The Investment Association

We think the distinction between category 1 and category 2 firms should be based on the business model of firms, which can vary significantly between different types of investment firms.
The most important fundamental prerequisite for the identification of a systemic important institution is significant balance sheet exposure. A quantitative analysis as it is currently undertaken in accordance with the EBA O-SII guidelines helps to identify systemically important institutions by identifying business models, which could potentially cause systemic risk.
EBA proposed in its report from 14 December 2015 to create a category of firms engaging in bank-like activities. Bank-like activities are according to the EBA report ‘bank-like’ intermediation and underwriting of risks at a significant scale. Such activities expose institutions to credit risk, primarily in the form of counterparty risk, and market risk for positions taken on own account. Firms, which are not engaging in these bank-like activities, are unlikely to meet the criteria of the guidelines. Most investment firms and the vast majority of investment firms are typically not engaging in these activities, are not exposed to these risks.
The guidelines are, therefore suitable to distinguish between systemic, bank-like investment firms and the rest of the investment firm universe.
The Investment Association believes that an appropriate prudential regime for investment firms has to be based on the nature of their business, reflecting the fundamental differences to banking and taking into account their economic function. The rules should, therefore, address operational risk as a key risk, and aim to minimise any disruption and return assets to the owners in a gone concern situation. Market and credit risk are not considered significant concerns for a typical asset manager. We, therefore, welcome EBA’s proposals and would encourage the EBA and the European legislators to continue their work and to follow the approach EBA has taken in its first report in 2015 and in the current discussion paper.
The proposals in the EBA discussion paper are a first step in the process of designing a new prudential regime for investment firms. We agree with the EBA’s concept of basing prudential requirements on the risks inherent in the business of investment firms and not copying across a poorly adapted version of a capital requirements regime designed for large international banks.
The proposed principles are not yet a guarantee that the final framework will work as an appropriate prudential rulebook, but we agree with most of the points the EBA made in chapter 4.2.2 paragraph number 12 a) – f).
We suggest with regard to EBA’s principle a) not to draw conclusions whether investment firms managing assets on behalf of third parties may be systemic. The global debate whether investment firms should be considered systemic is led by the FSB and IOSCO and we would suggest to base future regulation on their findings. We appreciate that some investment firms may engage in bank-like activities and that these investment firms can pose different risks to customers and markets. It is essential that the criteria to identify these firms are absolutely clear and based on activities, not on size or a potential designation of an investment firm as systemic.
Regarding principle b), we would suggest clarifying further the purposes of capital requirements for investment firms. EBA noted already in its report from December 2015 that the purpose of capital requirement standards for investment firms is a strengthening of the soundness and stability of investment firms on a ‘going concern’ basis.
Capital requirements should, according to paragraph 12 b) of the discussion paper ensure the continuity of services. We support EBA in its efforts to improve stability in financial markets but don’t think investment firms should be regulated on a going concern basis. The first and most important objective of a prudential regime for investment firms should be the protection of investors and markets. It is not necessary to protect the balance sheets of investment firms to achieve this objective.
We would encourage EBA to define the point to which continuity of services is necessary to protect investors and markets. Investment firms should be able to fail and a prudential regime should be designed to ensure that firms have enough resources to transfer their businesses or to return the assets they are managing. There is no benefit in protecting the balance sheet of investment firms for the sake of continuity alone.
The EBA expresses its view under paragraph 12 c) that prudential requirements for investment firms have to take into account the additional risk associated with holding client money and securities. We appreciate that handling or holding client money and securities can give rise to additional risk and that it is appropriate for a capital requirements regime to reflect these risks. Firms holding the relevant client money permissions are currently subject to very different requirements in different member states. Client money and securities have to be kept in segregated accounts in a number of member states. Firms in other member states are not required or legally not able to hold client money in ring-fenced accounts. The risk for investors to lose their assets is limited to breaches of conduct or transitional periods where clients’ assets (money or securities) are ring fenced. We think it is necessary to treat these risks differently to situations where client’s assets are not protected in insolvency.
We agree with the principles under e) and f).
The EBA introduces in paragraph number 12 f) the concept of risk to the firm itself and we understand that less well-capitalised firms might act differently under higher pressure and might be more susceptible to weaker controls and higher risk taking. An appropriate prudential framework should, however, cover all potential risk for markets and investors. There is no need to protect the firm itself, which should just be wound down in an orderly fashion. We see therefore no immediate need to include further capital requirements for commercial decisions made by firms with regard to their balance sheet exposures. We will come back to this point in our response to question 5.
Our members are currently all subject to prudential requirements. Most of the firms are regulated in accordance with CRD/CRR. Managers of collective investment vehicles are subject to capital requirements deriving from UCITS or AIFMD. We have no evidence that these capital requirements are insufficient for investment firms.
We agree, however, with EBA’s assessment, that some risks for investment firms subject to CRD/CRR may not be reflected fully, or indeed, at all, in the current CRD/CRR framework. A revised regime could be easier to implement and more effective in ensuring that firms hold capital which allows them to wind down in an orderly manner when necessary.
The EBA paper does not clarify whether supervisors should have powers to require additional capital similar to the current pillar II regime. The new regime for investment firms will have to set clear quantitative criteria for capital add-ons. Firms have to be able to predict their capital requirements and capital requirements should not be used as a supervisory enforcement mechanism.
Please see our response to question 8.
None of the listed activities should preclude a firm to fall under Category III.
We agree with the concept of a set of reasonably simple and observable capital proxies. It is essential that the calibration of these proxies is accurate. We appreciate EBA’s efforts to create a simpler framework which is easier to comply with and easier to apply by supervisors coherently, but all efforts to develop a prudential regime for investment firms which reflect risks better will be in vain if the K-factors are not representing the risks properly.

