By Richard Moss, Global Product Manager, Capital, AxiomSL.
Even though investment firms have very different primary business models and risk profiles as opposed to lending institutions, to date, for regulatory purposes many have been considered credit institutions and accordingly report under the Basel-driven capital requirements regulation (CRR). The CRR approach is too broad to effectively account for the risks faced by both investment firms and credit institutions. The risks encountered by credit institutions stem from their lending and deposit-taking activities, making them vulnerable to market, credit, operational, and liquidity risks. Investment firms, on the other hand, generally do not have large loan portfolios and do not take deposits. So, their risks are mainly centered around the impact of their activities on customers and the market, and should they fail, their effect on overall financial stability is less adverse than in the case of credit institutions. The IFR regime, according to the broader Investment Firms Directive (IFD), seeks to create a regulation with requirements that are proportionate to the size of the firms expected to comply, based on designated categories. However, just as it may be surprising that kryptonite makes Superman weak, the IFR/IFD regime unexpectedly makes things more complicated.
Heroic Intentions, But Unintended Consequences
With the June 26, 2021 deadline looming, investment management firms operating in Europe must implement the IFR regime based on their designated category. In addition, all investment firms authorized under MiFID (Markets in Financial Instruments Directive) will be subject to IFR.
- Category 1 – applies to firms with investments totaling more than €30 billion in assets that will continue to report under CRR and will not be subject to IFR.
- Category 2 – applies to firms with investments totaling less than €15 billion in assets at the consolidated level, but because they meet certain threshold requirements defined by so-called K-factors, they will be subject to IFR.
- Category 3 – applies to firms considered less significant based on certain thresholds and although they will fall under the new IFR rules, they will have a reduced IFR reporting burden.
IFR reporting will include new data collection, categorization, capital calculations, and requirements, plus, reporting will be more frequent. An additional complexity is that both the requirements and the implementation timeline for the U.K. will be different from those in Europe. And the details for the UK version known as the prudential investment firms regime are still pending. Notably, the European Banking Authority (EBA) advice to the European Commission provided in 2017 regarding IFR legislation showed that UK firms represented 57% of the 5,700 investment firms in the European Union.
The well-intentioned IFR regime aims to rectify the shortcomings of a patchwork spectrum of regulation that includes CRR, common reporting framework (COREP) and others — but rather than simplifying the calculation and reporting requirements, firms are left with an even more complex capital and liquidity reporting process. These layers of complications may leave firms feeling like they need to call on Superman for help.
Even A Superhero Can’t Make This Fly Away
Firms will be facing a multi-faceted problem and the new calculations will alter their perspective on their capital holdings. In fact, the EBA estimates that based on the results of IFR reporting, capital requirements for investment firms overall are expected to increase by 10%. Complying with these new requirements transparently and efficiently could feel like a kryptonite trap as firms deal with how best to address the new regulation quickly and efficiently. Problems requiring some superhero muscle include:
- Collecting more data from across disparate sources
- Accessing often difficult to obtain operational data
- Addressing more complex calculations and operating IFR in parallel with existing CRR reporting — including standardized approach (SA) and capital floor thresholds
- Reporting using XBRL format, and IFR and COREP templates Achieving transparent reconciliation results
Firms need to avoid encounters with kryptonite and be prepared with more data, more granularity, and more transparency.
It’s A Bird, It’s A Plane…No, It’s The K-Factors
As mentioned previously, IFR states that smaller investment firms will no longer be classified as credit institutions falling under CRR but will now be grouped as either category 2 or 3 institutions. Categorizations will be based on the aforementioned K-factors, which are quantitative indicators reflecting the risks that IFR aims to address. For example, category 2 firms must calculate capital based on the K-factor formula and, among other things, IFR places a greater emphasis on fixed overhead. Category 3 firms will not be required to calculate their capital requirement based on the K-factor formula, but they will need to calculate the K-factors for categorization purposes.
Like Lex Luthor, Parallel Reporting Lurks
The K-factor methodology is the most significant change to the IFR regime and may cause the most distress for organizations given its complexity. Full IFR implementation is not just a one-off because investment firms must continuously monitor their eligibility thresholds and provide evidence of such to regulators. Even a single transaction could lead to a category change and investment firms that fall into category 2 may be those most in danger of a villainous encounter with parallel reporting. If they fall into this category, they will be subject to the full IFR regime, and for the next five years must report both CRR and IFR. Furthermore, category 2 firms will need to calculate their capital requirements using a formula comprised of K-factors, which are divided into three risk groups: customers, market, and liquidity, and firmwide.
As an example of the methodology’s complexity, K-factors including NPR, K-TCD and K-con focus on different areas of risk — market, credit, and large exposure respectively — all of which must be taken into consideration. There is significant overlap between the principles of these K-factors and CRR, but they are not identical. For instance, the K-TCD shares components with existing SA-CCR calculations, but the IFR version may include other credit risk factors such as credit valuation adjustment (CVA). If that occurs, then in addition to needing more data, firms must report for both IFR and the COREP-related CVA calculations already required. For those with entities across Europe, this will mean cross-jurisdictional impact — including an additional of possibility of double reporting.
IFR Regime Reaches Across Metropolises, Adding Risks To Consider
To be ready for the June 2021 deadline and the effect IFR will have on a firm’s capital requirements in all of their operating jurisdictions, global financial institutions must focus on getting their organizations ready now. As they prepare, risk managers are highly aware of the need to mitigate IFR compliance risks related to operational efficiency, capital and liquidity calculation accuracy, and regulatory and internal scrutiny. Risk mitigation requires immediate action; attempting to incorporate new IFR changes and regulatory differences across jurisdictions using spreadsheets and manual, siloed processes is not sustainable, scalable, or efficient.
Faster Than A Speeding Bullet: Superman Adapts Quickly To Change
IFR will be initiated under a five-year transition period beginning in 2021. Accordingly, it is expected that the regulator will provide ongoing updates to requirements, categorizations, and data needs over the transition period. As the regulation evolves, investments firms will need to monitor changes and adapt quickly. Although this may not be a task requiring superhuman abilities, preparing for IFR and any ongoing changes still presents formidable challenges, including:
Firms can go from Clark Kent to Superman by implementing IFR quickly, and then powerfully continue to manage the regime within a holistic, data-driven ecosystem that addresses risk management, data governance and calculation changes.