Investment firms should begin preparing now for potential changes to the prudential regimes following new recommendations set out by the European Banking Authority (EBA) and European Securities and Markets Authority (ESMA).
The joint discussion paper by the EBA and ESMA - published on 3 June 2024 - considers the appropriateness of the current prudential framework for investment firms in the EU, as well as its coverage of new and emerging risks.
In the UK, the Financial Conduct Authority (FCA) is also reviewing the prudential frameworks that fall under its remit and has signalled that it recognises the “appropriateness of calibrating prudential rules in a proportionate way”.
With the EBA/ESMA paper kick-starting the EU review, firms should consider how any changes to the prudential framework(s) may impact a range of business practices, including their trading strategies, and operational and risk management processes.
Market risk - diverging standards for similar risks?
The reforms implementing the Basel 3.1 standards for banks have received significant attention over the past few years, including the revised market risk framework, known as the Fundamental Review of the Trading Book (FRTB).
Market risk standards for investment firms and credit institutions currently align due to the cross-references in the EU and UK regimes to the Capital Requirements Regulation (CRR) and UK CRR market risk frameworks.
In the UK, that will change when the banking reforms come into force next year unless amendments are made to the Investment Firms Prudential Regime (IFPR). We’ve previously discussed the impact this divergence may have on investment firms’ capital requirements for market risk, and the potential benefits of adopting the FRTB, which can be more capital-efficient for certain products. Consideration of whether these standards should be implemented for investment firms in the EU, with or without optionality, is a key topic in EU review as well.
Given the potential for similar market risk exposures or trading book activities to fall under divergent market risk standards in future, investment firms should assess the impact such differences could have on their amount of capital, trading strategies and overall competitiveness.
Firms should begin preparing for the cumulative impact any amendments to the prudential regimes could have on their product offering, trading strategy and competitiveness.
Liquidity requirements
The FCA has previously highlighted its concerns over some investment firms’ liquidity risk management and the supervisory work it plans to conduct to address this risk. The EBA/ESMA paper also questions whether the Investment Firms Regulation (IFR) liquidity requirements are fit for purpose. Investment firms should be alive to the potential for liquidity requirements to be strengthened, albeit from a significantly lighter-touch baseline than the corresponding requirements on banks.
Capturing new and emerging risks
The EBA/ESMA paper reflects on whether activities not currently accounted for in the IFR warrant amendment to the risks captured by the existing ‘K-factors’. Cryptoassets in the non-trading book, as well as investment services subject to other prudential regimes, are specifically highlighted as areas for further review. Firms should be aware of the potential for new requirements for these risks and review which business activities and services would fall within scope of any new or expanded rules.
Be prepared, but flexible
Investment firms should begin preparing for the cumulative impact any amendments to the prudential regimes could have on their product offering, trading strategy and competitiveness. But flexibility is also needed given the early stage we are at in the reform process.
As a next step, firms that fall under the IFR may wish to participate in the EBA/ESMA voluntary data collection exercise and public hearing to contribute their perspectives to the EU review process.
While the FCA has yet to publish any review of its own, its reference to proportionality hints towards a potential easing of the prudential framework in certain areas. A fundamental redrafting of the rules is unlikely but the different drivers and context for the review of the UK rules, including the regulator’s secondary competitiveness objective, increases the likelihood of divergence over time. While divergence brings challenges, a more proportionate regime may also bring opportunities for investment firms.
