The new prudential regime for investment firms: prudential consolidation and issues for groups

In this article, we look at the new prudential consolidation regime for investment firm groups set to be introduced by the Investment Firms Regulation (“IFR”) and the Investment Firms Directive (“IFD”) (“IFR/D”) in the EU on 26 June 2021. We also look at how prudential consolidation is expected to work in the UK post-Brexit, following the announcements from the UK Government and the FCA in June, which committed to introducing an equivalent UK Investment Firms Prudential Regime (the “UK IFPR”) by Summer 2021.

We focus on some of the key points that both EU and UK investment firm groups will need to be aware of when planning for the new regimes, whether considering the potential impact of consolidated capital or liquidity requirements for the first time, restructuring an existing group or integrating an acquisition. For example, groups where the only investment firms they contain are currently ‘exempt CAD’ firms for UK/FCA prudential purposes and cross-border investment firm groups operating in both the EU and the UK should follow developments in these areas as the changes may have a significant impact.

Background

From 26 June 2021, it is expected that the IFR/D will apply in the EU (subject to certain transitional provisions). Having played a significant role of the design of IFR/D pre-Brexit, the UK Government and the FCA have also committed to introducing an updated and more appropriate prudential regime for investment firms in the UK. On 23 June 2020, the FCA published a Discussion Paper (DP20/2) setting out its initial views on the IFR/D and requesting industry feedback on the design of an equivalent UK regime, ahead of its plans to consult on new rules later in 2020.

Previously, we wrote about the ten key points firms need to know now in anticipation of the new prudential regime for investment firms (link), and also the key initial takeaways from the FCA Discussion Paper on its plans for the new regime in the UK (link).

Recap: what is prudential consolidation?

Investment firms are typically subject to an individual regulatory capital requirement (i.e. a minimum level of capital that they must sustain) and may be subject to detailed liquidity requirements (i.e. a minimum level of readily available financial resources that can be used to meet the firm’s obligations). Prudential consolidation can mean that those requirements are also applied to an investment firm on the basis of the position of its wider ‘consolidation group’. Depending on the application of the relevant rules, the scope of a firm’s consolidation group may or may not include all of the entities included in its corporate/accounting group structure and can in some cases include unregulated entities. The scope of a consolidation group can sometimes be complicated as it can sometimes be formed through ‘horizontal consolidation’, i.e. consolidation of entities related other than by capital ties: by virtue of being managed on a unified basis, where one entity has significant influence over another, or where entities are under single management. Regulators have a lot of discretion in deciding whether these situations apply, so group structures need to be analysed on a case-by-case basis to determine the consolidation groups that may arise.

When will prudential consolidation be triggered?

Under the IFR, prudential consolidation will apply to certain groups that are ‘investment firm groups’. In summary, an ‘investment firm group’ is a group of parent and subsidiary undertakings of which at least one is an EU investment firm and which does not contain a credit institution (i.e. a bank). The prudential consolidation regime is triggered if there is a relevant “consolidating entity” at the top of an EU investment firm group (which may itself be a sub-group that forms part of a wider global group). Those consolidating entities are, in summary:

1. Union parent investment firms – that is, EU investment firms that have at least one investment firm or ‘financial institution’ as a subsidiary (or which have a smaller ‘participation’ in such a firm/institution), and which are not themselves subsidiaries of another EU investment firm or EU investment/parent mixed financial holding company;
2. Union parent investment holding companies – that is, EU ‘financial institutions’ which have exclusively or mainly investment firms or financial institutions as subsidiaries (at least one of which is an investment firm) and which are not themselves subsidiaries of an EU investment firm or of another EU investment holding company; and
3. Union parent mixed financial holding companies – that is, certain EU holding companies that are deemed to be part of a financial conglomerate under EU law.

One of the main points to note is that, unlike under the Capital Requirements Regulation (“CRR”) regime, the IFR prudential consolidation regime places regulatory requirements directly on in-scope parent undertakings. This may mean that parent undertakings which are otherwise unregulated (for example, pure holding companies) will have to meet regulatory obligations and could be subject to sanctions and other measures for non-compliance. In particular, in-scope parent undertakings will be directly subject to a consolidated capital requirement and, together with subsidiaries that are subject to the IFR, are responsible for putting in place certain organisational and control arrangements.

From a UK perspective, because under IFR/D there is no distinction between different “types” of investment firm, groups containing firms that are currently classed as ‘exempt CAD’ firms, and which do not contain ‘BIPRU’ or ‘IFPRU’ investment firms, may need to consider for the first time whether their group structure may lead to prudential consolidation. The fact that an ‘investment firm group’ does not include groups which include a credit institution means that those groups that do contain a credit institution will continue to be subject to the CRR prudential consolidation regime (if applicable) and not the IFR regime as well.

