UK: What does the Capital Requirements Directive Mean for Stockbrokers and Other Investment Firms? - Securities and Banking Update May 2005

Last Updated: 27 May 2005
Article by Eric Wooding

Most Read Contributor in UK, August 2017

The first question is "Is your firm caught in the Capital Requirements Directive (CRD) net?" The second is "What are the consequences if your firm is caught?" These questions are particularly difficult for investment firms owing to the complexity of the draft CRD and the fact that the FSA’s consultation paper does not provide an overall discussion of the issues for investment firms. In this article, Eric Wooding aims to help you get to grips with the issues.

Although the Basel Committee fashioned Basel II mainly with internationally active banks in mind, the EU Commission, following its policy of a level playing field in the financial services arena, has chosen to apply the new requirements much more widely. Thus in the European Economic Area, the CRD will apply to "credit institutions" (in the UK to banks and building societies but not credit unions) and to all investment firms "as defined".

In general terms, "as defined" means as defined in the Markets in Financial Instruments Directive (MiFID) as implemented in the UK but excluding firms which are only authorised to give investment advice and/or receive and transmit orders from investors without holding client money or securities. However, the Treasury and the FSA have yet to issue proposals regarding how the various mandatory and optional exemptions contained in the MiFID are to be implemented in the UK. So the precise scope of application of the CRD to investment firms in the UK is not yet clear.

However, the FSA has set out draft rules for determining which investment firms are within that scope in Section 1.1 of the draft Prudential sourcebook for banks, building societies and investment firms (BIPRU), which was published with CP05/3 "Strengthening capital standards". So firms should use these draft rules to make a provisional assessment of whether they are inside or outside the scope of the CRD and then review this provisional assessment in the light of the Treasury and the FSA consultations on the UK implementation of the MiFID, which are expected later this year.

In summary, the draft rules in BIPRU 1.1 identify four types of investment firm that will fall within the scope of the CRD, namely own account dealers, matched principal brokers, broker/managers, and adviser/arrangers. The table opposite summarises the key features of each type of firm based on the FSA’s inevitably more complex definitions. Apart from a degree of uncertainty about whether or not the CRD applies to them, investment firms also face uncertainty about the consequences if they do fall into the net. There are several sources of this uncertainty, including:

  • the CRD has not been finalised and in particular is subject to review by the European Parliament;
  • although consultation papers on the Trading Book Review have recently been issued both at Basel and EU levels, the final recommendations have not yet been made. Consequently, the treatment of counterparty risk in the trading book, including the treatment of unsettled transactions, is not yet finalised;
  • the draft handbook text in CP05/3 is incomplete in several respects. Two omissions likely to be significant for investment firms are the absence of draft rules on the standardised approach to credit risk and on Pillar 3 (disclosure requirements);
  • despite the fact that the issues which most affect investment firms differ considerably from those which affect banks, particularly large banks, CP05/3 does not contain a section which focuses on how the proposals will affect investment firms. Given the length and complexity of CP05/3 and the accompanying draft handbook text, not to mention the indigestibility of the draft CRD itself, this undoubtedly makes the task of investment firms wishing to come to grips with the proposals more difficult.

Type of investment firm

Key features

Own account dealer

Has permission to deal in designated investments as principal but is not a matched principal broker

Matched principal broker

Has permission to deal in designated investments as principal but satisfies the following conditions:
(1) deals as principal only to fulfil customer orders;
(2) holds positions for its own account only as a result of failure to match customer orders precisely;
(3) the total market value of positions held for own account are not more than 15% of Core Tier 1 capital plus perpetual non-cumulative preference shares; (4) the positions held for own account are incidental and provisional in nature and limited to the time required to carry out the transaction.


Has permission to deal in designated investments as agent or to manage such investments but does not have permission to deal in them as principal.


Has permission to bring about or make arrangements with a view to transactions in designated investments or advise on such investments but does not have permission to deal in them as principal or agent or to manage them.

Nevertheless it is possible to identify some key potential consequences for those investment firms which are caught in the CRD net (which the FSA calls "BIPRU investment firms" i.e. investment firms subject to the Prudential Sourcebook for banks, building societies and investment firms). Without in any way claiming to be comprehensive or exhaustive, the remainder of this article sets out and discusses some of those potential consequences. The discussion is of course based on the current proposals (i.e. draft CRD, Trading Book Review consultation papers, and CP05/3). As already indicated, further changes to these proposals may occur.