We agree that investment firms can cause risks for their customers and that these risks need to be addressed. Firms and supervisors have a broad range of measures at hand to minimise risks and to address situations in which risks materialise. Capital requirements are only one of the tools available to address the risk to customers. We agree with the principle that customers of investment firms need to be protected, but we are concerned that a number of the K-factors proposed in this section are not reflecting these risks appropriately. Please see also our response to question 6.

The vast majority of investment firms are not dealing on their own account. The proposed “K-factor” of proprietary trading activities (PTA) is, therefore, not relevant for these firms.

The EBA introduces the concept of risk to the firm itself (RtF) in chapter 4.2.2 paragraph number 12 f). We understand that a firm that is leveraged significantly may behave differently to a firm, which is not. This may change the risk profile of a firm, but only additional risk to customers and additional risk to markets should trigger additional capital requirements. The new framework should cover these risks under these categories and we would ask EBA at this point to allow a good degree of commercial judgement by firms.
Firms, which are growing, accessing new markets or planning acquisitions, will probably need to borrow to achieve their goals. The additional risk that might arise from these undertakings should firstly be addressed by holding capital against the risk to consumers and risk to markets. There is no additional value in protecting the balance sheet of firms. A balanced capital adequacy regime protects investors, markets and financial stability without hindering innovation and growth unduly. It is, therefore necessary to develop a framework that allows firms to take commercial decisions, afford them the opportunity to grow and to borrow when necessary, without triggering automatically a penalising double counting of risks and increased capital requirements if there is no incremental risk to markets and investors.
European legislation does not currently provide a harmonised definition of assets under management (AUM) that could be used as a basis for a calculation of capital requirements. We appreciate that managers managing large portfolios may potentially cause more harm to a greater number of customers, but we don’t think that an AUM figure is currently a suitable and comparable metric.
We would need a clear definition of AUM if AUM were to be used to determine capital requirements. Such a definition cannot be based on the sheer value of assets alone. The risk profile of different managers managing portfolios of the same size will depend on a multitude of factors like the number of transactions, the instruments held in a portfolio, the size of orders and volume of redemptions and subscriptions. EBA will have to provide a clear definition of AUM taking the different factors into account.
The new regime will also have to address the volatility of AUM figures. Volatile exchange rates are just one example for a situation causing abruptly significant changes of AUM figures. The final prudential framework has to provide methods allowing a smoothing of the capital requirements based on figures, which might change on a daily basis.

We have similar concerns with regard to the K-factor based on assets under advice (AUA). AUA can be used as a metric for operational risk, but the K-factor has to be adjusted to the specific situation of the firm and the type of customers.

Many investment firms currently hold client money and all are subject to strict requirements with regard to this business. In the UK client money is subject to the FCA’s CASS rulebook. The safeguards in place for client assets differ and we would suggest that the different levels of safeguards be reflected in the calculation of capital requirements for client money held (CMH).
A situation in which client money is not protected in the case of insolvency is not comparable with a scenario where client money is handled by investment firms, but ring-fenced. These are completely different risk situations. Conduct breaches and operational risk are the most significant risks for client money, which is not ring-fenced.
Client money, which is not held in segregated accounts, is exposed to a far wider range of risks. The new prudential regime has to take this into account and should additionally incentivise firms to optimise their client money policies. We would suggest permitting a significant down scalar where client money is ring-fenced.

This K-factor will be negligible for most investment firms. Present EU and global FSB standards ensure that any securities lending activities are properly collateralised. There might be scenarios under which the LTC K-factor could be useful, but it has to be calibrated properly and permit a reduction to zero where firms are mitigating risks by other means.

