The new prudential regime for investment firms: key points from the latest UK developments

• The UK Parliament published a Written Statement (HCWS309) from the Chancellor of the Exchequer, Rishi Sunak, which provides a high level update on the UK Government’s post-Brexit approach to certain EU-level reforms that are currently in progress.
• HM Treasury published a Policy Statement providing an update on its approach to legislating for new prudential standards in the forthcoming Financial Services Bill.
• The FCA published its initial views on the EU Investment Firms Regulation (“IFR”) and the Investment Firms Directive (“IFD”) and requests industry feedback on the design of an equivalent UK regime in a Discussion Paper (DP20/2) (the “DP”). The FCA is asking for comments and/or responses to the questions raised in the DP by 25 September 2020, ahead of a Consultation Paper which we expect to set out proposed changes to the FCA Handbook later in 2020.

In this article we highlight some of the key points from these papers, which should be helpful for investment firms that are currently planning for the expected transition to the new prudential regime in 2021. Please note that the FCA has reiterated that the DP represents its initial views that are subject to change. Investment firms should also look out for the FCA Consultation Paper and further papers from HM Treasury, which are also expected later this year.

It is now becoming clear that there will be some areas of divergence between the EU IFR/D and the UK regime, so it is important for UK investment firms and mixed EU/UK investment firm groups to follow both the EU and the UK developments closely. We will be publishing further updates in due course.

Brief background

From 26 June 2021, it is expected that the IFR/D will apply in the EU. Please see our recent article on the ten key points to know now in relation to the IFR/D, here. Because the UK has now left the EU, and because the IFR/D will not apply before the scheduled end of the Brexit Transition Period, the EU package will not automatically apply in the UK. Instead, the UK Government, HM Treasury and the FCA will be responsible for deciding the extent to which the EU regime will be brought into UK law and the extent of any divergence from the EU position. These latest papers provide important clarifications as to the UK’s approach and the direction of travel likely to be taken in the forthcoming FCA rules.

