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What does the prudential framework mean for Exempt-CAD firms?

Amongst those firms likely to be hit hardest are Exempt-CAD firms, which typically only provide investment advice or arrange deals. This category will not exist in the new framework and these firms will need to assess where they will fit in the regime.

Under the current Exempt-CAD requirements, prudential compliance is a relatively simple process. Firms hold capital in excess of a fixed minimum amount and submit reports to the FCA on a periodic basis.

However, under the new framework, the amount of capital they will be required to hold will rise by at least 50% and, in many cases, by significantly more. In addition, the time to ensure compliance with more complex and onerous capital, liquidity, reporting and governance requirements is sure to create a need for additional resources.

Why is this change happening?
Most investment firms are currently governed by the prudential capital framework for banking, as set out by the Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR).

This framework is ill-suited to most investment firms and regulators have long wanted to apply more appropriate arrangements for calculating regulatory capital in the sector. Progress on finalising new prudential capital rules for investment firms will likely be relatively swift.


When will this change happen?
Having proposed the new directive and regulation in December 2017, the European Commission can publish the final versions once they have fully passed through the EU’s normal law-making process. This is expected to come to fruition in 2019, so we expect that firms will have to be compliant with the regime at some point in 2020. Precisely when remains unclear at this point.

So, what’s an Exempt-CAD firm to do?
To date, Exempt-CAD firms operated outside the CRD/CRR framework. The new regime will mean increased capital requirements and governance burdens. As a first step, firms should explore the proposals to see which category they will fall under. In particular, Exempt-CAD firms will need to:

  • Boost capital

The new minimum, formula-based, requirements will force most Exempt-CAD firms to increase the amount of capital they hold by a significant amount:
- The initial capital requirement (ICR) of €50,000 will increase to €75,000;

- Firms will also have to contend with a Fixed Overheads Requirement (FOR) for the first time; equivalent to a quarter of annual expenditure. Larger firms may face additional “K-factor” capital requirements, calculated with reference to the type and volume of business they conduct.

Every Exempt-CAD firm needs to plan for the increase in capital that will be required to continue doing business after the framework comes into force.

  • Implement internal risk-based assessment

Firms will need to carry out an assessment of their capital requirements specific to the risks that they are exposed to. This means something akin to the Internal Capital Adequacy Assessment Process (ICAAP) and the Supervisory Review and Evaluation Process (SREP) frameworks apply for the first time for Exempt-CAD firms and would require a considerable amount of work.

The application of this “Pillar 2” regime could also give rise to the need to hold even more capital – depending on the outcome of the firm’s own assessment work as well as any regulatory review under a SREP.

  • Hold liquidity resources

Exempt-CAD firms will need to implement internal policies and procedures that allow them to monitor, measure and manage liquidity and liquidity resources. Firms will have to hold one-third of their FOR as liquidity, as a base-line requirement. Larger firms will have to implement additional liquidity calculations
and potentially will need to hold higher levels of liquidity.

The new prudential requirements create both risk and opportunity for firms. Firms need to ensure their business strategies can support the additional investment in people and resources that are necessary to fulfil the enhanced obligations applicable to them. For a small number of firms operating at the margin today, the answer may be that they cannot support the additional costs and capital needs with their current
business model.

For others, this will represent a potential business opportunity. The categorisation changes could provoke a strategic shift. Firms could decide to enter into new types of business previously avoided because of the consequential increase in regulatory requirements. Under the new regime, firms would already be fulfilling the same requirements for prudential capital so can try out a fuller scope of activity.

In short, Exempt-CAD firms face a sea change in the prudential requirements that they operate within. These rules have the capacity for substantial positive and negative consequences. What is clear is that firms should begin to review how the required increase in capital will impact their operations as soon as possible.

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