We assume the AUM K-factor will cover this for investment firms.
We consider an uplift factor, as noted above in our response to question 5 as unnecessary for firms, which are not leveraged significantly. An uplift factor may make sense for investment firms which are dealing on own account and which have significant balance sheet exposures. The proposed risk to firm uplift measure would only be appropriate if the use of the uplift factor would be limited to these business models. Additionally, we would encourage EBA also to allow for downscaling factors. Firms should have an incentive to be well capitalised and to improve their risk management.
We think that a new prudential rulebook should cover all investment firms and should be based on the risks inherent in their business model. Size is not necessarily a suitable criterion for the application of different standards. The new prudential framework has to be proportionate and to be adaptable enough to cover also firms, which are identified as Category III firms. The creation of a separate regulatory category for these firms appears to be a suitable solution to guarantee a proportionate and simple application of the new rules, as long as the whole system is coherent. We are, therefore supportive of a ‘built-in’ approach with sufficient transitional arrangements between classifications and possibilities to disapply disproportionate requirements where appropriate. A separate framework for Category III firms would bear a significant risk to create cliff edge situations. A smooth transition between categories minimises opportunities for regulatory arbitrage.
We don’t see the immediate need for reviewing the method for calculating a minimum “floor”; i.e. the calculation of fixed-overhead requirements as the eligible capital of at least one quarter of the fixed overhead requirements (FOR) of the preceding year.
We don’t think that being a large firm or trading financial instruments, including derivatives make a firm bank-like. The business models of large firms are not necessarily different from smaller firms. The new framework should be designed in a way, which allows a proportionate and easy application on a very broad range of firms. Risk profiles are not linked to the size of firms. It is therefore not necessary to treat these firms as fundamentally different. Please see also our response to Question 11.
We would support a new prudential framework for investment firms, which is tailored to the risks investment firms might pose. Such a regime has to be flexible enough to be suitable for the whole range of investment firms.
The current CRD /CRR regime is designed for banks and it is applied to all banks in Europe. It addresses, at least to a certain extent, systemic risk posed by institutions subject to CRD/CRR and allows, also to a certain extent, the disapplication of a number of onerous requirements where appropriate.
A similar approach should be taken in the new regime for investment firms. The prudential regime has to address the risks inherent in the business model. Supervisors and firms gathered sufficient experience with the CRD/CRR regime. Legislators should now be in a much better place to design a new regime, avoiding the numerous flaws of the CRD/CRR regime. The new regime should be adaptable enough to cover very large investment firms as well as firms which might be considered systemic.
The potential systemic risk posed by an investment firm will be very different to systemic risk posed by an internationally active large bank. CRD/CRR may or may not provide the tool kit to address the systemic risk in the banking world, but it is not addressing risks arising from activities by investment firms. A new prudential framework for investment firms will, therefore, be much better suited to address the potential systemic risk posed by investment firms. Investment firms which are considered to be systemic, but not bank-like should be covered by the new prudential framework for investment firms and should not remain to be subject to CRD/CRR.
Regarding the “systemic” nature of non-bank entities, we would ask EBA to take into account the ongoing discussions around the “structural vulnerabilities from asset management activities” at the FSB and IOSCO.
The new prudential regime should allow high quality, permanent capital to be fully recognised as regulatory capital.
High quality has the attributes of no maturity dates; holders cannot demand repayment and holders are subject to the risk of capital loss on a winding up. This may extend beyond CET1 to appropriate hybrid AT1 and tier 2 instruments. This type of capital remains available to allow firms to wind down in an orderly manner when necessary.
In line with the response to question 14, the principal test for the quality of capital should be whether it remains available to allow firms to wind down in an orderly manner when necessary. This may extend beyond CET1, but the capital must have the attributes that we discuss in that question.
It is hard to envisage common market stress scenarios, given that the balance sheets of our member firms are not used in their business models. Stress testing scenarios will have to be developed for individual firms, taking into account the broad range of investment firms and different strategies.
We agree that firms should be able to demonstrate they have sufficient liquidity, as well as the capital to manage an orderly wind down. It would be helpful for firms to have clear and simple rules to base the liquidity requirements on. FOR has proven to be a useful and practical basis for the calculation of liquidity requirements and we don’t see the need to introduce a different measure.
For the purposes of an overall liquidity adequacy rule, liquidity resources should not be confined to the amount or value of a firm's marketable, or otherwise realisable, assets. Firms should have the possibility to assess the adequacy of their resources and should have regard to the overall character of the resources available which enable them to meet their liabilities as they fall due.
Any assets which are marketable, or otherwise realisable and which enable a firm to generate funds in a timely manner should count as liquid assets. Additionally, firms will have to maintain a prudent funding profile in which assets are of appropriate maturities, taking account of the expected timing of liabilities; and be able to generate unsecured funding of appropriate tenor in a timely manner.
