Investment firms regulated by the Markets in Financial Instruments Directive (MiFID) are subject to capital requirements under the Capital Requirements Directive (CRD IV) and Capital Requirements Regulation (CRR).
The framework adopted by both the directive and the regulation, collectively known as the CRD IV package, presents a single set of prudential rules establishing capital adequacy requirements with the aim of ensuring “solvency of financial institutions and the reduction of systemic risk of failure of financial institutions”.
The above-mentioned rules capture credit institutions and investment firms under one and the same regulatory framework, and consequently, MiFID investment firms are subject to the same capital adequacy requirements (derived from Basel standards) that apply to EU credit institutions, including banks.
Definition of investment firms
The CRR determines the exact applicability of the regulation to investment firms by referring to the definition given in MiFID. The sole provision of investment advice or reception and transmission of orders without holding clients’ money and assets, excludes a firm from falling within the ambit of the definition of investment firms. Credit institutions and local firms are also excluded from the definition. Within the Maltese regulatory context, firms that are exempt from the provisions of the CRR comprise Category 1 Investment Services licence holders.
The prudential capital requirements
The mitigation of risk of harm to stakeholders has been the driving force behind the establishment of standard prudential requirements, thereby promoting the responsible management of various business risks by firms.
Such requirements for credit institutions and investment firms are divided into two separate categories: the initial capital requirements and the own funds requirement, related to solvency, liquidity and large exposures.
The role of the Fit and Proper Test surely cannot be devalued; satisfying the three categories of the test cumulatively is crucial for any prospective licence holder to be granted an investment services licence by the MFSA.
Solvency is one out of the three criteria comprising the fit and proper test, and which must be fulfilled on a continuing basis. The latter criterion is aimed at ensuring that the applicant has proper control and management of its liquidity and capital while also having sufficient financial resources to meet the minimum regulatory capital.
For the purposes of meeting the minimum regulatory capital, and hence satisfying the solvency test, an applicant is to hold a certain amount of initial capital, which constitutes the Capital Resources Requirement of an investment firm.
The specific amount of initial capital varies according to the category of investment services licence the applicant is seeking to obtain. A clear pattern emerges, whereby the initial capital required by licence holders becomes more onerous as the activities of the licence become more extensive. Naturally, this reflects the principle that more capital is required to cater for greater risks incurred.
Firms that seek to receive and transmit orders in relation to one or more instruments provide investment advice and place instruments without a firm commitment basis, but which do not intend to hold or control clients’ money or customers’ assets, require a Category 1a licence. The amount of initial capital required by such firms depends on whether a firm is registered under the Insurance Meditation Directive, in which case it would require €25,000. If not registered under this directive it would require €50,000 as initial capital.
Firms that seek to receive, transmit and/or provide investment advice and to place instruments without a firm commitment basis solely for non-private customers, but which do not intend to hold or control clients’ money or customer assets, will require a Category 1b licence. If the firm is not registered under the Insurance Mediation Directive, the initial capital required would either be €50,000 without Professional Indemnity Insurance (PII) or €20,000 with PII. If a firm is registered under the aforementioned directive, its initial capital is limited to €25,000.
MiFID firms and fund managers require a Category 2 licence, and an initial capital of €125,000. This licence is required by firms seeking to provide any investment service and to hold or control clients’ money or customers’ assets, but not by firms seeking to operate a multilateral trading facility, deal for their own account or underwrite or place instruments on a firm commitment basis.
A Category 3 licence allows firms to provide any investment service and to hold and control clients’ money or customer assets. To attain this licence, €730,000 is needed as initial capital.
A Category 4a licence is required by firms seeking to act as trustees or custodians of collective investment schemes, and firms requiring this licence will need €730,000 as initial capital.
A Category 4b licence, on the other hand, allows licence holders to act as custodians of AIFs or PIFs which have no redemption rights exercisable during a five-year period and to act as custodians to AIFs marketed in Malta. €125,000 is required as initial capital.
For Category 1a, 1b, and 4b licence holders, the Capital Resources Requirement will be the higher of the initial capital and the fixed overheads requirement.
The Capital Resources Requirement applicable to Category 2 licence holders which qualify as fund managers, will be the higher of the sum of the initial capital of €125,000 and an additional amount of own funds equivalent to 0.02 per cent of the amount by which the value of the portfolios under management exceed €250,000,000 and the fixed overheads requirement.
