The Asset Management sector is experiencing an increased and structural pressure from several and concurrent factors: geopolitical tension (related instability, macroeconomic and demographic challenges); new client demand; game changer FinTech and an intense regulatory wave. On the regulatory side, the majority of focus until now has been at fund level rather than investment firm level.
This article will comment on capital and liquidity impacts emerging from the regulatory proposal for a prudential framework applicable to investment firms, as adopted by the European Commission (EC) on December 20, 2017.
The New Proposal for Prudential Regulation
The EC proposals1, which have been put forward for adoption by the European Union (EU) Parliament and Council, subject to their final approval, amends the current EU prudential rules for investment firms and this may impact the capital to be put aside to support such business. Under the EU proposals, the vast majority of investment firms in the EU would no longer be subject to CRR/CRD rules originally designed for banks. While the largest and most "systemic" investment firms would be subject to the same regime as European banks.
Regulatory Evolution
The proposed prudential framework concludes a long period of regulatory debate and actions around the investment firm sector, started after the 2008 financial crisis. The Financial Stability Board (FSB) launched work on vulnerabilities of the asset management activities since March 2015. The vulnerabilities of the sector were identified around: possible transmission mechanism, concentration of big players (so called "systemic" debate) and amplification effects in case of investment/ disinvestments. Initially, FSB evaluated whether the entire investment firm sector required a "systemic importance" designation, with additional supervision similarly to the Insurance and Banking sectors. However, the final FSB recommendations2 have acknowledged the agency model underpinning the investment firm sector, suspending the abovementioned designation.
Separately, several regulatory initiatives have prioritized enhanced regulation at fund level, focusing on risk management and transparency (e.g. liquidity regulation issued by the Securities and Exchange Commission, AIMFD3 and MiFID4 within EU, etc.).
In parallel to the FSB work, EC and European Banking Authority (EBA) started in 2014 the assessment and review of CRR/CRD, to tailor them for the specific risks inherent on the Investment Firms sector. Existing CRR/CRD were considered too complex and subject to considerable fragmentation across Member States when applied to Investment Firms. As an evidence of the mentioned fragmentation, the regulatory practice in assessing ICAAP/ILAAP5 adequacy of Investment Firms' has shown an increased pressure in Pillar II demand6 (capital and liquidity) with different approaches across EU jurisdictions. This has resulted in a non-level playing field across EU countries, whereby investment firms residing in one country has to put aside more capital if compared with others.
Summary of new EC prudential framework for investment firms
The EC proposals set prudential requirements more proportionate and risk-sensitive for investment firms. The following key aspects are introduced.
Categorization. The proposals entail 3 classes for investment firms (rather than the previous 11 categories) and therefore simplify the approach.
Class 1 firms which are "systemic" investment firms and would remain under full CRR/CRD requirements as per Banks, e.g. capital, liquidity, disclosure, governance, remuneration, etc.
Class 2 firms7 are those which potential impacts on financial sectors and are required to calculate their capital requirements in relation to the new K-factors.
Class 3 includes small firms not included in previous classes. Capital requirements are based on the higher between the existing CRR provisions for fixed overheads or the revised levels of initial capital.
The new K-Factors have been determined and sized to account for the specific services and risks that investment firms pose. The K-factors cover Risk to Customers, Risk to Market and Risk to Firm, with specific coefficients and/or quantification rules in order to determine going concern capital levels.
The CRR/CRD proposals envisage also new calibrated liquidity requirement for class 2 and 3, both should demonstrate adequate internal procedures to manage their liquidity needs and are required to hold a minimum amount of liquid assets. Class 2 are required also to have proper monitor, quantification and reporting of concentration risk and set appropriate corporate governance and remuneration framework (on top of MiFID rules). Higher demand for "relevant" class 2 firms, to be identified by local authorities, is also possible. Finally, more disclosure is envisaged for Class 2 firms vs. Class 3.
Key Risk Management challenges for Investment firm
EBA has conducted an impact analysis which resulted in an estimate of plus 10% capital increase for the sector following the adoption of the new proposal, but with high volatility across typology of investment firms. For certain independent listed investment firms, this may thus impact them materially, increasing the capital to be allocated to support the business. Quantitative liquidity impact has been assessed not material. Beside the capital and liquidity EBA's estimated impacts, the new proposal, with a better calibration and more tailored and granular capital, liquidity and governance requirements for class 2 (and Class 3 in specific areas) calls for an update on risk management practice and business-strategic planning.
Worth mentioning that supervisory authorities will retain the power to review and evaluate the prudential situation of investment firms (ICAAP/ILAAP) and, where necessary, to require changes in internal governance and controls, risk management processes and, where needed, setting additional requirements in relation to capital and liquidity requirements.
Therefore, investment firms, depending on the sophistication and size levels, multi-country presence, and typologies of services, are expected to focus on the following areas and processes.
Embeddedness of ICAAP view into firms' governance and management. The firms' strategy needs to plan and monitor K-factors evolution, as shifting from Class 3 to Class 2 may have significant effects impacting profitability and governance.
Increase cooperation between Finance and Risk Management departments, to allow an effective development and business inclusion of ICAAP framework. Including a sound and robust data management framework between the two departments.
Significantly upgrade of the "not industry standard"8 risk managements skills. In particular, in areas as of liquidity risk monitoring and management, stress testing, cyber risk, resilience and model risk to satisfy higher demand from Supervisory assessment of ICAAP adequacy.
Update compliance departments to cope with regulatory pressure or review contracts with law firms and other providers of services currently used to facilitate compliance.
In conclusion, the new regulatory framework is more sensitive. However, it is recognizable that the Legislator, by setting and calibrating some of the KFactors (e.g. the K-AuM9) re-introduces a "systemic" element within the prudential framework.
The sector will thus need to assess the right risk strategy and business investments to adapt to the new framework, once the capital and the liquidity's impacts, at individual investment firm level, will be fully determined.
Footnotes
1 Capital Requirements Directives IV (CRD) and Capital Requirement Regulation (CRR)
2 FSB, "Policy Recommendation to address structural vulnerabilities from Asset Mangers (Jan 2017)"
3 Alternative Investment Fund Managers Directive
4 Markets in Financial Instruments Directive
5 Internal Capital Adequacy Assessment Process / Internal Liquidity Adequacy Assessment Process
6 The KPMG "Risk and ICAAP benchmarking survey 2017" reports an 82% median increase in capital requirement to Investment Firms after inspections.
7 Specific typology of services and size thresholds are determined in order to classify Firms within Class 2. Services: typology: dealing on own account; incurring in market and counterparty credit risk; safeguard and administer client asset; or hold client money. Size-Thresholds: Total Balance sheet higher than EUR 100mn; total gross revenues higher than EUR 30mn.
8 E.g. Operational risk, Market risk.
9 K-AUM (K factor for Asset under Management) which captures the risk of harm to clients from an incorrect discretionary management of customer portfolios or poor execution and provides reassurance and customer benefits in terms of the continuity of service of ongoing portfolio management and advice.
Originally published in AGEFI Luxembourg
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