How the EU capital adequacy regime will apply to those with DIM permissions

  • Describe the importance of new EU capital adequacy requirements
  • Identify how it will apply
  • Explain how it will work going forwards, post-Brexit
How the EU capital adequacy regime will apply to those with DIM permissions

The changes to the capital requirements for UK Discretionary Investment Managers can be traced back to a number of initiatives undertaken by the EU.

Even though the UK has left the EU, it is almost certain that new prudential regime will be adopted in its entirety for one good reason; UK financial services are a key exporter to the EU and therefore to continue this valuable trade it will be important to have commonality to ensure it continues with minimum disruption.

Before we go further, it is necessary to consider where we are now.

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 1 January 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 they 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.

It will also put more stringent reporting and testing responsibilities in place, and firms will require a robust process in order to ensure these new initiatives are met.

Most companies will move away from the existing CRD requirements to a new regime known as the Investment Firms Regulation (IFR) and Investment Firms Directive (IFD).

It is expected that this regime will take effect from 26 June 2021 with limited transitional provisions. The key points of the new regime are:

  • Larger investment firms will be treated as if they were credit institutions and will remain subject to the bank capital regime.
  • All other investment firms will be subject to a new harmonised EU regime.
  • Larger and interconnected firms will be subject to the new “K factor” approach for assessing capital adequacy requirements together with other rules relating to such matters as remuneration.
  • All investment firms will be subject to consolidated capital and other requirements, with limited waivers.

The EU was originally concerned that a large number of asset managers and advisory firms were subject to initial capital requirements under the Capital Requirements Directive, but were supervised via national regimes.

In the case of the UK, these were the BIPRU and IPRU(inv) regimes operated by the FCA. The scope of the new regime is to harmonise the prudential and supervisory requirements that apply to investment firms across the EU.

Of course, the new regime deals with EU regulated firms and, since Brexit, the UK is no longer part of the EU so, under a strict interpretation, firms here could not be affected depending on future negotiations. 

However, firms will still need to consider the impact of IFR and IFD because they could still be caught as a result of any transition period under the proposed EU withdrawal agreement.  

In addition, it is highly likely the UK will choose to implement virtually all of the IFR and IFD requirements in order to address any deficiencies in the current regime.