Prospective Category 2 MiFID firms, Category 3 or Category 4a licence holders must satisfy a CET1 capital ratio of 4.5 per cent, Tier 1 capital ratio of six per cent and a total capital ratio of eight per cent.
Investment firms must be well-equipped to cater for situations in which they might incur a loss. More specifically, firms must have own funds in sufficient quantity for immediate use, enabling them to absorb losses and thus be in a position to cover capital requirements for instances of Credit Risk, Operational Risk as well as Market Risk.
Under the CRR, the own funds of an institution consist of the sum of its Tier 1 capital and Tier 2 capital.
Moreover, the CRR obliges investment firms to maintain the own funds requirement at least equal to or in excess of its capital resources requirement, throughout the firm’s entire business operations. The licence holder’s own funds may not fall below the amount of initial capital required at the time of its authorisation. Under the MFSA rules, the own funds constitute the financial resources requirement of an investment firm.
Capital requirements for MiFID Firms – Proposed reform
Through its Report on Investment Firms, the European Banking Authority criticises the current prudential framework and in turn proposes significant changes to the EU’s regulatory capital rules for MiFID investment firms. Owing to its overly complex nature, the prudential regime in place for MiFID firms has become excessively burdensome for non-bank investment firms. In this regard, the authority envisions a shift from the current framework, which is primarily designed for banks, to a system that is simpler, more proportionate, and which above all, addresses the specific risk profiles of investment firms, unlike the fixed initial capital requirements currently set out in the CRD IV regime.
The EBA outlines a three-tier approach aimed at determining the systemic significance of investment firms and the extent to which such firms absorb bank-related risks. The EBA’s three-tier approach categorises investment firms into bank-like (systematic) investment firms, non-systematic investment firms and small, non-interconnected firms.
MiFID firms, which are deemed systemic and which run bank-like, conducting large-scale intermediation and undertaking substantial underwriting activities, expose them significantly to credit risk, involving counterparty risk and market risk for positions taken on own account (irrespective of whether it is for the sake of external clients or not). The full set of CRD IV/CRR rules apply to such systemically important firms.
On the other hand, a less burdensome prudential regime is more appropriate to non-bank-like investment firms, enabling such firms to address the specific risks posed to investors and market participants with respect to investment business risks, such as credit, market, operational and liquidity risk.
However, a simpler regime would apply for small and non-interconnected firms. The basis of the regime would be focused mainly on fixed overheads and large exposure requirements with the objective of setting aside sufficient capital for ensuring safe and sound management of their risks.
This approach essentially necessitates the development of a separate and specific prudential regime for non-systemic and non-interconnected firms. The regime must be such as to address the risks associated with holding client money and securities.
Market participants have welcomed the EBA’s invitation to comment on its discussion paper issued on November 4. While there is general consensus on the need to implement a more adequate prudential system that addresses the specific risk requirements of investment firms, some participants still deem the EBA’s propositions as far too intricate to be applied on a practical level.
The allocation of investment firms according to their systemic activities, as a matter of fact, has not been favoured by certain participants who consider the number of actual systemic or bank-like firms as being highly marginal, particularly in light of the fact that investment firms, unlike banks, do not take deposits from clients. Also based on the latter, the fact that investment firms cannot take deposits necessitates more clarification of what the term ‘bank-like’ means.
The latter participants have alternatively proposed to classify investment firms in a more proportionate manner, allocating investment firms to different risk categories, namely complex, for investment firms carrying out bank-like activities, medium risk, for investment firms which should be in the scope of some prudential requirements above a basic requirement, and low risk, for any other MiFID firm that would not fall under the scope of the CRR or the scope of prudential consolidation. The low risk category would include MTFs and also OTFs.
On the other hand, some positive points in relation to the discussion paper were also mentioned. The discretion afforded to national regulators in defining certain thresholds (e.g. number, size and activity of investment firms) was well received by market participants, seeing that national markets vary greatly in the various jurisdictions of the EU. Having a minimum level of assessment criteria while allowing a margin of appreciation to regulators was deemed to be an appropriate compromise.
Nicholas Warren is a senior manager in the Financial Services Practice Group at Chetcuti Cauchi Advocates. Gabriella Chircop is a legal trainee in the Financial Services practice group at Chetcuti Cauchi Advocates.