Key points

• The new UK regime, referred to as the Investment Firms Prudential Regime (“IFPR”), will largely be implemented via FCA rules by Summer 2021. HM Treasury has confirmed that it intends to delegate responsibility for designing and implementing the UK IFPR to the FCA, subject to Parliamentary oversight. We expect that many investment firms will welcome a more user-friendly approach to capital requirements regulation being set out in one place in the FCA Handbook, given the current fragmentation of some requirements between the FCA Handbook and EU regulations and guidance. HM Treasury has announced that the UK will endeavour to introduce the UK IFPR by Summer 2021, which is broadly consistent with the application of the IFR/D in the EU on 26 June 2021.
• Systemic investment firms will not need to be re-authorised as credit institutions. The EU IFR/D calls for the most systemic, “bank-like” investment firms to be re-authorised as (non-deposit taking) credit institutions under the CRR. The UK Government has confirmed that relevant UK investment firms that are currently supervised by the PRA (of which there are relatively few) will not need to go through this re-authorisation process. However, such investment firms that are designated as being subject to PRA supervision from a prudential perspective will fall under a CRD/CRR type UK regime rather than the UK IFPR.
• CRD V changes will not be applied to investment firms. HM Treasury has stated its intention that CRR II/CRD V and any subsequent updates to the banking regime should not apply to FCA regulated investment firms, who will continue to be subject to the current rules until the UK IFPR is in place.
• Small and non-interconnected investment firms (“SNIs”). The FCA expects a majority of the investment firms it regulates to qualify as the equivalent of SNIs under the UK IFPR, which should mean that a majority of such firms will be subject to a “lighter touch” version of the UK IFPR. This includes investment firms with assets under management of less than EUR 1.2bn or handling client orders of less than EUR 100m per day (cash trades) or EUR 1bn per day (derivatives). However, investment firms holding client money or assets will not qualify as an SNI, nor will firms dealing as principal or with a balance sheet total of EUR 100m or over or annual gross revenue from investment related business of EUR 30m or over. Most firms currently within the exempt CAD prudential category should qualify as an SNI.
• The end of IFPRU, BIPRU and exempt CAD. As expected, the FCA has suggested that it will drop its current prudential classifications, instead streamlining and simplifying its approach, by simply referring to “investment firms” for prudential purposes. This will continue to include AIFMs and UCITS managers with permission to carry out MiFID services.
• A new remuneration code. The FCA has also stated that the current IFPRU and BIPRU remuneration codes will be replaced, but broadly the same principles will continue to apply to ensure the balance between fixed and variable remuneration, and the structure of any variable remuneration, is appropriate and promotes sound and effective risk management. There will continue to be no bonus cap for UK investment firms. Proportionality will continue to be relevant, albeit applied in a different manner. The FCA has stated that it will encourage firms to consider applying the remuneration principles on a firm-wide basis, rather than limiting them to material risk takers. The FCA also comments on the interaction between the UK Equality Act 2010 and the new specific requirements around gender neutral remuneration policies.
• The end of Tier 3 capital. The FCA has suggested that, in line with the IFR/D approach, it will no longer permit BIPRU and exempt CAD firms to utilise Tier 3 capital under the UK IFPR.
• All firms will be expected to consider the K-factors. The FCA’s current expectation is that all firms will be expected to consider the relevant K-factors as part of their internal and supervisory discussions for monitoring sources of harm, even if they are SNIs that will not be subject to capital requirements based on the K-factors.
• Much needed clarification around the K-factors. The FCA has clarified its expectations around how the K-factors should be calculated, which is particularly useful for investment firms that are currently transition planning, because a lot of the practical detail of the IFR/D regime in this respect has only recently been published in draft form by the EBA. These are quite detailed and we will cover them in a separate update in due course.
• Impact of TTCA and CASS 8 mandates on K-factors. The FCA has stated that it expects that client money and assets that are subject to title transfer collateral arrangements (“TTCA”) or CASS 8 mandates (i.e. monies that are controlled but not held by a firm), will not be included in investment firms’ client money held (“CMH”) or assets safeguarded and administered (“ASA”) for the purposes of calculating the relevant K-factors.
• The Group Capital Test (“GCT”) will be adopted as an alternative to prudential consolidation. The FCA has stated that it will make rules to reflect its “willingness” to make use of the GCT as an alternative to prudential consolidation for relatively simple and less risky investment firm groups, and that it expects many such groups in the UK to be able to meet the requirements. Under the IFR/D, the default position is that prudential consolidation will apply to investment firm groups, leading to a consolidated capital requirement. The GCT is an alternative approach that is available with permission from the competent authority. Investment firm groups will want to consider carefully which approach will be most appropriate as the GCT will extend certain responsibilities to certain unregulated group entities rather than just the investment firms themselves.
• Group service companies and prudential consolidation. The FCA specifically comments that in its view the concept of an “ancillary service undertaking” is broad enough to include a group service company. The FCA notes that this is particularly important in the context of the consolidated fixed overheads requirement and prudential consolidation.
• Support for the extension of specific liquidity requirements to all investment firms. The IFR/D introduces binding requirements around the liquid assets that investment firms are required to hold (at least one third of their annual fixed overheads requirement). The FCA confirms that it would support a similar approach of extending new liquidity rules to all UK investment firms (including SNIs). This will be a significant change for many smaller investment firms.
• ICARA, the “new ICAAP”. The IFD introduces the concept of the Internal Capital and Risk Assessment (“ICARA”) process, which is similar in some respects to the current Internal Capital Adequacy Assessment Process (“ICAAP”), but does include key differences such as the need to consider wind-down planning. All investment firms will need to prepare for changes to the way in which they currently calculate their Pillar 2 capital and the FCA has signalled that there will be a move away from Individual Capital Guidance (“ICG”) to Pillar 2R and Pillar 2G. The FCA helpfully summarises those differences and sets out its thoughts as to how firms would transition.
• Simplified approach to reporting. The FCA does not expect the reporting forms under the UK IFPR to be as complex or as detailed as the current common reporting (“COREP”) forms under the CRR, but clearly the new forms are yet to be published and investment firms will need to review and adapt their reporting processes accordingly. Public disclosure on various topics (e.g. own funds and risk management) will be required from all non-SNI investment firms and also from SNIs that have issued certain types of capital.
• Transitional relief for matched principal brokers. One key change under the IFR/D is the absence of specific provision for lower initial capital requirements for matched principal brokers. Currently, matched principal brokers may be on a EUR 50k or EUR 125k initial capital requirement, which will uniformly increase to EUR 750k under the IFR/D regime. The FCA has stated that it expects that any increased capital requirements under the UK IFPR can be met by existing firms in phases, relying on transitional provisions (although this is not currently clear in the IFR/D text).
• ESG risks. As was expected, the FCA has confirmed that it will want to ensure that all investment firms integrate consideration of environmental, social and governance (“ESG”) related risks and opportunities into the business, investment and risk decisions they make.

We will continue to monitor the development of the EU IFR/D and the UK IFPR ahead of implementation and will keep our clients updated. We have already advised a number of clients on aspects of the new prudential regime and would be happy to answer any questions that you may have. Please get in touch with any of the contacts listed, or your usual CMS contact.