms, but it has not involved own fund requirements that are incompatible with the development of business. Nor has there been any evidence of a need for higher levels of own funds (please refer to our proposed analysis discussed in our answer to question 2). The new system should avoid having the effect of unnecessary or unjustified increases, in light of these evidences.
As pointed out earlier, complexity, unsuited to the firms’ activity profile, excess of ineffective evaluation and reporting work, incorrect vision of the solvency of the institutions with regard to their true risks, very complex and hard-to-understand reporting requirements, etc.

In addition, the current calculation of operational risk is clearly very high and not in line with the history of problems and costs associated with such aspect.
IGNACIO SANTILLÁN
F