The future of market risk frameworks: A tale of two firms

Broadly, two separate regimes now apply for financial institutions, as follows:

• The Capital Requirements Regulation (CRR) for PRA-regulated banks, building societies and systemically-important investment firms; and
• The Investment Firms Prudential Regime (IFPR) for FCA-regulated investment firms, also known as MIFIDPRU investment firms. For such firms, the MIFIDPRU rulebook sets out the prudential requirements that apply to them.

Despite the difference in the regulatory frameworks, there is an aspect of these respective prudential regimes where standards currently converge: regulatory market risk requirements. Unless further changes are announced by the FCA in the near future, that is however set to change with the introduction of the Basel 3.1 reforms being implemented by the PRA, which include the overhaul of the market risk standards applicable to PRA-regulated firms and known as the fundamental review of the trading book (FRTB) and which will come into force next year.

A future divergence in the market risk frameworks?

The own funds requirements for market risk under the IFPR framework are known as K-NPR, which correspond to the firm’s net position risk calculated in accordance with MIFIDPRU 4.12. The basis for K-NPR requirements is underpinned by the relevant market risk section of the UK CRR. Therefore, the own funds requirements for market risk have not changed under IFPR^[1] for MIFIDPRU investment firms when the new framework was introduced on 1 January 2022, as FCA-regulated investment firms have since been required to calculate the own funds requirements that they must hold in relation to market risk by reference to the UK CRR rules applicable to PRA-regulated firms "in the form in which it stood at 31 December 2021".

However, the PRA have set out their proposed implementation of the Basel 3.1 reforms which include the final rules for the revised market risk framework (FRTB) set out in their Policy Statement 17/23^[2], which will come into force for PRA-regulated firms on 1 July 2025.

FRTB introduces a series of changes which can be summarised as follows:

• Stricter rules to delineate the boundary between instruments that should be included in the trading and banking books;
• A revised internal model approach that is calibrated to better capture, among other things, tail risk and market illiquidity; and
  Threshold tests to introduce greater proportionality between firms that have a large trading book and others that may have relatively small and non-complex trading portfolios. The former will be required to adopt the risk-sensitive advanced standardised approach (ASA) which is underpinned by pricing models; whilst the latter will be able to opt for the simplified standardised approach (SSA), which is a recalibrated version of the existing framework with new asset class scalars to ensure a sufficiently conservative calibration.

At least for now, these reforms do not apply to FCA-regulated investment firms, irrespective of the size of their trading book or materiality of their own funds requirements in relation to market risk (K-NPR). In practice, this means that two firms with similar market risk exposures or trading book activities may be subject to two different sets of regulatory market risk standards if they fall under different regulatory regimes; in our example, one firm would be PRA-regulated (and therefore required to implement FRTB by 1 July 2025) whilst the other firm would be an FCA-regulated MIFIDPRU investment firm (and therefore not in scope of the FRTB changes). This divergence may have some unintended consequences. Two are particularly worth calling out:

• As the regulatory framework for market risk requirements will differ from 1 July 2025, the cost of capital and therefore return on equity may diverge for similar products or risk profiles between PRA- and FCA-regulated firms. This may create market distortions by putting similar firms (from the perspective of their trading activities) on an unequal footing, depending on the size and nature of their trading book activities and the level of divergence for a specific asset class or product.
• We understand that several MIFIDPRU investment firms would like to get further clarity as to whether FRTB will apply to them in the near future and, if that is the case, understand the timelines for implementation and detailed corresponding FCA requirements. It is currently uncertain as to what the future framework for MIFIDPRU investment firms will look like, which impacts business and capital planning. In our view, the current divergence, if it is here to stay, would result in an unlevel playing field between similar market participants (everything else being equal) across the two regulatory regimes.
  

Examples of upcoming divergence

Without any further changes in the market risk framework applicable to MIFIDPRU investment firms, we note the following examples of divergence that will arise once PRA-regulated firms have fully adopted the new FRTB framework.

• The existing standardised approach (relabelled SSA under FRTB) will be recalibrated for PRA-regulated firms, with scaling factors applied for each risk class.
• Additionally, for the SSA, the PRA has proposed to make further technical adjustments, such as moving away from the use of static lists to more dynamic criteria-based assessments for several discretions which are also actively used by several MIFIDPRU investment firms. It is unclear as to whether such firms will be expected to keep using static lists.
• Some MIFIDPRU investment firms may also meet the definition of a large trading book but will remain in scope of the current framework as it stood at 31 December 2021. It is our view that some MIFIDPRU investment firms may benefit from a level playing field by implementing the more risk-sensitive standardised approach which is more beneficial for certain products.
• Further, the PRA has also launched additional industry discussions and consultations; for example, further changes on the capitalisation of foreign exchange positions for market risk^[3]. When reading through the details of these proposals, there are some proposed changes that could benefit some MIFIDPRU firms. Unless there is some level of convergence, a separate treatment may apply for MIFIDPRU investment firms, should the proposed changes put forward by the PRA be implemented in the near future.
  

What this means for MIFIDPRU investment firms

The difference in approaches means that MIFIDPRU investment firms may be subject - whether as an interim period or in the longer run - to a different prudential market risk framework than that applicable to PRA-regulated firms, compared to the current convergence in the standards. The 1st of July 2025, which is the expected implementation of FRTB, is a key date when the regimes will diverge.

It remains unclear as to whether there will be alignment or divergence between the regimes. The FCA has previously communicated that it would have regard to changes to the CRR regime when reviewing its rules on calculating market risk^[4]. Therefore, the FCA may choose to update the market risk requirements applicable under IFPR at a future date. However, the FCA may also choose to remove the link between K-NPR in MiFIDPRU and the UK CRR altogether^[5], which could result in further divergence between PRA-regulated and FCA-regulated firms.

There may be a rationale for standards to diverge in some cases (this is indeed also one of the purposes of the IFPR, to introduce greater proportionality); however, this needs to be carefully considered and articulated. The current upcoming divergence, as it stands, appears to be more a byproduct of difference in regulatory timing rather than strictly by design.

We recommend that MIFIDPRU investment firms with a material K-NPR component as part of their k-factor requirements do the following:

• Make an assessment of the proposed changes that will apply to PRA-regulated firms, both final FRTB rules as part of the Basel 3.1 reforms and other components which remain at the consultation or discussion stages (such as Consultation Paper 17/23).
• Make a detailed assessment of the impact of the divergence on their K-NPR and what this means for their overall competitiveness (compared to PRA-regulated firms) based on their current product offering. The examples we listed are not an exhaustive list and the impact will be different depending on each firm’s risk profile and size and scale of their trading book activities.

Therefore, investment firms with a material K-NPR component should be proactive in their assessment of the upcoming divergence to understand the impact on their competitiveness (compared with PRA-regulated banks) and their broader product offering and trading strategy.