Perspective 2 | What does this categorization of firms mean for me?


Perspective 2 | What does this categorization of firms mean for me?

An article series with five different perspectives

IFD/IFR distinguishes four classes of investment firms. A different class has different regulatory implications for a firm. This article discusses the different classes and how this affects you as a firm.

What does this categorization of firms mean for me?

This is the second article in our series on the impact of the Investment Firm Directive (IFD) and the Investment Firm Regulation (IFR). In our previous article , we briefly touched upon the classification of firms under IFD/IFR. In this article, we will explore the impact of classification in further detail.

Where does my firm fit?

IFD/IFR distinguishes three new classes of investment firms, with class one divided into two subclasses where a distinction is made between ‘systemic’ and ‘non-systemic’ firms. The largest class, class 1A firms, have €30B or more in consolidated assets, trade on own account, and/or perform underwriting of financial instruments . These systemic firms are obliged to obtain a banking license under IFD/IFR. These firms therefore remain subject to CRD IV/CRR (ECB supervision) and may offer “...all of the services of a credit institution firm.
If an investment firm has €15B or more in consolidated assets, trades on own account and/or performs underwriting it is not obliged to apply for a banking license, but remains subject to the CRD IV/CRR regime. These firms are known as class 1B firms.
There are currently two (out of 225) investment firms domiciled in the Netherlands that fall in class 1A and therefore have to comply with the CRD IV/CRR .
Please note that an investment firm with consolidated assets of €5B or more that trade on own account and/or perform underwriting services may be required to comply with CRD IV/CRR at the supervisors’ discretion. Investment firms themselves can also request the regulator to apply the CRD IV/CRR if this is deemed more appropriate for the risk profile of the firm (e.g. members of a banking group).

Non-systemic firms, firms that have less than €15B in consolidated assets or do not trade on own account or perform underwriting services , fall under the IFD/IFR requirements, rather than the CRD IV/CRR ones. By default, these are class 2 firms, and subject to all provisions under IFD/IFR. There are several exemptions for small and non-interconnected firms, also known as class 3 firms.
The Dutch regulator has proposed to apply the IFD/IFR requirements equally to managers of Alternative Investment Funds (AIFMs) and managers of Undertakings for Collective Investment in Transferable Securities (UCITS) Funds where they perform investment services and/or activities .

What’s the difference between class 2 and 3?

Although firms from both class 2 and 3 are subject to the IFD/IFR regime, there are differences and exemptions. In the following paragraphs, the differences between class 2 and 3 are discussed.

Capital requirements

Investment firms are required to hold capital to cover the risks incurred in their operation, such as market risk, credit risk and operational risk. Part of this capital requirement is the own funds requirement. In order to determine the own funds requirement, class 2 firms are required to use the highest of the following capital requirements:

  • The highest permanent minimum capital requirement for each of the services the firm provides
  • One quarter of the fixed overheads of the preceding year
  • The K-factor requirement

    Class 3 firms do not use the K-factor requirement to determine the pillar 1 capital requirements, but instead only use the higher of the permanent minimum or the fixed overhead capital requirements.

Class 3 firms will still need to calculate their K-factors in order to determine in which class they fall. If a parent firm meets the requirements for being classified as a class 3 firm on a consolidated basis, the consolidated capital requirements are still the higher of the permanent minimum or the consolidated fixed overhead capital requirements .
Class 2 firms are required to continuously monitor the level and composition of their capital and to ensure they hold sufficient capital to cover the risks to which the firm is exposed . This is reminiscent of the Internal Capital Adequacy Assessment Process (ICAAP) under CRD IV/CRR . Class 3 firms are in principle exempt from the ICAAP, but the supervisor may request a firm to implement ICAAP when deemed necessary.

Liquidity requirements

Investment firms are required to hold at least one third of their fixed overhead requirement in liquid assets. This applies to both class 2 and class 3 firms, but the competent authority may exempt class 3 firms that meet certain requirements from this obligation. Furthermore, class 3 firms, and class 2 firms that do not deal on own account or perform underwriting services are allowed to count short term receivables, fees and commissions to partially meet the liquidity requirement . As with the level of capital, class 2 firms are required to monitor the level of liquidity. Class 3 firms may be included as deemed necessary by the competent authority. Again, the monitoring process requirements are reminiscent of the requirements for the Internal Liquidity Adequacy Assessment Process (ILAAP).