1. Some BIPRU investment firms – broadly speaking those whose permissions allow them to deal on own account or underwrite – will be subject to a new capital requirement for operational risk which will replace the expenditure based requirement.

Firms will need to decide between three methods of calculating the operational risk requirement. For nearly all investment firms (all except international investment banks), the most risk sensitive approach – the Advanced Measurement Approach (AMA) – is wholly impractical. Hence in reality the choice is between the very crude Basic Indicator Approach (BIA) and the almost as crude Standardised Approach (TSA).

Under the BIA the requirement is calculated as 15% of total annual income (i.e. the sum of net interest income and net non-interest income), averaged over three years. Under TSA, the revenue of the business must be allocated to defined business lines and the firm’s total operational risk capital requirement is found by summing the requirements for each relevant business line, calculated as a percentage of the business line’s annual income averaged over three years

For firms with little or no retail brokerage or asset management business, there is evidently little incentive to go beyond the simplest approach, the BIA. Firms carrying on asset management and/or retail brokerage business may secure a reduced operational risk capital requirement under TSA but need to weigh this advantage against the costs involved in meeting the additional systems and control requirements necessary to qualify for TSA and the work involved in allocating the firm’s business lines into the categories prescribed by the directive.

Whichever method they use to calculate the operational risk requirement, firms will also need to estimate the difference between that requirement and the expenditure based requirement to which they are subject now. Where there is a material increase (e.g. one which materially reduces the firm’s regulatory capital surplus and hence, in the case of a rated firm, potentially affects the firm’s credit rating), management may need to consider boosting the capital base. However, in practice the change in capital requirement may be neutral or slightly positive for some entities, depending on the level of ongoing operating costs in the business.

Firms which belong to an investment firm or banking group will of course need to consider the consolidated position. It is important to note that where a group contains just one BIPRU investment firm that is subject to the operational risk charge at the level of the individual firm, or a bank, the CRD appears to require the FSA (or other EEA consolidated supervisor) to apply the operational risk charge on a consolidated basis. This is so even if most of the group’s investment business is carried out by firms that at an individual company level are exempt from the operational risk requirement.

2. BIPRU investment firms which are "limited licence" or "limited activity" firms will be exempt from the operational risk requirement. They will instead be subject to the fixed overhead requirement (FOR), which is a modified version of the current expenditure based requirement.

"Limited licence" firms are, in brief, investment firms that fall within the scope of the CRD but either do not have permission to deal as principal at all or else the permission is so restricted they may not deal on own account or underwrite. The essential limitation on a "limited licence firm" is therefore that it may not deal on own account or underwrite.

"Limited activity" firms are somewhat less restricted than limited licence firms in that they may deal on own account to some extent. However either that own account dealing must be for restricted purposes (to fulfil client orders or for the purpose of gaining access to an exchange or clearing/settlement system for the purpose of executing a client order) or the firm must have no external customers, hold no client money/assets and satisfy certain other conditions.

The FSA believes that the FOR will result in lower capital requirements for many limited licence/activity firms. It gives three reasons for this view: (1) its new definition of fixed overheads will reduce the amount of capital firms have to hold where they have "other variable overheads"; (2) some firms – in particular securities and futures firms that are limited licence or limited activity – will have lower capital requirements because the definition of fixed overheads excludes shared commissions payable to employees which are directly related to commission income include in total revenue and (3) the total capital requirement for limited licence firms (not limited activity firms) is the higher of the (market and credit) risk-based requirements and the FOR, not the sum of them.

Given the potential reduction in capital requirements as a result of meeting the definition of limited licence/activity, firms that find they currently do not satisfy the definition may wish to consider whether this is because of permissions which they do not actually use.

While classification as limited licence/activity is potentially beneficial at the individual firm level, as noted earlier this potential benefit is really of scant significance where a limited licence/activity firm belong to an investment firm group that contains a BIPRU investment firm that is not limited. For then the operational risk capital requirement would appear to apply at the consolidated level. This is also true where a limited licence/activity firm belongs to a group which contains a bank or building society.

