Few investment firms are fully prepared for the impact of the Capital Requirements Directive (CRD). In fact, where resource is a constraint, many are unlikely to have even read the consultation document. In this article, we address some of the key considerations for firms in this position.
The consultation period for ‘Strengthening Capital Standards 2’ (CP06/3) ended on 28 April 2006 giving interested parties little time to digest and assess the impact of over 1,300 pages of consultation and draft rules. With the feedback statement due in July and the finalised handbook rules and guidance in October, what should investment firms be doing to prepare?
Scope
Only investment firms subject to the Markets in Financial Instruments Directive (MiFID) must meet the requirements of the CRD (the re-cast Capital Adequacy Directive). The Financial Services Authority’s (FSA) consultation paper ‘Organisational systems and controls’ (CP06/9), Annex 5: Perimeter Guidance (MiFID and the Recast CAD Scope) Instrument 2006, provides useful information for firms making this assessment ( http://www.fsa.gov.uk/pubs/cp/cp06_09.pd).
Categorisation
The next step for CAD investment firms is to establish their base capital. The table below summarises in high-level terms how existing CAD firms will be categorised under the recast CAD. However, you will need to consider whether changes in MiFID compared to the Investment Services Directive impact on your base capital consideration.
Firms must then ascertain whether they are a limited licence, limited activity or fullscope BIPRU investment firm. Although the consultation provides some guidance in this area, a detailed chart of which permissions need to be limited or restricted in order to meet the FSA’s requirements has not been produced. The FSA’s consultation paper ‘Organisational systems and controls’ (CP06/9), Annex 5: Perimeter Guidance (MiFID and the Recast CAD Scope) Instrument 2006 again provides a decision tree which goes part of the way there http://www.fsa.gov.uk/pubs/international/draft_guidance.pdf).
Impact on capital resources Requirement
Investment firms will calculate their capital requirements in line with the following.
Limited licence investment firms apply the higher of:
- base capital resources (50k or 125k)
- credit risk (CR) + market risk (MR), or
- fixed overheads requirement (FOR).
Limited activity investment firms apply the higher of:
- base capital resources (730k), or
- the sum of CR + MR + FOR.
Full-scope investment firms apply the higher of:
- base capital resources (730k), or
- the sum of CR + MR + operational risk capital requirement (ORCR).
Timing and transitional provisions
The CRD will come into force on 1 January 2007, but the transitional arrangements will be effective until 1 January 2008. This will allow firms to delay applying certain aspects of the new requirements.
It is likely that many investment firms will decide to delay the transition to the new CR rules and, as a consequence, will also delay implementing the new pillar 2 (individual capital adequacy) and pillar 3 (rules of disclosure) requirements.
Regardless of these transitional provisions, the following elements of the new regime will apply from 1 January 2007:
- capital definition, FOR and new base capital requirements
- a new consolidation regime for groups
- trading book definition and updated Position Risk Requirement (PRR) and PRR for foreign exchange risk
- systems and controls requirements which are currently being consulted on in CP06/09.
However, firms cannot afford to delay in considering the impact as firstly the changes may affect the level of capital they hold and secondly, certain waiver applications will need to be made well in advance of 1 January 2007.
Firms should therefore undertake the following practical steps before 1 January 2007.
- A review of their capital to ensure that the new definition can be met.
- Applications for varying permissions to ensure correct categorisation.
- Application for a ‘CAD waiver’ where investment groups can meet the exemption criteria.
Looking ahead
As we approach 2007 the CRD is only one element of a significantly changing regulatory environment. Smith & Williamson can help your firm prepare for these changes so that when they come into force, there is minimal disruption to your business.
Key definitions
CR – The CRD introduces advanced methods for calculating credit risk. However, for small, limited licence and limited activity firms the FSA has created a simplified version of the standardised approach and, in reality, most of these firms will continue to apply the IPRU (INV) 9 Chapter 10 and 5 rules through 2007 as allowed by the transitional rules (see below). Firms should however also note changes to the calculations of counterparty credit risk in chapter 13 of the BIPRU.
FOR – This replaces the expenditure base requirement and will apply from 1 January 2007.
ORCR – Firms can adopt one of three methodologies: the basic indicator approach, the standardised approach or the advanced measurement approaches. The adopted approach will largely depend on the size, nature, scale and complexity of the firm. The CRD also allows for national discretion to exempt some investment firms until December 2011. The FSA has specified certain conditions under which this exemption may be applied.
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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