Governance requirements

The IFD level 1 text on internal governance requirements is very similar to the articles in the CRD IV level 1 text. The European Banking Authority (EBA) will issue more specific guidelines on IFD/IFR internal governance , and these may differ from the guidelines issued for firms subject to CRD IV/CRR. The draft implementing technical standards issued on June 4th by EBA as part of the consultation do not include any requirements on governance.
The IFD internal governance requirements generally only apply to class 2 firms. The requirements include that firms should have a clear organizational structure with well-defined lines of responsibility. In addition, effective processes should be in place to identify and manage the risks that investment firms might be exposed to or pose to others. Firms that have over €100M in on- and off-balance sheet assets are required to have a Risk committee consisting of non-executive members of the management body.
The requirements also include adequate internal control mechanisms and remuneration policies that are consistent with effective risk management .

Remuneration requirements

Both under IFD/IFR and CRD IV/CRR investment firms must have clearly documented remuneration policies proportionate to the size, internal organization and the scope and complexity of the activities of the firm. The firm’s management must periodically review the remuneration policy and has the responsibility to oversee its implementation. The policy should make a clear distinction between the criteria applied to the fixed and variable remuneration.
IFD/IFR places great emphasis on gender neutrality within remuneration, whereas this is not made explicit in CRD IV/CRR.
Those Investment firms whose value of on and off-balance sheet assets exceeds €100M are obliged to establish a remuneration committee. EU member states have some leeway to raise this threshold for investment firms that meet certain criteria . The remuneration committee is responsible for the preparation of decisions regarding remuneration and shall exercise its competent and independent judgement on remuneration policies and practices. The committee must be gender-balanced and comprised of individuals who are not in an executive role .
Class 3 investment firms are exempt from the IFD remuneration requirements.

Disclosure requirements

Reporting and disclosure obligations under IFD/IFR are reduced significantly compared to the CRD IV/CRR requirements. Disclosures on risk management objectives and policies, internal governance arrangements, the composition of own funds, and the approach to assessing capital adequacy all remain, as well as remuneration disclosures. Disclosures pertaining to the calculation of capital adequacy under CRD IV/CRR are replaced by disclosures pertaining to the calculation of capital adequacy under IFD/IFR.
In addition, IFD/IFR introduces new disclosure requirements regarding the voting behavior in general meetings of companies in which shares are held of firms awarding variable remuneration and requires biannual disclosures on environmental, social and governance risks for firms with assets greater than €100M.
Class 3 firms are exempt from the aforementioned disclosure requirements.

Regulatory reporting requirements

IFD/IFR requires investment firms to report quarterly to the relevant supervisor on the own fund requirements and calculations, the calculated K-factors, concentration risk, and liquidity requirements. Additional reporting is required for firms that deal on own account or perform underwriting services . These reports replace the reports to the relevant competent authority required under CRD IV/CRR.
Class 3 firms are not exempt from the regulatory reporting requirements; they may however submit the abovementioned reports annually rather than quarterly . However, class 3 firms are exempt from reporting on concentration risk. These firms are required to report on liquidity payments only if these requirements apply to them .

Supervisory review and evaluation process

As mentioned, the IFD/IFR will retain the ICAAP and Supervisory Review and Evaluation Process (SREP). The ICAAP and liquidity review processes are performed by the firm to ensure it has proper levels of capital and liquidity . The firm’s processes need to be appropriate and proportionate to the nature, scale and complexity of the activities. The supervisor executes the SREP and assesses if the firm complies with the IFD/IFR and if the firm takes into account all the risks to which it is exposed .
The obligation to maintain adequate capital and liquidity assessment arrangements that applies to class 2 firms will not automatically apply to class 3 firms. Supervisors may determine on a case-by-case basis the extent to which the SREP is applicable to class 3 firms and how it is carried out with regard to the size, nature, scale and complexity of the activities of those firms.

Classification matters

The IFD/IFR classification of investment firms raises some fundamental questions related to the business model of investment firms.
Investment firms in class 3 have several high impact exemptions from the IFD/IFR regulatory requirements. Class 2 firms that are close to meeting the requirements for class 3 may choose to reevaluate their business model to classify as a small and non-interconnected firm. By divesting or reducing specific services the firms may increase profitability by lowering operational and capital costs.
Conversely, increased capital obligations and operational costs to meet regulatory requirements once a firm moves from class 3 to class 2 may change the optimal growth strategy for a class 3 firm .

So what’s next?

On June 2nd, 2020, the EBA published a roadmap for the implementation of the new prudential regime for investment firms. The roadmap outlines the EBA’s work plan for the mandates described in IFD/IFR and clarifies the sequencing and rational behind their prioritization.

Deloitte will follow these developments closely and keep you posted.

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