Q. What will the new prudential regime mean for investment companies?
A. As it stands, companies that have permission to provide discretionary investment management services to clients must apply the Capital Requirements Directive when they calculate their capital adequacy requirements.
This is done through a process known as the internal capital adequacy assessment process.
The background to the Icaap is the CRD that fully came into force on January 1 2008.
It was this directive that imposed a legal requirement for all companies affected by the CRD (that is, Bipru companies) to put in place an Icaap.
The CRD regime is based on three ‘pillars’, and it is a requirement under pillar two that companies must, among other things, regularly assess the amount of internal capital they consider adequate to cover all of the risks to which you are exposed within the context of their overall risk management framework.
However, the EU has now finalised a new framework for investment companies that, when implemented, will affect how discretionary investment management companies calculate their capital adequacy.
Most companies will move away from the existing CRD requirements to a new regime known as the Investment Firms Regulation and Investment Firms Directive.
It is expected that this regime will take effect from June 26 2021.
IFR/IFD creates three categories of company. A business must apply a range of factors in order to determine which category applies.
Class one companies are described within the framework as systemic companies and are more likely to be dual-regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
However, class two or class three companies will fall within the non-systemic distinction, which is likely to apply to a company providing DIM services.
The main regulatory change will be an increase in the initial capital requirement and, for some companies, the introduction of a new methodology for calculating the ongoing risk-based capital requirement that applies to the business.
For example, it is expected that a company that is currently Bipru €50,000 (£46,200) limited licence firm will see their initial capital requirement increase to €75,000 from June 26 2021 onwards, subject to a potential transition period.
Initial capital will continue to represent the absolute minimum a company must hold to meet its capital requirements.
There will also be a new methodology for calculating the ongoing capital requirement, which will be known as the K-factor.
The K-factor will provide a quantitative indicator for specifically identified risks.
There will be three K-factor groups: risks to customers, risk to markets, and risk to companies. The formula for calculating a company’s fixed overhead requirement is expected to stay the same.
It is likely that regulators will continue to exercise existing powers of assessment, such as the Icaap, going forward, albeit with adjustments to the process.
Regulators will also continue to have the power to require companies to hold additional capital where required.