In June 2020 the EBA published a consultation paper containing draft Regulatory Technical Standards on prudential consolidation, which sets out in some detail how regulators may approach applying the rules on horizontal consolidation. As this was drafted after the UK’s involvement in drafting the EU regime ceased post-Brexit, it remains to be seen whether the FCA will diverge significantly from the approach taken by the EBA.

The definition of ‘investment holding company’ (an element of the definition of the second trigger entity described above) also points to a potential area open for interpretation. There are various tests that are relevant for determining when this applies, including looking at the proportion of financial sector subsidiaries an entity has and calculating certain balance sheet tests, but regulators also have wide discretion to consider other factors.

What are the consequences of prudential consolidation?

Under the new regime, the default type of prudential consolidation where it applies is for in-scope investment firm groups to apply the rules on own funds, capital, concentration risk, liquidity, and disclosure and reporting on the basis of their consolidated situation. The ‘consolidated situation’ means the situation resulting from applying these rules to a Union parent investment firm, Union parent investment holding company or Union parent mixed financial holding company as if that undertaking formed a single investment firm together with all the investment firms, financial institutions, ancillary services undertakings and tied agents in the investment firm group (including those in third countries which would meet the relevant definition if established in the EU).

This may mean higher own funds requirements overall as entities that would not otherwise be subject to prudential rules (e.g. group service companies that qualify as ancillary services undertakings) may need to be taken into account. This could, for example, result in a higher fixed overheads calculation and, as a result, a higher liquidity requirement (which is set at one third of the fixed overheads calculation). Similarly, consolidating entities will need to consider the exposure of all relevant entities in the investment firm group to individual clients or client groups when monitoring compliance with the concentration risk limits, which could restrict investment firms’ ability to transact with certain clients where other group companies also do business with them.

Derogation: the group capital test

For some investment firm groups, however, there may be another option. Under the IFR, local regulators are allowed in certain circumstances to permit groups whose structure is deemed ‘sufficiently simple’ to apply a group capital test instead of applying the individual requirements on a consolidated basis. Where the group capital test is applied, all of the in-scope parent entities in the group would be required to hold own funds to cover the sum of the full book value of certain capital instruments each entity holds in any of its subsidiaries that are investment firms, financial institutions, ancillary services undertakings or tied agents.

The FCA has commented that its preference is to make rules in the UK that reflect its willingness to make use of the group capital test and that it expects that many UK investment firms groups would be eligible for the group capital test if they wanted to use it.

Other waivers

Regulators can also grant waivers from applying the IFR liquidity requirements on a consolidated basis in certain circumstances. The FCA has confirmed that it would expect investment firm groups that do not want to be subject to consolidated liquidity requirements and which meet certain requirements to seek to take advantage of this derogation.

Cross border consolidation and Brexit

Under the IFD, if two or more EU investment firms share a parent company in a third country, local regulators will be required to assess whether those firms are subject to equivalent supervision in the third country. If they are not, Member States must allow for ‘appropriate supervisory techniques’ to achieve the objectives of the IFR/D group supervision regime, which may include requiring the establishment of a holding company subject to IFR prudential consolidation in the EU.

The FCA has confirmed that it would be minded to replicate the effect of this discretion for a non-UK parent company having two or more subsidiaries in the UK.

This essentially means that after the end of the Brexit transition period, unless the EU determines that the UK regime is equivalent, EU regulators could require investment firm groups with UK parent companies of multiple EU investment firms to establish intermediate parent undertakings in the EU. The same could apply vice versa with the FCA potentially requiring parent companies to be established in the UK.

The IFD provision is similar to the equivalent provision under the Capital Requirements Directive (“CRD”), which currently applies to in-scope investment firms. However, there are certain differences in the wording and it remains to be seen if this will have an impact on the approach taken by regulators in practice.

Next steps

The FCA’s initial views set out in its Discussion Paper signal that UK IFPR consolidation provisions will closely resemble those in IFR/D. However, there are areas in which the UK’s approach could have an impact on the practical application of the rules. These include:

• the FCA’s approach to assessing the ‘nature, scale and complexity of the investment firm group’ when determining whether to require investment firm groups to apply liquidity requirements on a consolidated basis;
• the FCA’s interpretation of what constitutes a group being deemed ‘sufficiently simple’ and any guidance on or examples of group structures that it considers will be suitable for a group capital test; and
• how the UK will approach horizontal and cross-border consolidation.

We are currently advising clients on the potential impact of the UK IFPR on their group and look forward to the forthcoming FCA Consultation Paper, which should provide greater certainty on key issues for firms currently preparing for implementation.