Lastly, there are some investment firms (e.g. name passing brokers in some wholesale markets) whose current expenditure requirement is based on 6 weeks expenditure. If such firms fall within the "limited licence" category they are likely to suffer an increase in their capital requirement since the FOR is based on 13 weeks expenditure.

3. BIPRU investment firms will be subject to potentially heavier counterparty risk capital charges for DvP transactions which remain unsettled 5 or more days after settlement date. Potentially heavier counterparty risk capital charges may also apply to unsettled non-DvP transactions.

Taking DvP transactions first, a key proposal is to require any positive current exposure (i.e. based on the movement in market price since the trade was done) to be deducted from capital (i.e. a 100% capital charge) if the transaction remains unsettled 5 or more business days after settlement date. As readers will be aware, the FSA’s current rules for cash against documents transactions by securities and futures firms that are investment firms impose lower charges for transactions unsettled for between 5 and 45 business days after settlement day (8% for the 5-15 days bucket, 50% for 16-30 days and 75% for 31-45 days) and require a 100% charge only from 46 days onwards.

In addition, a potentially more onerous treatment is proposed for DvP transactions with a long settlement lag (i.e. settlement day more than 5 business days after trade day) for the period from trade day up to 4 days after settlement day i.e. during this period they will no longer automatically incur no capital charge but rather will be treated as forwards.

Turning now to non-DvP transactions, a key proposal is to require the value transferred by the firm plus any current exposure to be deducted from capital if the counterparty has not made payment/delivery two or more business days after the due date. This is considerably more onerous than the current Chapter 10 rules for free deliveries.

4. All BIPRU investment firms (i.e. including limited licence/activity firms) will be required to develop and maintain an Internal Capital Adequacy Assessment Process ("ICAAP") which the FSA supervisors will review and evaluate as part of their Supervisory Review and Evaluation Process. The FSA proposes to issue Individual Capital Guidance ("ICG") to firms "backed up by other regulatory measures as necessary".

This may be viewed as an extended version of the "secondary requirement" which FSA may currently apply to Chapter 10 securities and futures firms. It remains to be seen whether most BIPRU investment firms will be subject to ICG that imposes capital requirements above the absolute minimum required by the CRD. This is of course already the norm in the banking world where the FSA prescribes a minimum capital ratio in excess of 8% for most banks. Although the draft Handbook text published with CP 05/3 contains some useful guidance regarding the ICAAP for "simple" and "moderately complex" firms and also for different types of BIPRU investment firm (securities firms and asset managers), and the CP stresses that the FSA will be proportionate in its approach, many firms will be unclear what is really to be expected of them. Such firms will naturally wish to discuss the matter with their supervisor, if they have one. Where an investment firm does not have an assigned supervisor, it is currently far from clear how the SREP/ICG process will work.

5. Subject to certain exemptions, the FSA will require BIPRU investment firms to make annual public disclosures regarding the structure and adequacy of their capital, the risks to which they are subject and how they are managed.

The requirement applies at the level of the EEA group, although the FSA says that it may disapply the requirement where a firm with a third country parent is able to prove that comparable disclosures are made on a consolidated basis by that parent. For BIPRU investment firms that belong to listed groups, the new requirement may be regarded as evolutionary i.e. an extension of the requirements of FRS 13. For unlisted firms, the requirements represent a much more significant increase in current disclosure requirements.

Draft Handbook text on this aspect of the new regime is not included in CP 05/3 but will be included in the consultation paper to be issued later this year once the CRD is finalised. One reason for this is that the FSA wishes to wait until proposed revisions to accounting standards (both ED 7 (IASB) and FRED 33 (ASB)) regarding financial instruments disclosure are completed. The extent to which the CRD disclosure requirements overlap with the requirements of accounting standards is important since those requirements which duplicate requirements of accounting standards will of course have to be audited whereas the FSA, applying a light touch on Pillar 3, does not propose that disclosures that derive only from the CRD (i.e. are not required by accounting standards) should be audited.

When must you be ready?

Based on the FSA’s current proposals, on 1 January 2007 firms on the standardised approach to credit risk (which will be nearly all BIPRU investment firms) must choose between starting to calculate their minimum capital requirements in accordance with the new requirements and continuing to use the current approach until 1 January 2008. In addition, the ICAAP and public disclosure requirements will come into effect from 1 January 2007. So not long to go.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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