The European Parliament has approved a package of legislation which will overhaul the prudential regulation of the majority of EU investment firms, and significantly change the remuneration rules for some firms.

The investment firms regulation and directive (IFR and IFD) will affect a very wide range of non-bank financial institutions including asset managers, investment banks, stock brokers, private equity and venture capital firms. The reform package will also change the terms on which non-EU firms can access EU financial markets. The new regime is expected to apply from Q2 2021, with new capital requirements being phased in by 2026.

Our report provides an overview of the new prudential regime and identifies the key areas of impact. Some firms will face higher capital requirements and more stringent remuneration rules under the new regime, so investment firms should assess the likely impact of the new regime now. Of course, some investment firms might benefit from the risk-sensitive approach under the new prudential regime and may be subject to less onerous prudential requirements than they are today.

Key impacts of the IFR / IFD

Classification to become more risk sensitive

Investment firms will fall into one of four prudential classes depending on the type of activities they are licensed to perform, and – this is new for many firms - the scale of their activity and size of their assets. Firms will need to make potentially complex assessments as to which class they fall into and will need processes for monitoring whether their classification changes over time, as moving between classes will have a potentially onerous impact on their prudential treatment.

Bank licence for Class 1 firms

Investment firms that are licensed to deal on own account and/or provide underwriting/placing on a firm commitment basis, and that have assets above €30bn (individually or on a group basis) will be Class 1 firms. They will need to become licensed as credit institutions (i.e. banks) and will become subject to the liquidity coverage ratio (in some jurisdictions for the first time) as well as other CRR prudential rules such as the leverage ratio. Class 1 firms incorporated in the Euro area will also become subject to the prudential supervision of the European Central Bank which (amongst other things) will require these firms to establish working relationships with their new prudential supervisor.

Significant prudential and remuneration requirements for Class 1 minus firms

Investment firms which have dealing on own account and/or underwriting/firm placing permissions but do not meet the €30bn asset threshold for Class 1 may still find themselves subject to the same rules as Class 1 firms if they meet certain lower asset thresholds. These ‘Class 1 minus’ firms will not become credit institutions but will, nevertheless, be subject to the more stringent prudential requirements in CRR/CRDIV (and soon CRR2/CRDV), including the leverage ratio, complex liquidity rules and capital buffers. The impact of this could be significant for some firms, particularly if Class 1 minus classification is at the instigation of their local regulator. Class 1 minus firms will also be subject to the stringent remuneration rules in CRDIV (as amended by CRDV), including bonus cap, malus and clawback provisions, deferral of variable pay and non-cash rules.

Some firms capable of being in Class 3 may still find themselves in Class 2 due to volume of activity

Because the new prudential classification does not simply categorise investment firms by reference to their scope of permissions, exempt-CAD or BIPRU firms in the UK (and those in equivalent categories in other EU jurisdictions) may find themselves in Class 2 under the new regime. This will be the case for any investment firms exceeding, individually or on a group basis, any one or more of four thresholds set by reference to (i) assets under management (including ongoing non-discretionary advisory arrangements), (ii) client orders handled (or received and transmitted), (iii) annual gross turnover, or (iv) on- and off-balance sheet assets. We explain these thresholds in more detail in our report and indicate how these may impact portfolio managers and investment advisers.

More stringent requirements on capital for some Class 2/3 firms

IFR/IFD treats the same instruments as eligible capital as those that are eligible under CRR. The proportions of CET1, AT1 and T2 capital are also similar to those in CRR. Firms that are currently subject to less stringent rules on own funds will need to review their capital instruments. The IFR’s rules for deductions from CET1 are less sophisticated than those in CRR, which may adversely impact Class 2 and 3 firms.

Monitoring Class 2 firm risks and impact on variable capital

Class 2 firms will need to put in place governance and processes to monitor how the risks they pose to their clients, the market and to themselves develop over time. This will involve Class 2 firms calculating their so-called K-Factors - the method introduced by the IFR/IFD for evaluating the risks posed by a firm – and translating these into variable capital requirements. Some Class 2 firms will become subject to variable capital requirements for the first time.

More stringent remuneration requirements for Class 2 firms

Class 2 firms will be subject to concrete remuneration requirements including a requirement to issue at least 50% of variable pay in non-cash instruments, deferral of a proportion of variable pay for 3 to 5 years, malus and clawback. Class 2 firms will also need to publicly disclose certain aspects of their remuneration system and of the awards made. Some Class 2 firms will need to establish a remuneration committee.

Investment firm groups and consolidation

The default rule is that investment firms must comply with the key prudential requirements of IFR/IFD on a solo basis. However, a consolidation framework also requires groups of EU investment firms to comply on a consolidated basis. Local regulators may allow small and non-complex groups of investment firms to apply a group capital test instead of consolidation.