Balance sheet exposures might generate a type of concentration risk, but the final prudential regime will have to find a balanced way to mitigate these risks. A large exposure regime that unnecessarily complicates the operating models of cash-rich investment firms simply due to the size of cash balances at banks would increase operational risk as a result. Significant cash positions can arise periodically in business as usual situations. Investment firms may build up significant cash positions for a short period of time whenever they raise an invoice for their management fees. A large exposure regime has to take peak scenarios into account and must not complicate day-to-day business unnecessarily.
We support the position proposed by the EBA and would suggest that for category II and III investment firms the current ‘investment firm consolidation waiver’ becomes the default position under the new regime. An aggregation of solo positions rather than a full consolidation will lead probably to an increased position for the group as a whole but would have the merit of being a significantly reduced operational burden. The new system should still allow for full consolidation, but it would not be appropriate to make this the default position.
The IA believes that all individual firms should be able to meet the regime's requirements on a solo entity basis. Risks to customers should not be mitigated by capital held in a parent banking entity, which may be deploying that capital in a range of non-related risk activities. Investment firms should not automatically be in the scope of regulatory consolidation for a banking group. It is unnecessary to include these firms into a CRD consolidation group when they are not running balance sheet risk. It should, however, be possible for these firms to apply for a solution that, where a regulator is confident that CRD related processes deliver at least as stringent a regime, allows full consolidation.
The new regime for investment firms will have to set clear quantitative criteria for capital add-ons. Firms have to be able to predict their capital requirements and capital requirements should not be used as a supervisory enforcement mechanism.
It is excessively and unnecessarily burdensome for firms to provide a complete decomposition of the balance sheet and the resulting exposures where the business models do not necessarily use the balance sheet like banks would.
We don’t believe that recovery and resolution should be the focus of a prudential regime for firms, which conduct agency business. Instead, the ability to wind the firm down in an orderly fashion, so as to avoid RtC and RtM must be the primary intention.
The IA does not support limits on the amount of remuneration or the ratio of fixed to variable remuneration for firms who are running an agency business. However, some RtC can crystallise post event, and after the normal accounting and remuneration round within an organisation. Therefore the IA believes that some element of deferral and clawback provisions can be appropriate. Firms whose remuneration structures demonstrate a stricter long-term alignment between the interest of the recipient and those of the client should be regarded as posing a lower RtC and should be incentivised to apply such remuneration policies by allowing a down scalar to reflect the reduced RtC.
The remuneration requirements maximum ratio of fixed to variable remuneration was introduced under CRD IV to prevent individuals from being incentivised to take inappropriate risks. Investment firms are taking risks for their investors in accordance with investment mandates. Risk takers in investment firms running an agency business have no incentives to breach these mandates. A higher proportion of variable remuneration incentivises individuals only to take risks in accordance with agreed investment mandates. The maximum ratio of fixed to variable remuneration is, therefore, not improving financial stability; on the contrary, the maximum ratio increases fixed costs for all institutions and prevents firms from cutting cost in stress scenarios. We don’t see any merit in such a cap for any institution, but it is particularly disproportionate for investment firms running an agency business.
The EU legislative landscape is already extremely complex and changes to the CRR to introduce proportionality judgements will only increase that complexity for firms and for competent authorities. The IA believes that the new prudential regime for investment firms should be established in its own right with a clear statement of the firm types to which it applies. The CRD/CRR should have clear exclusion statements within them, excluding all firms covered by the new regime. The current CRD/CRR regime was poorly adapted to the business of investment firms and needed numerous exemptions to be workable. The CRD/CRR regime is rightly developing in lockstep with the recommendations of the Basel Committee, but it is not the responsibility of the Basel Committee to take into account the specific needs and developments of investment firms. Each review of CRD/CRR bears, therefore, the risk to lead to a prudential framework, which is even less suitable for investment firms.
The current framework causes significant operational burdens for investment firms calculating their exposures; in particular, the standardised credit risk calculation is not suitable for investment firms. Firms with no trading book business may be required under the current standardised credit risk calculation to hold capital against credit risks for settlement balances where the risks are negligible. The risk weightings for these risk are higher than those applied to mortgages where there is a genuine credit risk.
The leverage ratio and the CRD/CRR disclosures requirements are equally unsuitable for investment firms.
The current pillar II framework is mainly based on a qualitative analysis by national supervisors. The framework lacks sufficient guidance for firms to predict these pillar II requirements and this lack of clear guidance for firms and supervisors leads to significant inconsistencies in supervision.
Johannes Woelfing